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Gold stocks have shown some decent strength so far in 2014. The 26.3% gain to the end of August leads all TSX sub-sectors. However, the sharp losses in 2013 mean that the Gold Index is still down by over 20% for three years and down 7% over the last five years, the worst performance of any sub-index since the market lows in 2009! While geo-political risks could have been expected to push gold prices higher over the traditionally-strong summer quarter, the price has been drifting lower on physical selling out of the Far East and further reductions in the NYSE-listed Gold ETF.
Gold stocks have done better than gold bullion as many mining companies have shut down unprofitable mines and focused more on operational improvements rather than just growth in production. But the sector still needs higher bullion prices to support higher stock prices. Ultimately the biggest mover of gold prices is inflation! Gold, in the end, is a form of currency, except that it is not controlled by any central bank and is not the liability of any government. By default, the value of gold always goes higher when the value of paper currencies, such as the U.S. dollar and the Euro, depreciate. History shows that the inflation is the biggest source of currency depreciation, since it erodes the purchasing power of those currencies. So watch for gold to have a bigger upward move if and when inflation starts to become a concern again. The chart below shows the tight correlation between inflation and the changes in gold prices over the past few years. If all this money printing by central banks does finally push inflation higher, then we can expect a quick upward move in gold prices.
But, for now, deflation has been the bigger risk as the global economy staggered through the financial crisis. We reduced our exposure to gold stocks following the recent gains, cutting positions in Yamana Gold and B2Gold and selling our entire position in GDX, the gold stock ETF. We are soon heading into a ‘seasonally weaker’ period for gold stocks and wanted to lock in the gains achieved so far this year. We also want to see how well gold prices hold in the current range, especially given the strength in the U.S. dollar and the recent breakdown in oil prices.
We have also reduced stock positions in the rest of our balanced portfolios for many of the reasons mentioned above. The stock market may continue to rise but we see less reason for strength in the near term. The supports for stocks look tenuous and we are still looking for a 5-10% retreat in prices before we re-establish positions. Another example of weak support for stocks is that so much of the gain in earnings has come from stock buybacks, which reduces the share count and increases earnings per share, therefore making earnings growth appear stronger than it actually is. There were $159 billion of buybacks in the first quarter of 2014, the most active single three-month period since 2007, when companies spent $172 billion in the third quarter. Shares bought from April through June are on pace to reach about $130 billion, according to S&P. Apple’s $18 billion repurchase in the first quarter and the $16 billion it spent between April and June of 2013 are the two biggest buybacks by any company in data compiled by S&P starting in 1998. They came as the stock advanced as much as 77 percent over 15 months after falling to a 16-month low in April 2013. We recently reduced our position in Apple after it broke above the US$100 level.
Deal flow has been another big story over the past year with takeovers in excess of US$2 trillion keeping a positive tone on global stock markets. So while the sudden abandonment of 21st Century Fox’s $75 billion bid for Time Warner isn’t likely to end speculation about possible mergers in the entertainment industry, it has to be noted as the largest deal ever cancelled. Two megamergers on the distribution side of the television industry announced this year— Comcast’s proposed acquisition of Time Warner Cable and AT&T’s plan to buy DirecTV, had sparked talk that content companies could respond. Maybe Google will buy Disney……or vice-versa! This is all starting to become vaguely reminiscent of 2000; hopefully it doesn’t end the same way. For now, though, we think that some caution in the stock market is warranted. Especially as we navigate through the ‘traditionally tough’ months of September and October.