There’s an old joke that goes something like this…
Q: What’s the difference between gold stock investors… and a pigeon?
A: The pigeon is able to put a deposit on a BMW.
But are long-suffering gold stock investors about to have the last laugh?
After 12 months of steep falls, gold stocks are now ludicrously cheap. And the best cure for a low price…is a low price.
Gold prices and gold stock prices have gone in opposite directions for a while now. In the last 12 months gold has crept up slightly, while the gold stocks that make up the index GDXJ have HALVED.
Right now the gold equity market looks more like a warzone. But the best time to buy is when there is blood on the streets…
This chart shows 40 years of the world goldmining index, benchmarked against the gold price.
It gives some idea of just how cheap gold stocks now are. On this metric, gold stocks are as cheap now as they were at the height of the GFC.
And prior to that, the last time they spent any amount of time at these levels was 1989!
World Gold Mining Index — Back to 1989 Levels
The red line in the chart shows the average level over the last 40 years. This gold index would have to rally 43% just to get back to this level.
One of the main reasons that gold stocks are falling is not so much a flat gold price, but higher production costs. Miners everywhere are facing the same nightmare: the costs of labour, fuel, equipment — and paying the government’s pound of flesh — are rising everywhere. Gold mining is an expensive business.
Without a rising gold price, the miners’ profit margins are therefore getting smaller.
So can we expect a rising gold price any time soon to turn this situation around?
If you take historic patterns as any guidance, then gold is well overdue for a rally in the second half of this year.
In the last 11 years, gold has risen each year. Over this period, its median annual gain has been 18.9%.
We have a little under half a year to go for 2012, and so far gold has done very little. Just to match its historic performance, gold would need to rally to around $1850 by year’s end.
If we saw that, the miners profit margins would explode, and we would see gold mining stocks soar in response.
Going back to the chart above, if we saw a recovery around this level, it would create a ‘double bottom’. This is a technical charting pattern that can signal the start of the next leg up. For example, we saw a double bottom form between 1999 and 2001, prior to the index doubling in value.
I asked our technical trading expert, Murray Dawes, for his take on the index:
‘It’s quite clear from the chart of the goldmining index divided by the gold price that gold stocks have copped an absolute beating over the past year. The ratio is back to levels reached during the extreme lows after the crash in 2008. That’s quite amazing when you consider the gold price is more than double where it was in 2008.
‘The extreme bearishness on gold stocks can be explained by the rising costs they face and the lack of any real dividend from most of the stocks in the index, but when you consider that there will definitely be more money printing by central banks over the next few years it’s hard not to come to the conclusion that the uptrend in gold will continue and many gold stocks should start to rake in some big profits.
‘The ratio appears to be back at a major support level so I would expect to see a bounce from here.’
That would be very welcome, and well overdue, news for gold stock investors’ ears.
But what could cause gold to rally in the second half of this year, to trigger this?
In a word: Europe.
The European debt fiasco is unstoppable now. The chaos has graduated to Spain, and now Italy. The ECB couldn’t stop Greece from exploding, so I don’t fancy its chances of stopping the disease now that it has infected some of the bloc’s biggest economies.
When you want to get a feel for what the market really thinks, then you need to look past the stock market, and listen to the bond markets.
And I’m not talking about Spain’s or Italy’s bonds. Instead, you want to see what is happening to the world’s biggest bond market — the US bond market.
It is the biggest and most liquid market in the world. When institutional investors want to store a few billion somewhere, the US bond market is often their first choice. It’s not my idea of a fun time, but each to their own.
What has happened here is breath-taking. There is now so much money looking for a safe place to hide, that investors in these bonds are taking a historically low yield. In fact it’s now within a whisker of a 200-year low of just 1.48%. Even more remarkable is that this is below the US inflation rate — so investors are actually taking a negative real yield.
They’re effectively paying to store their money in US-bonds. Given this, it is hard to imagine many more investors taking them up.
To put it another way — like a car-park, the bond market is nearly ‘full’.
But what’s all this got to do with gold?
Simply this: the ship (financial system) is sinking, and the lifeboats (US bonds) are now full.
However, there are some other lifeboats (gold) that most of the passengers (the market) are yet to notice.
Gold is no one else’s liability, for one thing. It also offers a market which is as liquid, and as big as some of the larger bond markets.
At some point soon, the institutional investors will have to pay attention, and understand that gold actually offers the best lifeboat around.
Once this happens, we could see a huge flow of funds into gold, and get that well overdue leg-up in the gold price.
And gold stocks are the place to be when this happens — because they magnify any move gold makes.
At the rate that central banks are printing money, you won’t have long to wait to laugh at anyone who joked about comparing gold stock investors to pigeons!
Dr. Alex Cowie
Editor, Money Morning
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Written by Dr. Alex Cowie
Dr Alex Cowie is Money Morning‘s Chief Resources Analyst. (To have his newest investment ideas delivered straight to your inbox you can subscribe to Money Morning for free here).
He is also the editor and chief analyst for Diggers and Drillers — Australia’s premier resource stock advisory service.
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