Gold Miners Leveraged to the Gold Price

The Eurozone can't be far away from quantitative easing which should act as a further tailwind for the gold price and some new statistics that I uncovered when looking through a recent report from the World Gold Council has impacted my thinking - see the 'Demand by Category' table below.

As subscribers may recall, I have used the phrase 'Two out of three ain't bad' to describe my current view on gold - that there are two positives and one negative, and the negative being that the current gold price is already well ahead of the price justified by inflation. Now I think it could be a case of three positives to one negative but of course that wrecks up my neat 'MeatLoaf-like' title. Life is just not fair.

But on a serious note, I enclose an update on the gold theme with more emphasis on the gold miners - a short version for those subscribers pressed for time at weekends and a longer version for those who have more time. Any subscriber who would like to revisit the more detailed notes on the Gold Theme can use the 'Knowledge Base Search' facility at the top RHS at the Home Page (when logged in) to search through previous weekly comments. In addition, there are two longer articles from 2009 in the 'Featured Articles' section which is also situated at the RHS of the Home Page. The remain very relevant.

Subscribers should note that I don't believe that the Gold & Gold Miners theme fits the 'Value' approach to investing that characterises this website. The theme is covered, then, as an exception to the rule on the basis that it is THE THEME of our times and I find it an exciting theme. Each subscriber must then decide for themselves whether to incorporate the theme into their own investment portfolio.

Gold & Gold Miners - The Short Version

There are four reasons for suggesting that the gold price will break into new high ground sooner or later and that the gold miners are due an explosive run. I also suggested this a few weeks ago, without the enclosed facts, and, while I may also be early this time, I nonetheless feel it is remains a strong possibility for a number of reasons;

1. As most investors have come to realise in the 2000s, the supply of gold cannot be increased at will (debased) making it the only currency that acts as a true store of wealth.
    
2. Whatever the outcome in Europe, currency devaluations are with us, money printing will continue and interest rates after inflation (referred to as Real Interest Rates), which are a crucial factor in the cost of holding gold, should stay below zero for a considerable period. Quite simply, the developed world cannot afford higher interest rates given the level of debt at both the consumer and government level.
    
3. While gold is no longer a cheap asset when measured against recorded inflation (far from it in fact), there are none of the typical signs that the gold bull market is over;
   
   a. The signs of excessive investment demand for gold that were identifiable at the peak of the last great gold bull market in 1980 are not yet present, suggesting that investment-driven demand has not peaked. This, combined with finite supplies, suggests that demand from institutional and private investors and central banks will increase further in this cycle and push the gold price further up from here. 
   
   b. The gold price remains in a consistent uptrend and the recent setback is unlikely to be anything more than the unwinding of an over-bought condition. Indeed, few true bull markets end without an explosive rise in price at the end. In contrast, this current gold bull market has been steady and consistent and none of the signs of irrational investor behaviour are present.
   
    
4. Gold miners are highly leveraged to the gold price. For a number of reasons they have lagged the gold price in the past few years. A resolution to the Eurozone debt crisis could alter investors’ attitude to risk assets providing the much needed catalyst for the gold miners.

 
How to Participate
The major gold ETFs are GLD from State Street Global Advisors in the US and traded on the US markets and GBS from ETF Securities, the London-based commodities ETFs specialist, and traded on the London Stock Exchange. Van Eck, the US-based alternative asset ETF provider has listed two ETFs tracking gold miners. The first, the Market Vectors Gold Miners ETF (GDX), tracks a wide range of large, mid and small-sized gold mining stocks. The second, Market Vectors Junior Gold Miners ETF (GDXJ), provides exposure to less well established gold (and silver) mining and exploration companies. 

Gold & Gold Miners - The Longer Version

1. Gold is the only Currency that is not a Debt Instrument
Gold is the only currency that is not an I.O.U. from a government and, therefore, it is not a debt instrument. Gold is independent of the world’s monetary system and has been since time began. A reminder of gold’s remarkable physical attributes can help us understand why gold came to be a currency in the first place thousands of years ago.

Gold is the heaviest metal (highest density), it is virtually indestructible and its melting point is 1064 degrees Celsius. It is the most stretchable pure metal known to man - a single gram can be crafted into a sheet one metre squared, which is so thin that the sun can shine through. It does not oxidise (rust) in air or water, it has no taste in its purest form and it is an excellent conductor of electricity. Its physical beauty has seen it used as Jewellery for thousands of years. In addition, its robustness and dependability has seen it in increasing demand in many new complex industrial applications where price is less of a consideration. 

In geological terms, gold bearing rock is very rare and even when it is discovered an average tonne of gold ore yields only 6 grams of gold. That is six parts to a million. Its durability, rarity and divisibility make it valuable and tradable and allow significant wealth to be stored or transported with relative ease. It is easy to understand, therefore, how gold has been an accepted form of money for thousands of years.
 

2. The Current Cost of Holding Gold is Negative – Just Like in the 1970s
In a low to negative real interest rate environment, it costs investors little or nothing to hold gold – which is significant as gold yields no income. Of course, gold does not have to offer a yield as there is no debt behind gold and so there is no risk of the asset going bust. Unlike paper currencies, gold is an asset and not a liability. The chart above highlights the difference between the yield on the US 10-year bond and US inflation. As in the late 1970s, current real interest rates in the US, both short and long-term, are negative. This continues to provide a critical tailwind for the gold price.

3. Two Typical Signs of a Gold Bull Market End are Absent;

•  Investor demand rises strongly
• The gold price rise goes parabolic

Bull markets in gold are typified by a significant rise in investor demand. As the table shows, at the peak in the gold bull market in 1980, investment demand made up 47% of all demand in that year. Jewellery demand had fallen back to 38% (from over 70% in 1970) due to the higher prices.

By the end of 2000, after a 20-year bear market in gold, Jewellery demand was back at 80% of annual demand as investment demand slumped to 5%. By end 2010, Jewellery demand had fallen back substantially again and investment demand had risen substantially. But investment demand is not back to levels seen in 1980 suggesting that demand is unlikely to have been satiated yet.

In addition, we have not seen the typical price action that often signals an end to a bull market – an acceleration in the price trend towards the end. To date, the rise in the gold price has been steady and consistent as the chart opposite highlights. Since the set-back near the end of the global credit crisis in 2008, the gold price rise has consistently tracked its 30-week moving average deviating from the steady trend on only a few occasions. This suggests investor demand remains rational and not emotional.

There have been enough bull market blow-offs to show investors the price action that can prevail at the end of rampant bull markets. The chart below is very instructive in this regard. The gold bull market in the 1970s ended in January 1980 but not before the price accelerated some 50% in the last few months. The technology bull market, typified by the rise in the tech-laden Nasdaq Index, ended in March 2000 after a similar parabolic rise from mid to late-1999. Yet, when we plot the current gold bull market along the same trajectory, it is obvious that a parabolic rise in the gold price in this bull market, which started in 1999, is not evident.
 
And this finding is consistent with the earlier fact that investor demand still has not reached the levels seen in 1980, at the height of the last great gold bull market. The horizontal scale at the bottom of the chart represents the number of years each bull market was in existence.

4. Gold Miners are Leveraged to the Gold Price
The possible anomaly in this gold bull market is that the miners have been left well behind in the past few years. Yes, the miners have recovered from a mauling towards the end of the global credit crisis in late 2008 as all assets were liquidated. But they have not moved to reflect the subsequent doubling in the gold price. Like all mining companies, a significant portion of their costs are fixed given the huge levels of capital expenditure required to bring a mine to production. For example, if Mining Company X generates $10 million of revenues and $2 million profits when the gold price is $1,000 an ounce, then, all other things equal, at $1,500 an ounce, revenues should climb to $15 million and profits to $7 million (a more than tripling in earnings for a 50% rise in the gold price). I have exaggerated the numbers to make the point.
 

Hence, a rise in the selling price of gold should, at some stage, fall directly to the bottom line. In the early years of this gold bull market rising costs, like energy costs and heavy exploration costs due to stiffer environmental regulations, meant that the profits of gold miners did not explode as expected. But eventually they must if the gold price keeps rising. And in the past year profits of the miners have started to show the leverage to the gold price that the market has been expecting.

Yet, the share prices of the gold miners have remained subdued. This most likely reflects the broader difficulties affecting equity markets. The miners have been outperforming the general equity markets but they have not been reflecting the likely continued rapid rise in their earnings which will result if the gold price either stays where it is or continues to rise. I remain positive on the gold bull market theme and it appears to me that there is a significant catch-up play likely to unfold in the miners.