Major Changes Apparent in Investors' Behavior
1. Gold - The Strongest Currency
Gold is making new highs in practically every currency in the world. A consolidation period that lasted for over a year and a half is over and gold is now rallying, not only due to weakness in the US dollar but also due to high investment demand around the world. This is the strongest bull market confirmation yet. Gold has now become the strongest currency.
2. Bond and Credit Markets
The spread between the yields on the longer term bonds and the shorter term notes is widening at approximately the same speed as in 2000-2001. This means that the bond market is anticipating a large rise in the growth of the money supply prompted by the Fed. The widening of the spreads, which is likely to continue, is a good indicator of an impending recession and is bullish for gold.
The market is now pricing a 160% chance of a 25bp rate cut, which means there is a 60% chance of a 50bp cut.
To date, the Federal Reserve has been very cautious in fighting the credit crisis and the weakening economy. It has only reluctantly cut the fed funds rates. All the talk about the Fed and the ECB pumping large amounts of money into the economy lacks substance. The highly publicized infusion of credit by the central banks in an attempt to help the ailing banking system is having almost no effect on the solvency of the financial sector. These funds are short term and have to be repaid by the banks within a few weeks at most. The media only seems to mention the auctions of new funds, but not the repayment of the old credit. In reality, the amount of additional funds added by the central banks since last summer has been negligible. This can be explored in detail by reading John Hussman's article.
Contrary to some analysts' beliefs, we think during the past year, gold has been rising due to escalating inflation expectations, rather than due to actual monetary inflation. In fact, the current gold rally and the fundamental conditions are becoming more and more comparable to the highly profitable 2001-2003 run.
3. Earnings Growth
Due to slowing economic growth, Standard and Poor's is now expected to begin revising earnings growth estimates downward for most sectors in the US economy. For the precious metals producers, the opposite is true. Slowing economic growth and strong gold price is exactly the medicine that gold / silver producers and developers need.
The medicine is kicking in and the Gold Bugs Index ($HUI) has just made an all-time-high weekly close. As there are few safe havens in a recessionary environment, gold and silver stocks are becoming beneficiaries of sector rotation away from financials, tech, and consumer related stocks.
Despite the fact that the Nasdaq 100 index was the best performing major index in 2007, a breakout in the ratio between $HUI and $NDX in the chart below is looming. When this happens, it will signify a confirmation of a sector rotation and a sea of change for precious metals investors bringing a possible rerun of 2001 and 2002 when gold / silver indices made their largest advances.
What is Still Missing?
1. Gold Still Weaker than Most Other Hard Assets
The past four years have been highly profitable for most commodities. Even though we do not consider gold a commodity, comparing gold to energy and other metals is highly informative. The most instructive way to assess performance of various assets is by adjusting them retroactively for inflation. For crude oil, the all time high in these terms is about $120 - within striking distance from today's levels. For gold, it is $2,150 to $3,000, depending on the inflation numbers you use, nevertheless, a long way to go.
It is important to remember that the nature of gold is countercyclical. This is the primary reason why gold has underperformed base metals and energy for the past four years of strong economic growth.
Times are changing. Many economies in the world are starting to show signs of a slowdown. Widening yield spreads in the chart below (30-Year T-Bonds / 5-Year T-Notes - $TYX:$FVX) are signaling economic weakness and gold is starting to outperform base metals.
But the main problem for gold and silver stocks remains. Energy costs continue to be stubbornly high. The winners for the past four years have been oil stocks as shown by the Amex Oil Index ($XOI).
What does a 57% growth in crude oil price mean during a year of slowing growth? A spike! This is not to say that a burst is coming, but it does mean that a prolonged price consolidation on oil is the most probable outcome this year.
2. Gold Bug Sentiment Too High
The shorter term worry that we have is the rapidly growing bullish sentiment among the gold bugs. While just a few weeks ago, many were capitulating, now optimistic projections of gold reaching $1,000 and higher prevail. This means that a short term consolidation before we can move significantly higher is likely.
3. Junior Mining Companies Remain Depressed
Valuation levels for gold and silver exploration and development are ridiculously low. Tremendous volatility in 2007 has forced a lot of the smaller investors out of the picture and there are now some exceptional bargains out there.
This situation is akin to what is happening in the broader market where Google, Apple and Research In Motion have contributed to most of the gains in Nasdaq 100 in 2007. In precious metals mining, a few larger players, such as Barrick Gold, Newmont Mining and Goldcorp are pushing the indices higher, while the mid-caps are languishing and the small and micro caps have practically been forgotten.
The Best Place To Be Invested
Big gold companies have made respectable advances, but their valuations have increased as well. They appear to be fairly valued at today's precious metals prices.
The small caps are yet to fully participate in the rally. We believe that the crisis of confidence has now been factored in and surprises from press releases should start to come in on a more positive side. Production and development cost pressures should start to moderate and the crisis of confidence will begin to fade away into the past. The first good signal that this process has already begun is a spectacular recovery amounting to 100% gains on Novagold over the last couple of weeks.
History of the gold bull markets shows that small gold and silver stocks become major beneficiaries in the later stages of precious metals rallies. Investors start looking for better value as big cap mining stocks become expensive.
The small cap gold and silver stocks are only preparing to head north. Being less liquid and having a higher perceived risk, but also a better value, they almost always rally dramatically in the later stages of the sector upturn.
