Over the past week we've seen the first bearish action in the major gold stocks since the Amex Gold BUGS Index (HUI) bottomed on 13th March. We say this not because the gold stocks have pulled back (pullbacks are normal and are often 'healthy'), but because they have pulled back sharply relative to the gold price. The recent weakness in the gold stock indices can be partly attributed to strength in the South African currency (Rand strength is putting substantial downward pressure on the prices of the SA gold stocks). However, the below chart of the NEM/gold ratio (the Newmont Mining stock price divided by the gold price) confirms that there is more to this pullback than just Rand strength (NEM is not adversely affected by Rand strength but it has significantly under-performed the gold price over the past week).
So, what's wrong with the gold shares?
When we look around at what is happening in other markets the lousy action in the gold shares doesn't make a lot of sense. In particular:
a) A weak US$ combined with a firm stock market provides the ideal environment for gold shares. Over the past week the stock market has edged higher while the US$ has been soft, so this was a period when gold stocks should not have been unduly weak.
b) Although the overall stock market has been reasonably firm over the past week it has probably already reached an important peak or is within 2-3 days of doing so. This is a time when the performance of gold stocks should be improving, not deteriorating.
c) Gold's price action has been constructive, suggesting that a higher bullion price is likely over the next few weeks.
The only relationship we monitor that does provide a possible explanation for the weakness in gold stocks, not just over the past week but also over the past 3-4 months, is shown on the following chart. The chart compares the TSI Gold Stock Index with the yield spread (the yield on the 30-year T-Bond minus the yield on the 13-week T-Bill). Gold stocks tend to move with the yield spread, that is, they rise when the yield spread is rising and they fall when the yield spread is falling. Note that the rally in the yield spread that began last Sep-Oct failed to make a new high (above the May-2002 high) and that the yield spread has been edging lower over the past 2 weeks.
As to why gold stocks often trend in the same direction as the yield spread, we can think of two possible reasons. First, one of the main differences between the yield on a 30-year bond and the yield on a 13-week bill is the inflation premium that is built into the bond yield. So, when long-term interest rates rise relative to short-term interest rates it could be because investors' inflation expectations are rising. Second, when the investment demand for short-term Treasury debt increases relative to the investment demand for long-term Treasury debt, causing short-term interest rates to fall relative to long-term interest rates, that is, causing the yield spread to rise, it can be a sign that investors are becoming more risk averse. Another way of saying this is that long-term bonds are inherently more risky than shorter-term bonds, so when money is flooding into short-term debt at the expense of longer-term debt it means that investors are more worried about the future (they are less willing to make long-term bets). Gold stocks, in turn, tend to be favoured by investors during those times when the general confidence level is low/falling.
[By the way, there is no reason to expect the relationship between the yield spread and gold stock prices to work on a daily or even a weekly basis. However, it most likely wasn't a coincidence that the good performance of gold stocks on Thursday 1st May was accompanied by an upturn in the yield spread.]
Whatever the reason for the recent weakness in gold stocks relative to the gold price, it shouldn't be ignored. As such, we have suggested that it would be appropriate to do some selling of trading positions in gold stocks. In other words, it would be appropriate to take out some insurance. If the past week's price action in the gold stocks turns out to be a storm in a tea cup then the stocks that are sold now can be re-purchased if the HUI moves above last week's high (131.5).
If the short-term bearish case is confirmed over the next week or so, either via the HUI closing below Tuesday's low (120.44) or via continued weakness in the HUI relative to the gold price, the long-term bullish case for gold stocks would be NOT be affected. However, a drop to well below the March low would become likely.