For Gold Shares, It's Deja Vu All Over Again
Chris Temple, Editor
The National Investor
www.nationalinvestor.comA couple weeks ago, I authored a commentary comparing the growing similarities between the Summer of 2003 and the Summer of 1987 where the stock market is concerned. Back in 1987, long-term interest rates had been rising sharply for many months. Our nation’s budget and trade deficits were rapidly worsening. The foreign exchange value of the dollar was in decline. Gold was moving higher.
For several months, Wall Street blissfully ignored the gathering storm and powered higher, with the Dow Jones Industrial Average peaking at 2,722 in August—a gain, at the time, of some 30% on the year. Finally, though, stocks came back to reality—HARD.
Those same ingredients that joined together to finally hammer the stock market in 1987 are in place now. The numbers are different, as are some of the surrounding circumstances; yet the general environment is about the same. You may well hear more comparisons to 1987 as the weeks go by.
Over the last few days, I’ve been pondering another historical parallel as I look at the increasingly disparate behavior between gold and gold shares. This one, however, deals with events much more recent. Let me take you back to June of 2002. Gold shares had been on one of their biggest tears in years. Many gold stocks doubled, tripled or more in the belief that the long, painful bear market for the metal was over and that better days were ahead.
It’s not unusual for gold mining stocks to so anticipate a move in the price of the underlying metal that they will run far ahead of it in the early stages of a bull market. In fact, it’s quite normal. However, sooner or later the metal’s price—and the economics of the gold mining business itself—must commensurately improve.
Gold prices did indeed move up along with the shares in early 2002, though not nearly as much. As most of you no doubt remember, the $325-330 per ounce area was impregnable for quite a while, a fact that was becoming more evident as gold shares continued soaring to their peaks. Unable to confirm the rosy expectations of the buyers of mining shares, gold let the gold stock buyers down. Share price valuations of last June for those producing gold could not be justified with the product selling for $325 per ounce. Finally, the shares sold off—HARD. In a few months’ time, the sector had lost approximately a third of its value.
Fast forward to August, 2003. After suffering in the doldrums for a while, gold stocks have shown their greatest sustained strength since that great first half of 2002. Since April 1, the Amex Gold Bugs Index (HUI) is up by nearly 45% as of yesterday.
However, the price of gold itself is up by a piddling 5% in that same time span. Further, it has had considerable trouble recently sustaining any upward momentum. This is in spite of a continued mixed bag of economic news, a still-floundering U.S. dollar and turmoil in the bond market.
Having finally succeeded in recent days in moving above their 2002 highs, gold shares appear to be in much the same quandary as they were last June. In my view, barring a fairly quick spike in the gold price, more gold mining companies than not have seen their share prices run too far ahead of the gold price. Further, given that the economics of mining gold have in some respects actually deteriorated over the past year, the valuations of some producers have become downright lofty.
Let’s talk about that last subject for just a minute. I’ve often said that “gold companies are companies, too,” and that investors MUST remember that. The economics of the industry have changed dramatically over the last year or so, yet you wouldn’t know it from the blindly bullish shilling of many.
The decline in the value of the U.S. dollar has helped the gold price; however, in the cases of most companies located outside the U.S., this has been a negative factor. Producers located in countries whose currencies have sharply appreciated against Alan Greenspan’s depreciating scrip have seen their fixed costs rise substantially, offsetting or even exceeding the benefits of a rising gold price. Second quarter reports from throughout the sector have been testimony to the damage that a falling U.S. dollar has done to the bottom lines in operations from Canada to Australia, South Africa to New Zealand, and points in between. Add to this higher energy costs for everyone (that’s right—companies don’t merely pick gold coins off of trees) and I daresay that the industry’s economics as a whole are little improved from when gold was $20 an ounce less a year ago.
No, things won’t remain this way forever. I continue to believe that gold’s price will grind higher on into the future, and that well-run, well-capitalized companies will benefit, as will their shareholders. As long as demand does not wilt too much, companies over time will be able to pass on most or all of their higher costs; something that companies in many other industries presently are unable to do.
For the moment, however, we have another valuation dilemma, just as we did last June. There are, of course, two ways to fix this. The most pleasant for all of us would be for the price of gold to break out of its narrowing trading range and move to new highs. Such a positive breakout, according to gold’s price chart, would ideally move gold past its most recent peaks, and above $370 per ounce. Better still, it would be a move instigated by more serious longer-term commitments, and less so by the hedge funds and other professional traders who have—for better AND worse—been the major influence in gold this year.
The alternative would be decidedly unpleasant: a nasty correction in the valuation of gold shares, just as the one we saw after the June, 2002 peak. With each passing day that gold stays noticeably weak in comparison to gold shares, the chances of this fate occurring increases. Were gold actually to break to the downside, a rout in gold shares on the same scale as what the sector endured last Summer and early Fall would be almost certain.
Either way, it won’t be too long before we see one outcome or the other.
-Chris Temple
www.nationalinvestor.com
August 8, 2003
(NOTE: Chris has just completed a comprehensive update on the gold sector which, among other things, includes a look at gold’s fundamentals, investment demand, the future monetary role of gold, how to select viable gold companies for investment/trading purposes and more. As an introduction to The National Investor, he’s offering a FREE COPY to our readers; to get yours, send a request via e-mail to chris@nationalinvestor.com.)
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