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I could not have put it better than this note from the trading desk at a leading London broker, which I have just been sent. I am sorry that I cannot include the chart referred to but you can guess what it looks like. The report states:
Gold has had a quiet year thus far. Despite the prospect of more money printing by the world’s central banks, and minuscule interest rates, it seems that not many people see inflation as a big threat at the moment.
But things can change quickly in the financial world. Often the best time to buy things is when nobody really wants them. It’s interesting that renowned investors George Soros and John Paulson have been buying gold recently.
It looks a smart move to us. Gold is worth holding, if only as a form of insurance against paper money going bad – which it eventually will – if all the printing continues. We certainly see no reason to hold low-yielding government bonds. But the relationship between gold prices and the price of gold stocks has broken down sharply this year. Have a look at the chart above. It tracks the spot price of gold (yellow line) with the HUI index of gold mining stocks (white line) during the last year. The HUI index includes gold mining companies that do not hedge the price of their gold production beyond 18 months. This means that these companies should see their revenues closely correlated to changes in the price of gold.
Yet, as you can see during the last six months, gold stocks have significantly underperformed against the price of gold bullion. But even over a longer period of time, a broad index of gold stocks like the HUI has done worse than bullion. During the last ten years, the HUI index has gone from 120.8 to 424.3 – an increase of just over 250%. Now that’s pretty good, and a lot better than having your money in most stock market funds.
But the price of gold has risen from $308 to $1,604 per troy ounce – an increase of 420%. There have been brief periods when gold stocks have performed better than gold but it doesn’t look like the leverage theory has worked out in practice. Why?
There are several reasons. One is the fact that gold mining companies used to hedge their production by getting another party – typically a bank – to buy their output at a guaranteed price. Scarred by years of low and lacklustre gold prices, they wanted some security for their efforts. As the price of gold surged many companies lost out on big profits because they had already agreed to sell their output for much lower prices.
Now, of course, hedging is virtually non-existent among most major gold mining companies. But the other big problem they’ve now encountered is cost. It’s costing a lot more money for mining companies to get their gold out of the ground. Cash costs have soared due to high energy prices and the cost of specialised workers.
This has meant that profits have actually been going down at a lot of gold mining companies. It’s quite ironic that gold companies that have been seen as beneficiaries of inflation have now become victims of it. You could say that if gold stocks haven’t done what they should have done, then why bother with them?
Well, some interesting changes are afoot in the sector. And when gold sees a renewed surge of interest – as we expect it will – neglected gold stocks could benefit.
With the rest of the mining sector being hit by the slowdown in demand for industrial metals, you also have to wonder how much longer rampant cost inflation will be hurting gold miners. If other big players are cutting back on projects, then the pressure driving up the costs of staff and machinery will ease off.
But there’s one other major driver that could ignite the sector – and that’s takeover activity.
Ends.
We have already seen the first inklings of bid activity thanks to Endeavour Mining, to which I referred to HERE the other day with respect to obvious takeover target Cluff. There will be more. And while I do not think George Soros has called Facebook correctly (he bought), he is usually correct.
For what it is worth, this broker’s trading play on the sector is Centamin (CEY) where it sees 25% short term upside. This stock is undoubtedly cheap in terms of what gold it sits on and produces but it operates in Egypt where there are “issues.”
