Tuesday, March 08, 2011

Sure the Market's Rational - Just Give It Two Decades!

8, 21 & 27 March 2011

In Canada, gold stocks have been lagging the price of gold from the start of the gold bull market in 2002 (they were quite lively in later 2003, from May 2005 - May 2006, and of course after the October 2008 crash, but that's about it!).

Of course, the Canadian dollar has run up from $0.62 US to $1.03 US during that same period (a trend that will continue for most of this decade). That is a 66% gain - no small headwind against the US dollar gold price! (Unfortunately, I can't chart the SPTGD Canadian Gold Miners Index against Canadian dollar gold, or I would!)

However, even when we look at gold mining stocks in US dollar terms, we still see a decline in the ratio of the stock prices of gold miners (the HUI "Gold Bugs" index) to the price of gold from 2003 onward.

What's wrong with this "ratio" decline? I can tell you - gold miners' profits are rising faster than their costs, due to the now 10-year long gold bull market - but the miners are losing in value against gold, whereas rationality tells us that they should be gaining as their margins inexorably rise!

Consider too that gold has been quite strong - more than sufficient to cover rising costs - in Canadian dollar terms as well, as seen below (Canadian dollar gold had risen from $390 to $1405 as of March 7, 2011):

Is the market therefore irrational?

My gut response is to say, "Yes, absolutely - this downtrend in gold mining stocks relative to gold is totally crazy!"

However, as we have discussed here many times, this is just the "wall of worry" that all bull markets climb. In fact, I'll tell you exactly what is happening. Gold has been gaining in price for 10 years - and it has at least 7-9 (and perhaps many more) years to go.

However, every time gold makes a new high, the broad majority of investors start to prepare for the possibility that "the top is in." Then when gold sells off even $10-$20, due to normal market fluctuations, they unload the gold stocks they had bought a few days or weeks earlier. On a daily or weekly basis, this pattern of fluctuation looks like noise, but as you can see on the long-term charts above, the market is now dramatically underpricing the stocks of global gold mining companies (60% of all mining companies are listed on the Canadian exchanges).

That is, everybody knows this is a 10-year bull market, but the great majority entirely lack confidence that it will be an 11-year or 12-year bull market, let alone a 17 to 18-year bull market (which is typical of such cycles), or perhaps a 2 to 3-decade bull market, as we have seen recently in bonds - which surely are topping out somewhere about now.

Take today's action as another example of that consistent pattern. Only yesterday, gold made a new all-time record high of $1444.40. However, today it sold down to as low as $1423.40 (a $21 decline, but from a record high level!).

What then happened to the gold stock sector? Let this come as no surprise to you - gold stocks were smashed, with both the HUI and SPTGD gold stock indices losing over 1%. Hey, and what happened yesterday? Oh, the same thing. On that day, gold sold at the highest nominal US dollar price it has ever commanded in history - and the stock prices of gold mining companies sustained losses of about 1.5% on both the US and Canadian exchanges - greater than their losses today!

Again, on a daily basis, this looks like noise. but it actually represents a cumulative 9-year downtrend in the market price of gold mining companies relative to the soaring price of the commodity they sell at ever-increasing profits - gold!

If the market is indeed irrational, as demonstrated above, will it then correct at some point for such obvious mispricing of gold mining companies?

You betcha!

If history is any guide, the odds are 99.99% that the answer is "yes." At some point, the market will price gold stocks rationally - and then, more confoundingly still - it will go on to over-value them!

So what am I claiming here?

Basically, I am stating that markets are in fact 100% rational - just not in terms of their daily behaviour, which over time may accumulate to periods of years and - as we see in the present example - decades!

What then are the lessons?

Pretty simple, actually.

Investors who hold on to gold mining stocks at today's prices will virtually certainly see fabulous gains at some future point, probably still several years in the future, as gold stocks move from being undervalued to being rationally valued, and then to being overvalued.

Sounds crazy?

Hey, this is human nature we are discussing - cumulative human psychology if you will! This is just what humans do. All the charts are doing is reflecting our own behaviour back to us - bizarre though it may be!

Based on historical trends, gold stocks are likely to be fairly valued (again) a few more years forward - perhaps as soon as 2012, based on multi-decade patterns of strength and weakness in this particular sector, which have been identified by Pamela and Mary Ann Aden.

Then what? Well, a few years further out, the market will over-value gold stocks, and then it will be time to sell them - but by my reckoning, that period of over-valuation will not occur until near the end of the present decade - or perhaps even later.

In fact, the consistently negative relative price action of the past decade has been very bullish for gold stocks!

Why is that?

Basically, contrarian psychology is at work here. After ten years, it should be quite obvious to essentially everyone who is paying attention that gold is in a sustained bull market.

As obvious as this sounds, the great majority of investors do not yet perceive this. They view the entire period to date as an anomaly - a mysterious or irrational trend that at any moment is likely to reverse.

After 10 years, you might think that such twisted logic would no longer be persuasive. Yet one need study the price action in gold and gold stocks over only the past two days to see that the same pattern which has kept gold stocks undervalued for a decade is persisting at this very moment!

Here's the funny thing about markets though - and all investors who have studied history know this - the present pattern of pricing gold stocks will not end until it has turned around to its opposite.

That is, to anyone with historical awareness, the recent top in the gold price ($1444.40) cannot possibly be the top price in the present trend, because the market is still undervaluing - vs. overvaluing - gold mining companies.

Historically - these two patterns have never occurred at the same time. That is, the gold market can "top out" only when gold mining stocks have become overvalued. There is no precedent for such an occurrence at a time when mining stocks are under-priced relative to gold, particularly while still in a 9-year relative downtrend!

Again, reversals at junctures such as we see at present simply do not happen - ever!

(To be clear, I'm not saying that we will necessarily ever recapture the ratio highs of 2002-2003 - or that gold mining shares can't randomly fall quite a bit below where they are priced today. Rather, I am discussing larger patterns. What I maintain is that the bull market in gold stocks can end only when gold stocks are over-valued, that is, when they are in a sustained uptrend relative to the price of gold. Such ending patterns have no resemblance whatsoever to the pattern we have witnessed for the past 9 years!)

History teaches an incontrovertible lesson. No sectoral bull market has ever ended with stock prices at undervalued levels. All bull markets end in overvaluation - every one, every time! And again, if history is our guide, no commodity has ever advanced for ten years and then reversed while the shares of companies that produce the commodity were lagging in price. This just plain does not occur - ever!

Now, that is about as close to a golden guarantee as you are ever going to get that the present bull market in gold has years to go, even if on many days gold stocks fall off a cliff when we see price declines in gold itself of $10-$20 or more - even when those declines follow record highs!

As has been said, "Don't sweat the small stuff - and it's all small stuff!"

What's the big picture here?

This is a bull market in gold, and at some point mainstream investors will wake up to this fact and drive the prices of gold stocks much higher than they are today.

And, if you're holding gold stocks already?

Just relax and take the ride.

It may be bumpy, but the ultimate direction is always up in markets of this type.

It is your golden guarantee!

21 March 2011: For your edification, I am posting below the most subtle chart of a rising trend that I have EVER seen:

The above chart is of the ratio of the "HUI" gold stock index to the price of gold. Now, look at the four "bottom" points on the chart starting on August 4, 2010. Now, do the math to a few decimal places. That's right!. Taking the last four bottom points into consideration, gold stocks are now rising against the price of gold - with the differential across the four bottom points amounting to a cumulative gain of .0034!

That, my friends, is perhaps the most subtle rising trend you will ever witness in a lifetime, but - and this is very important - the direction is up!

Savour it, gold investors! This is good.... you may never see anything like this again!

For the doubters in the crowd, here is the same chart from January 2010 through the present:

Yes, indeed. It's an uptrend... still!

27 March 2011:

Ho hum.... Gold set another record high this week.

The consequences? Well, things were going great until a new all-time record-high gold price was set at $1447.30 on Thursday. Then all hell broke loose!

Gold sold off and gold stocks sold off on Thursday and Friday both (though it was otherwise a net positive week for both gold and gold mining stocks).

Here is the 5-day gold chart:

And the 5-day chart of the HUI "basket of unhedged gold stocks":

Yep. There is nothing worse than record high gold prices for the gold stocks - or even for gold itself!

And yes, the psychology will change at some point. But don't hold your breath!

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