By Andy Hecht, Editor, Trade Hunter
Dear Sovereign Investor,
Gold has been in a secular bull market now for more than 10 years after blasting off from prices below $300 per ounce in 2001. In 2008, gold surpassed the 1980 high price of $850 and has not stopped rallying since, climbing to $1,577.40 in May of this year.
Over the years, gold-mining shares have had a high correlation to the moves in the underlying gold bullion price. It makes sense… gold producers make more money when gold prices go up and less money when gold prices go down.
However, there have been times when the shares in these companies have either outperformed or underperformed moves in gold. An astute investor can take advantage of these situations to enhance returns in the gold market while always staying invested in gold, the ultimate reserve currency!
Recently, shares in some of the most profitable and well-established gold mining companies have come under extreme pressure. This has caused quite a divergence between the price of gold bullion and the price of mining shares.
Of course, individual companies have their own fundamentals.
Management issues, production yields, currency fluctuations, litigation, political events and other factors impact their net values relative to gold.
However, over the past month we have witnessed a wholesale correction in the basket of gold mining shares. That simply means that either gold bullion prices are too high or the share prices (as a whole) are too low.
Let’s take a look at this daily chart of the Philadelphia Gold and Silver Producer Index (XAU) versus the price of gold bullion:
Gold Stocks Are Really Underperforming Gold Bullion
As you can clearly see, since April 2011 the shares of gold producers have diverged considerably from gold prices.
What This Divergence Means for Gold Investors
In June, my colleague Eric Roseman wrote about the downward move in gold-mining shares to Commodity Trend Alert subscribers. He said…
“The ongoing panic-selling is just way out of whack with the fundamentals. Most analysts are projecting gold-mining stock profits based on $1,000 gold; it’s just insanity. I’ve never seen a market so negative on the prospects of an industry. From their highs earlier in April, the large-cap gold miners are down 18%.”
What’s the implication for gold investors?
As Eric explains, “The gold stocks are still in the tank but that’s where you want to be invested. Judging by previous corrections of this magnitude since the early 1970s, gold stocks should double over the next 12-18 months. The X5 Ratio, which divides the mining stocks into gold, is still at an extreme level trading at 7.43.”
For some context, for the past 25+ years, the ratio has averaged 4.5:1, so the recent divergence in values is significant. In the current environment, gold-mining shares are undervalued by more than 60%.
Remember, these companies take gold out of the ground and sell it. A price of $1,500 per ounce dramatically increases these companies’ profits. Their stock prices don’t currently reflect these higher profits.
What an opportunity!
From 1992 – 1996, gold mining shares outperformed the price of gold bullion. During that period, the ratio of gold to the XAU actually traded between 2.6:1 and 3.5:1. That means gold was very cheap relative to the share prices of gold producers.
Let’s look at the recent price moves of some influential gold miners…
Two Heavyweight Gold Producers Underperform Gold
Here we have a chart of gold bullion prices versus Barrick Gold (NYSE: ABX) and Goldcorp (NYSE: GG) share prices. ABX and GG are heavyweight gold producers who have been around for years, and they are “Class A” gold-mining concerns.
Notice that since the end of April, gold has fallen by a mere 5.18%. Meanwhile, ABX and GG shares have fallen by 19.5% and 15%, respectively! This chart really illustrates that divergence.
A Golden Opportunity in the Miners
The bottom line is that either gold prices are too expensive today or gold mining stocks are too cheap.
As a long-term bull in the gold market, I believe that the latter is true. That’s why I think that there is a “golden” opportunity to switch out of some longer term physical bullion holdings at current levels and purchase shares in top-tier gold producing companies. If the price of gold falls, these shares are less susceptible to downdrafts in price, as they’ve already moved down dramatically!
As I have pointed out many times over the past months, gold’s ascent has been slow and steady. It cannot be characterized as a “bubble.” What the daily historical volatility of the gold market tells us is that the yellow metal tracks currencies such as the U.S. dollar or the euro more closely than it tracks commodities.
As such, despite the short-term gyrations in value, the yellow metal has become the world’s ultimate safe-haven reserve currency. Central banks are net buyers, and investors have been buying and hoarding gold for a decade now. This trend continues, and given worldwide economic fundamentals, there is no reason to believe that this will change anytime soon.
Once gold continues its rally (perhaps after only a modest correction), gold producers’ share prices will have to increase as these companies continue to mine gold and sell it for higher and higher market prices. These companies are bound to see their profits skyrocket, and the price of their shares will reflect this!
There are times when gold prices are cheap relative to gold mining shares. This happened from 1992-1996. There are times, like today, when the opposite is true.
Astute gold market investors should always be looking to “tweak” or adjust portions of their portfolios – switching from gold mining shares to physical bullion or instruments that reflect the physical bullion price as opportunities present themselves.
Happy Trade Hunting…
Editor, Trade Hunter