One of the biggest stories in the past month has been the collapse in gold prices.  In the first half of April gold prices imploded, dropping over 15% in one week before recovering somewhat in the latter part of the month.  Gold stocks, as they typically do, dropped more than gold itself, with the TSX Gold and Silver sub-index falling almost 30%.  Everyone had an opinion on the fall from this being the end of the 10-year bull market in gold to worries about sales from Central Banks from cash-strapped countries such as Cyprus to the failure of gold to assume its traditional role as a ‘safe-haven’ investment in times of crisis.  Others pointed out the fact that gold is a traditional hedge against inflation and that inflation has yet to become a problem anywhere despite the massive printing of money by the U.S. Federal Reserve, among others.  What was clear was that a huge amount of money has come out of the main Gold ETF, the SPDR Gold Trust.  While the trust held only about 5 million ounces of gold in 2005, holdings had risen over the subsequent 7 years to peak at almost 44 million ounces in late 2012.  Holdings have dropped sharply in 2013, down over 9 million ounces to under 35 million as of last week.

Since most financial players got involved in the gold trade through the ETF, it also made sense that the ETF saw the largest and swiftest decline.  The other major buyers in the gold market, central banks and physical buyers for jewelry, have actually increased their purchases dramatically on the price weakness, with huge physical demand for the commodity from individual buyers in China and India.  This is one reason why gold prices have snapped back up by over US$100 per ounce from the lows.  Our view is that the bull market in gold is far from over.  First of all, bull markets end on parabolic moves to the upside, much like what we see in the Japanese stock market in the late 1980’s or the U.S. technology stocks in the late 1990’s.  Gold prices peaked at US$1900 per ounce in late 2011 and have been trading in a lower range since that time before collapsing last month.  This is more reminiscent of the stock market in 1987, which is now really called a sharp correction in a rising market, evidenced by the fact that stocks recovered all those losses and moved to new highs within a year.  We see similar buying coming back to the gold market for one simple reason, the depreciation of the three major currency regions of the world, the U.S., Europe and Japan.  As long as the central banks from these regions continue to print money at unprecedented rates, those currencies will depreciate against non-paper currencies such as gold.  This has not occurred over the past year since the U.S. dollar has been rallying because U.S. economic growth has exceeded that of the other developed markets.  But this is really the ‘best house in a bad neighbourhood’ argument since all of these countries are printing money at record rates which will eventually translate into higher inflation levels.  The U.S. debt has risen to over US$16 trillion and continues to head higher.  At some point this will put further downward pressure on the U.S. dollar, which will be a benefit to gold and most other commodities.

The chart below shows the ratio of gold prices to the Dow Jones Industrial Average.  The rising line on that chart from 1980 to 2000 indicates a period when stocks out-performed gold.  This ended around 2000 and gold prices rose versus stocks until late 2011.  The ratio remains in the correction band and we expect that downward trend to resume.

Is the Bull Market in Gold over?

Gold stocks have suffered the most due to their excessive spree of acquisitions over the past five years combined with rising production costs which have kept the companies from gaining any benefit from the rising gold price.  Gold stocks also lost investors since most financial players bought the commodity directly through the gold ETF, thereby bypassing production and sovereign government risks.  This reduced valuations for gold stocks generally, dropping them from trading at around 2 times Net Asset Value (NAV) to where they trade today, at a discount to NAV. But the companies are now finding a ‘new religion’ in terms of their commitments to profitable projects and a focus on cost and debt reduction and more intention to return cash to shareholders.  This will reduce mine expenditures in general and is clearly a negative for many of the heavy machinery and engineering companies that have benefitted from the plethora of new mines being developed.  But the gold companies themselves now appear far more committed to ‘shareholder friendly’ strategies.  Whether this is a real initiative or whether they are just paying ‘lip service’ to disgruntled shareholders will only be known over time, but with the stocks trading at their lowest valuations in decades and the price of gold having stabilized at current levels, we feel the risk-reward of adding to core names is attractive.  Some of the stocks we like that have production growth, low cost mines and are generating positive cash flow include Goldcorp (G), B2 Gold (BTO), New Gold (NGD) and Osisko Mining (OSK).  We added to all those positions in the recent downturn.

While markets will remain volatile and we may yet see another correction over the next few months, many stocks have fallen enough in the past month to make them attractive again.  Last week we covered all our short positions and brought stock weightings back up to a neutral level.  We added to names in the Basic Materials, Energy, Financial and Technology sectors.  The bottom line is that we still see stocks as under-valued and likely to rise over the next 3-5 year period.  Profits underlying the S&P 500 are more than double what they were at the 2000 market peak and 18% higher than in 2007.  That makes price-to-earnings ratios lower:  13 times forward earnings now, versus 15 in 2007 and a whopping 25 in 2000.  But it’s not just earnings that suggest stock valuations aren’t bloated.  Relative to the book value of company assets, shares are 20% cheaper than in 2007 and less than half their price of 2000.  That’s not a guarantee that stocks will continue to rise since earnings growth is slowing from here until the global economy picks up some further momentum.  But stocks are the most attractive asset class at current levels when taking interest rates into account.  In that scenario, there is not a compelling argument to stay underweight in stocks.

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