Sunday, February 18, 2007

Gold Stocks are Getting Ready to Lead

18 February 2007

Sentiment has become increasingly bearish on gold stocks relative to gold since late 2003, and this can be seen in the decline of value of the Gold Bugs Index (HUI) relative to the price of gold since that time.

Increasingly, we hear of the difficulties faced by gold producers, including rising political risk (including exploitative government intervention in unstable countries ranging from Venezuela to Bolivia to Eritrea to Russia to Indonesia), rising costs of equipment and energy, power shortages (Ghana), regulatory delays and blockages, labour unrest and sabotage, price to earnings ratios that parallel those on the NASDAQ exchange during its bubble days (and that bubble has many years of unwinding still ahead of it), difficulty raising funds for development and exploration (the broad market is still focused on yesterday’s favourites in such sectors as technology, finance and housing), environmental concerns and local community objection to mine development.

Additionally, some bellwether gold mining stocks are floundering, and these range from Newmont Mining – facing production declines, leadership turnover and problems in almost all of the above areas, to Gold Fields – facing declining reserves, a deteriorating political climate in South Africa and unimaginable cost increases, to Barrick Gold – still weighed down by the costly legacy of its bear market hedging practices, to Iamgold – facing a work stoppage and vicious acts of sabotage, to companies such as Nevsun, Crystallex, Gold Reserve and Apex Silver – facing political risk and government exploitation in the unstable countries where they operate.

My present purpose is not to evaluate the above problems, except to say that many environmental and local community concerns may be quite valid, and that a number of the above-cited problems are obviously going to worsen further.

However, markets inevitably turn at times when bearish sentiment preponderates, and in my view, that is certainly the case in gold mining stocks relative to gold today.

As the Aden sisters recently indicated, fundamental concerns tend to drive investment markets, but technical patterns direct their movements. As a psychologist (and let me prefix the term “amateur” when it comes to applying any knowledge I have to investment markets), technical indicators greatly interest me, as they are no more than a graphic representation of the collective behavioural patterns of humans. Therefore, I take technical patterns as very critical scientific data with respect to human behaviour in the investment markets.

At this point, the technical indicators are telling us that there is an overriding fundamental pattern that is favourable to gold miners, and it is not being discussed enough.

That pattern is the ineluctably rising price of gold, in particular, the movement of the price of gold into a new and stronger uptrend channel which launched in the last quarter of 2005. Behind gold’s stellar rise are the global fundamentals which support its climbing nominal (currency) value, and these have been well-described by countless others. Suffice it to say that the global trend of currency deterioration (monetary inflation) and associated increasing political instability (I believe the two are causally linked) will be powering the price of gold upwards over coming decades (in my opinion, for an additional 2-3 decades).

Does the rising price of gold cancel out the other risks and problems associated with the gold mining business?

In a word, yes, regardless of how formidable these particular problems may be.

The rising price of gold essentially trumps the myriad quite genuine and in many cases escalating problems faced by those in the gold mining business.

But there is also a second reason to favour the gold miners at this juncture, and this relates to a well-known fundamental factor of market dynamics. That is, the multitude of difficulties associated with operating mining companies create massive barriers to entry, and this lends powerful advantage to those with their foot already in the door of this perilous but profitable business.

In one of the market’s ceaseless paradoxes, the massive difficulties associated with operating mining companies functions in their favour in terms of market valuation. The primary advantages are two.

First, global gold mining production is still falling, despite the fact that gold is now in its 6th year of rising (it will soon triple its bear market lows of ($252.50 - $255.00 from 1999-2001). Why is production declining under favourable market circumstances? For all the reasons we have just discussed.

And that leads us to the second benefit enjoyed by existing mining companies. The lengthy (often 10-15 year) and perilous process of acquiring mining claims and developing mines to the operational level offers a potent first mover advantage to those mining companies that were visionary (and fortunate) enough to be able to move forward with property acquisition and mine development plans during gold’s brutal 1980-2001 bear market. It will be many years before new entrants on the scene can hope to catch up.

This fundamental situation will power the price of gold higher over coming decades.

And, very soon, this fundamental situation will again give impetus to the value of gold mining (and other precious metal) equity investments.

What causes me to assert this?

Here, I redirect my discussion from market fundamentals to technical indicators.

The bearish view of the gold mining business has pushed the value of mining stocks to the very bottom of their uptrend channels.

A close view of the charts shows that the price of gold launched a new uptrend in mid-2005, and despite the bearish view of their prospects relative to gold itself, gold mining companies led this trend change by several months after bottoming in the second quarter of 2005. That in itself is a bullish indicator for the value of gold stocks.

However, while gold moved firmly off the bottom of this fundamentally favourable channel after re-testing it in early January, gold stocks have followed, but demonstrated less energy in their rise.

Similarly to gold itself, gold stocks have until recently been locked into a triangular consolidation pattern. However, gold broke out of this pattern to the upside on February 9, 2007, and the Gold Bugs Index (HUI) is indicating that it will soon follow (perhaps one more pullback over the next 1-2 weeks is possible).

This brings us to the topic of the HUI:Gold ratio (which I have discussed previously). This ratio defines the value of unhedged US gold mining stocks relative to the price of gold, and it reached its bull market peak (.639) far back in November 2003, and is presently languishing at .52.

However, while most all eyes have been elsewhere, this ratio has steadily been climbing (also in a triangular consolidation pattern), with lower highs, but also with higher lows. This triangular pattern is set to break by mid-2007, and the odds favour an upside move.

Why is that?

While both the price of gold and the HUI index itself have moved into new uptrends since early to mid-2005, the HUI:Gold ratio is locked into a single trend which remains unbroken since late 2001. The likelihood that this uptrend would break down while gold and the HUI are now advancing in new (power) uptrends seems highly unlikely for fundamental reasons.

That is, the HUI:Gold ratio must soon break either up or down, and a downside breakout is highly improbable.

While I lack the tools to illustrate it, the more probable course is in fact to retest the top of this uptrend channel at some future point – and in my view, this could possibly occur as soon as mid-2008 (though possibly later). This would imply a dramatic upwards move in the Gold Bugs Index at a time when all eyes are focused elsewhere – and of course, this is just the kind of “trick” that defines the capricious nature of market behaviour.

In short, I am saying that due to strong market fundamentals for the value of the product which gold mining companies produce (gold), and due to lagging global supply and still very formidable barriers to entry, the investment markets will favour gold mining stocks relative to the price of gold over the next year to year-and-a-half – and that this will take place precisely when few, even in the gold community, are giving much thought to this possibility.

My conservative target (and I am not a professional investment advisor) is 480 for the HUI. However, at whatever point the HUI:Gold ratio again moves to the top of its multi-year uptrend channel (and tops do get tested as well as lows), the HUI:Gold ratio would reach .80. Were gold to be trading in the $1000 range at this time, it would imply a value of 700-800 for the HUI, and this would be double current levels.

I entirely concur with Goldrunner that the next HUI peak will be at the 480 level and probably this year, possibly only a few months away, and that an upside test in the HUI:Gold ratio’s 5-6 year uptrend channel could bring the HUI to the 700-800 range by as soon as mid-2008 – though the upside test might in fact require more years than that to develop.

While I am uncertain that we will see a doubling in the HUI by mid-2008, what I think is almost inevitable is a retest of the previous top in the HUI:Gold ratio, and that was .639 in late 2003.

In this case, again with gold in the $1000 range, the HUI would at the least advance to the mid-600 level, and that would take it 300 points higher than its current value.

Let me also address the perplexing issue of the “slowness” of the advance of both the price of gold and the value of the Gold Bugs Index in a bull market.

Those who are looking to find “literal” parallels with the 1970s bull market are sure to be disappointed, as the dramatic eightfold increase from 1977 to 1980 will not be repeated in the present bull market at this time (and dismiss such talk if you begin to hear it even as the market advances).

This misconception arises from misunderstanding of the fractal nature of investment technicals. That is – our present fractal is extended in both duration and amplitude, and at this point, duration trumps amplitude. That is, an opportunity for an eightfold or greater increase in the price of gold is quite probable in the current bull market, but certainly nowhere in the near future. In the present much stronger, fundamentally-driven and therefore much more slowly advancing gold bull market, such a dramatic “end game” move will be many, many years away – and this is a good thing.

In fact, let me put this in perspective by referencing my earlier discussion (based on the Adens’ research) in “A Three Stage Gold Bull Market?” that the ratio of the market value of gold mining stocks to the price of gold has been in an over-three-decade-long downtrend. It would be highly unusual for such an adverse relationship to persist in a gold bull market.

Thus, if this multi-decade trend is to turn in favour of gold mining companies, in my view, the greatest likelihood is that this reversal will in fact take place in mid-2007. As this would signal a breakout from an almost four-decade-long secular downtrend, it would be a quite exciting event – though I think it almost certain to go widely unheralded.

Let me add that the break of the four-decade downtrend could in all probability signal the birth of an uptrend in the value of gold mining companies relative to the price of gold which could quite conceivably endure for a similar time period (that is, on the order of a third of a century).

The unhurried and meandering pace of the third millennium gold bull market reflects the much greater strength of the present market when contrasted to the “brief period of excitement” that characterized the 1970’s bull.

My central thesis here is that our current gold bull market is actually built on much firmer fundamentals than was the 1970’s gold bull, and thus that it will advance over a much lengthier period of time, and correspondingly, advance to much higher levels.

That is, slower is stronger.

So enjoy the lengthy journey of the bull market in gold and gold equities, and take pleasure in the many delights that it holds in store for us along the way – though let us not forget to take caution that bull markets inevitably surprise us with vicious downtrends when our optimism is at its peak.

ADDENDUM: Could I be wrong? Well, that question is easy to answer. If anyone were right every time, that person would soon control all the resources in the investment marketplace – and at least one has come close – as Warren Buffett has made amazingly few long-term errors over the half-century course of his investing career. And Mr. Buffett does in fact own a huge personal portion of the investment marketplace, thereby coming as close as anyone to demonstrating that my thesis (about being right every time) is correct.

That is, were he perfect, Mr. Buffett would in fact own it all. Though he does not now own absolutely everything, Mr. Buffett has certainly come closer than anyone else to achieving this.

(Disclaimer: I know with absolute certainty that I am not as smart as Mr. Buffett.)

One historic mistake on Mr. Buffett’s part: Mr. Buffett purchased Euros at a timely juncture, but he would have done better still by buying gold, a currency he disfavours to his modest personal disadvantage.

How might I be wrong?

I could be wrong about the gold price moving up relatively soon this year. I could be wrong about the market’s willingness to look past the formidable and multitudinous problems of gold mining to see the long-term advantages. Most specifically, I could be wrong that the HUI:Gold ratio will break up rather than down.

Why might the HUI:Gold ratio break downwards rather than upwards?

Well, the gold mining business could get even worse than it already is (hard to imagine but possible).

Gold could lag or pull back, stalling in its climb (easy to imagine, but unlikely for both technical and fundamental reasons).

The Gold Bugs Index could decline in sympathy with a drastic downward break in the broad financial markets (this in my view is a high probability scenario and almost certainly will happen at some point, though I presently favour a scenario in which general equities continue their 8-year stall and gold and gold miners continue to advance, at least for now. I am more sanguine about “more of the same” in the broad markets for 2007, but pretty nervous about 2008, but that is too many steps ahead, and unknowable until it actually happens.)

I apologize that I lack charting tools to illustrate the trendlines I have described,

I will present some relevant charts below.

1. Gold started a new uptrend in mid-2005. It is presently headed to retest the 1980 high in the $800 range, and then higher:

2. The Gold Bugs Index (HUI) launched into a stronger uptrend in early 2005, and is presently headed to highs near 480 and then in the mid-600s, and at some point, approaching 700-800:

3. The HUI:Gold ratio, long neglected due to basing since its 2003 peak, can go little further forward in time without initiating either a new advancing or declining phase. A decline is less likely in my view for both fundamental and technical reasons, and so a powerful advance is likely to begin no later than mid-2007. The 2003 high at .639 will be retested, and at some point, perhaps years away (but possibly as soon as 2008) the top of the uptrend channel will also be tested, and this would be at the .80 level, implying a doubling or more in the Gold Bugs Index from its present levels over perhaps the next 1-3 years.


  1. I like the blog changes.... nice selection of photos.

    We'll have to corner Megan and Thomas and make them pose for pictures.

  2. Sounds fine to me. Equal opportunity to all. In keeping with the motto of the Utopian Party, if they care about this, they are invited to take initiative to send me a photo of themselves that they like. Otherwise, they are stuck with my capricious and unpredicatble tastes.