Gold stocks lead gold and gold leads currencies and currency moves correlate with stocks and bonds. Gold stocks have been declining for two or so years now. This is in part due to unavailability of capital and credit for gold mining projects, but in our assessment, not the whole story. We believe gold stocks are also correctly forecasting lower gold prices.
Long term readers know my gold pricing model puts fair value at $1100 per ounce (Alpha Magazine Aug 24, 2011). So at $1700-$1800, gold was about 60% overvalued, floating on a sea of credit. Gold declining now tells me the sea of credit is receding here and now. This should translate to a higher US Dollar and pressure on asset prices globally.
Gold mining stocks remain cheap by almost any objective measure.
One way to look at mining stocks is to compare them to the price of gold itself.
Comparing miners to the price of gold itself, show miners are cheaper today than they have been in decades.
Today, gold appears undervalued relative to the growth in the monetary base that has occurred up to now, and in light of the monetary expansion the Fed and other central banks are currently undertaking, gold appears more undervalued. The Fed’s current quantitative easing program probably won’t be curtailed until households stop deleveraging and the government can handle the rising interest expense on its expanding debt.
Yet, in the face of all this, many gold mining stocks are now selling at valuations that suggest the market has priced in a decline in the price of gold back to 2007 levels, before the Fed began expanding its balance sheet during the financial crisis. Many gold mining stocks are now selling near or below their book value, which is the market’s way of saying that these businesses won’t be able to add shareholder value in the coming years by mining gold and silver. If the price of gold were to decline below $700 or so, it would certainly be the case that most mining companies wouldn’t be able to profitably sell gold. Yet such a decline in gold is the main implied assumption being priced in by the market today, and this has sent valuations of gold mining stocks to their lowest levels since the current bull market began.
The gold price is set by investor preferences, which cannot be measured directly. But I think that we understand the main factors in the world that influence investor preferences in relation to gold. These factors are the growth rate of money supply, the volume and quality of debt, political uncertainty, confiscation risk, and the attractiveness (or lack thereof) of other possible assets. As individuals filter these events through their own thoughts they form their preferences. But that’s not something that’s measurable.
I suspect that the reason for the emphasis on quantities is that they that can be measured. Measurement is the basis of all science. And if we want our analysis to be rigorous and objective, so the thinking goes, we had better start with numbers and do a very fine job at measuring those numbers accurately. If you are an analyst you have to write a report for your clients, after all they have paid for it, so they have to come up with things that can be measured and the quantity is the only thing that can be measured so they write about quantities.
And in the end this is the problem for gold price analysts, you’re talking about a market in which it’s difficult to really quantify what’s going on. I think that looking at some broad statistical relationships over a period of history, like gold price to money supply, to debt, things like that, might give some idea about where the price is going. Or maybe not, maybe you run into the problem I mentioned about synchronous correlations that are not predictive.
Part of the problem is that statistics work better the more data you have. But we really don’t have a lot of data about how the gold price behaves in relation to other things. The unbacked global floating exchange rate system has never been tried before our time. How many complete bull and bear cycles has the gold/fiat market gone through? My guess is that when we look back we will see that we are now still within the first cycle. Our sample size is one.
I do think we will have a bubble in gold, although it may take the form of a collapse of the monetary and a return to some form of gold as money in which case, the bubble will not end, it would simply transition over to the new system in which gold would go from being a non-money asset to money.
I have been following this market since the late 90s. I remember reading that gold was in a bubble at every price above 320 dollars. I very much like the writings of William Fleckenstein, an American investment writer. He has pointed out how often you read in the financial media that gold is already in a bubble, a point he quite rightly disputes. Fleckenstein has pointed out that the people who say this did not identify the equity bubble, did not believe that we had a housing bubble, nor have they identified the current genuine bubble, which in the bond market. But now these same people are so good at spotting bubbles that they can tell you that gold is in one.
Most of them did not identify gold as something which was worth buying at the bottom, have never owned a single ounce of gold, have missed the entire move up over the last dozen years, and now that they’re completely out of the market, they smugly tell us for our own good that gold is in a bubble and we should sell.
So, I don’t know that we need to listen to those people and take them very seriously.
I don’t know what the intrinsic value of gold is. I don’t think gold mines are good businesses (on the whole) because they combine rapidly depleting assets with high capital intensitivity and they are constantly acquiring other businesses (mines) sold by liars and dreamers and schemers. And I don’t think this will end well, whatever the case may be. So, I am happy to own a little gold and wait and see what happens.
I wonder what the short interest is on gold miners?
About the author:
Murray Graham is a private investor and a student of the value investing philosophy. He does not hold any charters, certifications, advanced degrees or other merit badges and he doesn't intend to acquire any. He may be contacted at his blog.
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