More On Gold Stocks Versus Gold Bullion
Steve Saville
26 February 2008
Below is an extract from a commentary originally posted at www.speculative-investor.com on
21st February 2008.
Over the past few weeks we've devoted a fair amount
of commentary space to the fact that gold stocks, as a group, have performed
poorly relative to gold bullion over virtually all timeframes up to about 2
years. Additionally, we've noted that as a result of this underperformance the
average gold stock recently became as cheap, relative to gold bullion, as it
was at the May-2005 bottom, and that last week the GDX/gold ratio dropped back
to its August-2007 low (which was, in turn, its lowest level since the second
quarter of 2005).
Another way to view the situation is to compare the price of gold with the
average valuation being assigned by the market to the in-ground resources of
junior gold mining companies. This exercise has been done by Canaccord and it
shows that since 11th October last year the rise in the gold price from $750 to
$900 was accompanied by a 30% DECLINE in the average market value of the junior
mining sector's in-ground gold resources. From a valuation perspective this
would only make sense if the average in-ground gold resource had been
dramatically over-valued to begin with or if the rise in gold's nominal price
had been associated with a decline in gold's real price (gold's price relative
to other investments and tangibles). Neither of these is true, so should we
conclude that the gold sector's performance simply doesn't make sense?
Well, that depends on what is meant by "sense". It wouldn't make
sense if the stock market were a machine that assigned prices based on an
accurate measurement of value, but the stock market is not now and has never
been such a machine. In fact, when it comes to value the stock market is
totally clueless. Some analysts talk about the market as if it were an
all-seeing, all-knowing oracle, but if that were true then dramatic price
adjustments would never occur. That such price adjustments occur quite often
reflects the reality that the stock market is, in effect, a manic-depressive
mob that spends most of its time being either too optimistic or too
pessimistic.
The stock market's habit of shifting from one valuation extreme to another
creates excellent money-making opportunities, but you won't be able to take
advantage of these opportunities if you blindly assume that the market is right
or that past trends will continue. The market is like an emotional pendulum --
the further it swings in one direction the closer it comes to swinging back in
the other direction.
Applying the pendulum analogy to the relationship between gold stocks and gold
bullion, the best time to be intermediate-term BEARISH on gold stocks relative
to gold bullion is following a lengthy period during which the stocks have been
STRONG relative to the bullion and the emotional pendulum has reached an
optimistic extreme (extreme optimism about the prospects of gold stocks), as was
the case at the end of 2003 and during the first half of 2006. By the same
token, the right time to be intermediate-term BULLISH on gold stocks relative
to gold bullion is when the pendulum has reached the opposite extreme (extreme
pessimism about the prospects of gold stocks) in response to a lengthy period
of UNDER-PERFORMANCE by the stocks, as was the case in 2000-2001 and May-2005,
and as is, perhaps, the case today. The point, in a nutshell, is that the best
time to buy gold stocks is after they have been beaten down to the point where
they are very low relative to gold and the majority has become convinced that
the metal is the better investment.
In general terms, one of the main reasons why most people aren't able to
outperform the market is that they get sucked into the market's current
emotional state. They become increasingly pessimistic when they should be
getting increasingly optimistic and become increasingly optimistic when they
should be getting increasingly pessimistic. Along similar lines, the time when
it will be particularly appropriate to question the common knowledge and to
scrutinise the horizon for signs of a trend change will be after the emotional
pendulum has traveled in one direction over an extended period.
Getting back to the gold stocks versus gold bullion issue, sometimes a dramatic
sell-off leading to extreme relative under-valuation will be enough, in itself,
to bring about a trend change. This was the case in April-May of 2005 when gold
stocks plunged relative to the gold price at the tail-end of an 18-month
consolidation. At other times there will be a specific catalyst that, when
coupled with under-valuation, will bring about a trend change. This was the
case in November of 2000 when extreme under-valuation combined with a major
trend reversal in the US yield-spread laid the foundation for a large rally in
the gold sector.
The current situation is similar to the final quarter of 2000 in that most gold
stocks have become very under-valued relative to gold bullion and, as discussed
in the latest Weekly Update, there is a potential catalyst for change in the
form of a major upward trend reversal in the US yield-spread. The start of a
large rally in gold stocks relative to gold bullion could still be a few months
away, but the support structure for such a rally is in place. Therefore,
investors should be getting increasingly OPTIMISTIC about the prospects for the
gold sector.
Steve Saville
26 February 2008
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