first majestic silver

The Wild & Woolly Gold Stocks!

November 27, 2014

Charts created using Omega TradeStation 2000i.  Chart data supplied by Dial Data

If one loves to ride a roller coaster, then owning gold stocks may be for you. The above chart of the Philadelphia Gold & Silver Exchange (XAU) is enough to give anyone that sinking feeling one gets while riding a roller coaster. On a roller coaster when the drop comes, you have the feeling that your stomach is floating in your chest. As to your heart well……

Note: I am using the XAU because the XAU has the longest history. Normally I use the Gold Bugs Index (HUI) and TSX Gold Index (TGD). The XAU contains Freeport McMoran (FCX-NYSE) a company that is predominately copper rather than gold and silver. As such, I find both the HUI and the TGD more properly reflects the gold and silver stocks. The XAU is an index of 30 stocks vs. 18 stocks in the HUI and 40 stocks in the TGD. Some stocks are common to all three indices.

I am sure those who have survived through the most recent gold stock “drop zone” have the same feeling as one would have being on a roller coaster. The trouble is, as everyone knows, when you are on a roller coaster you can’t exactly get off at the top. The vicarious thrill of the roller coaster is going through the drop. As to whether one gets a vicarious thrill of continuing to own gold stocks through the drop is not known. Some people even “hurl” during the drop. The good news is as with a roller coaster, one eventually hits the bottom and the long ride to another top gets underway.

None of this is to suggest that the current drop is over. But after 47 months and a drop of 74%, odds would favour that a potential major low could soon occur. The current drop has been as bad as the 1996-2000 collapse in terms of the percentage decline and has lasted almost as long. For someone who went to sleep at the lows of 1986 they would wake up in 2014 and assume nothing much had happened as the XAU was where it was 28 years earlier. It is not exactly an advertisement to own gold stocks. If one considers inflation, it was even lower. The current market is down to where it was at the bottom in 2000, well below the 1986 low.

philadelphia gold and silver exchange

Charts created using Omega TradeStation 2000i.  Chart data supplied by Dial Data

What all this has accomplished is to push gold stocks to their lowest valuations in years according to research from Scotiabank GBM and AGF Precious Metals. Valuations are not only the lowest seen over the past decade but valuations are also lower than those seen at lows in 1986, 1992, 2000 and 2008.  Not only are valuations cheap but the spread between the S&P500 and the XAU has never been wider. Investor sentiment for gold stocks continues to hover near all-time lows. The Gold/XAU ratio, a measurement that determines whether one should hold gold vs. gold stocks, has never been so high in favour of gold. The gold stocks are downright “scorned”.

gold/xau ratio

Charts created using Omega TradeStation 2000i.  Chart data supplied by Dial Data

So why following a three year collapse would things be about to change? This may sound like “spitting in the wind” but sometimes it is just time and the tide shifts rather unexpectedly. Gold, everyone says, is a hedge against inflation but then everyone is reminded at the depths of the Great Depression while the Dow Jones Industrials (DJI) was falling 89% gold as represented by Homestake Mining (today Barrick Gold) was rising 400%. In 1934, the US government revalued gold higher from $20.67 to $35 an increase of 70%. The Gold Reserve Act also outlawed the private possession of gold forcing individuals to sell it to the US Treasury at the previous price of $20.67. The gold was stored in Fort Knox and many believe it became the basis for the Exchange Stabilization Fund (ESF) who today is better known as the “Plunge Protection Team”.

In the 1930’s deflation, not inflation was the problem. Deflation is rearing its head once again. Both the Euro zone and Japan are threatening to fall into deflation. Official headline inflation in North America (US and Canada) remains below the targets of the Fed and the BofC. The BOJ is embarking on an aggressive program of QE and the ECB appears to be on the verge of doing the same thing to try to spark inflation. One thing it is setting off is devaluation of their currencies (Euro and Yen) and what many are calling currency wars.

The major central banks have exploded their balance sheets since the financial collapse of 2008. The Fed’s balance sheet has gone from around $800 billion prior to the financial crisis to over $4 trillion today a gain of 400%. The BOJ has expanded its balance sheet from 40% of GDP to 50% of GDP in just 18 months. Given the new round of QE, the BOJ’s balance sheet will move to 70% of GDP (Japanese GDP is roughly $4.9 trillion). Since 2007 central banks assets have roughly tripled from $7.5 trillion to over $22 trillion as of mid-2014. The chart below shows the central bank assets as a percentage of GDP.

advanced economy central bank assets

Source: National Central Banks and IMF from

The range for the advanced economies central banks goes from Canada’s 5% to Switzerland’s 80%. Emerging markets central banks have even larger balance sheets (as a % of GDP) then the advanced economies. Hong Kong for example has seen their central bank’s balance sheet move to almost 140% of GDP. One can note, however, that the percentage has actually declined for PBOC (China) and BofR (Russia). Both China and Russia have been active in acquiring gold to shore up their reserves. Russia is believed to have added 18.7 tonnes in October to their gold reserves.

emerging market economy central bank assets

Source: National Central Banks and IMF from

This weekend is the gold referendum in Switzerland that if passed the Swiss National Bank (SNB) would not be allowed to sell any more gold; they would have to increase their gold reserves from its current 7% to 20% of reserves; and, to repatriate their gold that is currently being held elsewhere. The referendum is opposed by the SNB, the Swiss banks and the Swiss Government.

Apparently, Washington also opposes the referendum and it would not be surprising if all the advanced economies central banks opposed the move.  If the referendum passes, it could act as a constraint on the SNB and other central banks fear referendums could spread. The forces against the referendum have resorted to trying to prevent the yes side from raising money and even blocked them from participating in a debate. The referendum has become a class-based poll with the well off against and the rest for. Still given close polls its outcome may be too close to call.  

Repatriating gold is spreading. The Netherlands recently repatriated 120 tonnes of their gold from various foreign vaults. That repatriation throws into question as to why it has taken the Bundesbank (Germany) upwards of five years to repatriate their gold. Other Euro zone countries are asking the same question. The French opposition party the National Front, a right-wing party (some say extreme right-wing) led by Marine Le Pen is demanding that the Banque de France (BOF) join the list of countries that have repatriated or tried to repatriate their gold.  According to polls, the National Front is ahead of Hollande’s government and could win the next election.

Repatriation of gold got underway in 2011 when the government of Venezuela led by the late Hugo Chavez repatriated their gold. That also coincided with the top in gold prices. Some believe that the suppression of gold prices over the past few years has been led by the Bullion banks (Barclays Bank, ScotiaMoccata, Deutsche Bank, JP Morgan Chase, HSBC Bank, and, UBS) and their need to buy gold to replace the gold they and others sold into the market during the late 1990’s and early 2000’s. The gold was originally leased from many of the world’s central banks. The central bank gold shortage has been estimated by some to be upwards of 12 to 14 thousand tonnes although some believe it is only around 5 or 6 thousand tonnes.  

Gold is not so much as a hedge against either inflation or deflation but a hedge against government when things appear to be “going off the track”. The 2008 financial crisis and subsequent rounds of QE was a prime example. Gold rose from roughly $700 to $1,900. When it appeared that the central banks might have things under control gold prices fell.

Could the markets soon be entering another period of financial turbulence? That is possible given that the BOJ and the ECB are once again embarking on another massive round of QE. Not only is the new round of QE knocking their currencies down it is potentially setting off currency wars. Deflation could be becoming the new norm for the Euro zone and Japan.  China is also slowing and embarking on a round of QE as well. This could turn into the biggest financial crisis since the Great Depression. The world is laden with debt that has grown over 40% since the financial crisis of 2008. There are ongoing fears of debt defaults. Debt defaults are deflationary. Could the US economy be close to slowing down or falling into a deflationary trap? The US is a part of the world economy and not immune from economic forces elsewhere.

There is fear that sanctions could be wound up once again against Russia. The US is apparently putting pressure on a host of foreign banks that have operations in the US to either join the sanctions or face punitive measures including being barred from banking operations in the US. Recall that the US levied a record $9 billion fine against BNP Paribas the giant French bank for violating US sanctions against Sudan, Iran and other countries. France felt the fine was unfair, unilateral, unreasonable and meddling in the affairs of a foreign company in telling them who they can deal with. Banks that are coming under pressure are from China and Saudi Arabia amongst others. Neither China or Saudi Arabia have joined sanctions against Russia nor have many others including the remaining BRICS and Latin America. Even some eastern European countries are resisting joining sanctions.

In order to get around sanctions Russia has besides building up its gold reserves been asking to be paid in rubles for their oil & gas or if paid in US$ they sell them to convert the proceeds to gold. As well, Russia is cutting energy deals with China that would be in Yuan. China has been in the process of setting up global currency trading in a host of countries in Yuan and doing Yuan currency swaps to facilitate operations. All of this is considered an attack against the US$ the world’s reserve currency. Russia and China have been clear about their desire to break the global hegemony of the US$ as the world’s reserve currency.

For a number of these reasons not only could gold be at the point of changing its direction but it would spark the gold stocks as well. Since the low in early November, the gold stocks have outperformed. As the chart at the outset shows, the XAU has been through a series of wild and woolly roller coaster rides since it came into existence in 1983. There have been five crashes averaging 66% and four huge rallies averaging 245%. On average, the crashes have lasted 41 months and that includes the seven-month crash seen in 2008 at the height of the financial crisis. The rallies have lasted on average 42 months roughly the same as the crashes. But the range has been wide from 14 months to 89 months. Yes, there have been sharp corrections along the way but all have generally only lasted a few months and none have been as steep as the big crash declines.

The gold stocks and the gold indices (XAU, HUI and TGD) may be at important crossroads.  Yes the ride can be quite wild and woolly. The same can be said of the junior TSX Venture Exchange (CDNX) where numerous junior exploration stocks are listed. It too has been through some wild rises and collapses with gains and losses quite comparable to the larger cap indices. The gold indices have made new lows this month but appeared poised to close up sharply. Similar patterns were seen at the bottom of earlier crashes in 1986, 1992, 2000 and 2008. While one cannot say for certainty that a final bottom is in the length and depth of the crash suggests that a change in direction could soon occur. This is coming against the backdrop of growing deflation, increased QE, loss of confidence in governments and their ability to control events and growing war drums in the Ukraine and the Mid-East.

While the gold stocks have been through some wild and woolly rides those that had the “stomach” to grit it out during the decline could soon be rewarded for their patience. This time one must learn how to step off the roller coaster near the top. It is very difficult to step off a roller coaster but if successful, it could prove to be rewarding.  

Copyright 2014 All rights reserved David Chapman

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David Chapman regularly writes articles of interest for the investing public. David has over 40 years of experience as an authority on finance and investments via his range of work experience and in-depth market knowledge.

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