This was written about a week ago. It was a pretty gutsy call considering gold had fallen to almost $750.
If anyone wants the rest of the newsletter leave your email and Ill shoot it through to you (there are supposed to be some graphs as well but they didn’t copy across).
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As Good as Gold It’s difficult to recall a period of such extreme volatility in the share market as what we have experienced over the past 12 months. With swings in the hundreds of points being made in just hours of trading, what used to take weeks in the share market is now being gained or lost in just days. Between 2003 and 2006 there were only two days in which the Dow Jones Industrial Average moved by more than 2%. While many sectors have been through a ‘re-rating’ of late, one of the sectors to have most recently incurred the wrath of the market is the gold sector. As illustrated by the graphs below, both Lihir Gold and Newcrest Mining have seen their share prices significantly discounted over the past three months.
But the question isn’t ‘where has the gold price come from?’, rather, the question we need to consider is: where to from here?
The Three Catalysts Since the institution of organised trade, gold has been the store of value that everything else has been measured against. In modern times there have been three catalysts that have affected the price of gold over the long term. 1. Inflation: • Seen as a natural hedge against the devaluation of paper money, gold has typically outperformed during prolonged periods of inflation. 2. Risk of financial collapse: • When sovereign risk appears and there is no “safe currency”, gold is often purchased for its universal appeal and recognized for its intrinsic value. As such, when financial markets threaten to collapse gold has rallied as an alternative investment. 3. The US dollar: • In modern times gold has been quoted in US dollars. Therefore, when the dollar falls (as it has since 2000) gold tends to appreciate. As the old brokerage adage goes, “past performance does not guarantee future returns”. Still, considering the longevity of the correlation and the commonsense aspect of the relationships it would seem a prudent approach to at least consider these fundamental aspects and their likely effect on gold shares over the medium term.
Inflation: Anyone who has bought groceries recently is sure to have noticed the effects of inflation. But for those who prefer measurable facts to anecdotal evidence, consider that the official Australian inflation rate is currently running at almost double the RBA’s target rate. The US currently has interest rates below their inflation rate and much of Asia is experiencing official rates near 10%. Suffice to say there is not a government in the world that isn’t concerned by local and global inflation. That Australia, Europe and the US seem likely to reduce interest rates again says nothing of their inflation concerns, but more of their fear of recession.
Financial Collapse: Consider the financial environment since June 2007. To mention just a few of the more well known names, we have seen the effective collapse of: • Indy Mac • Bear Stearns • Lehman Brothers The Nationalisation of: • Northern rock (UK) • Fannie Mae and Freddie Mac (USA) And the ongoing collapses of: • MFS Not to mention the severe wealth diminution in former market darlings: • Allco Finance • Babcock and Brown Clearly the sub-prime crisis coupled with the on going credit crisis has placed much of the global financial market under pressure, particularly those companies which had over-geared balance sheets. This is not to suggest the entire system is at risk, but clearly there is a general fear in the global financial markets.
American Dollar: Since 2000 the US dollar has depreciated some 40%. Some would argue that this was the result of a weakening American economy, others suggest it is the result of a loose Fed and an increased money supply.
Since July there has been a dollar rally, but many analysts suggest this is a short term rally (much like what we saw in 2005) bought on by advantageous terms of trade and the higher attractiveness of US exports.
The Disconnect: A common theme across the commodities universe has been the disconnect between the value of the assets held by the companies and the value of their shares. As has been the case for many commodities recently, gold is down significantly (25%) from its recent highs. Yet many gold companies are down more than 50% from their recent highs.
There are about as many theories for this disconnect as there are analysts following the market. Yet there is one point on which everyone must agree. More hedge funds are selling in the commodities market than there has ever been before. Whether it’s a cyclical transfer of capital from the last winning trade in search of the next one or pressure from clients redeeming their funds, there is no doubt that this massive transfer of capital is causing a misevaluation on many fronts. The most recent being commodities companies.
The Outlook: While no one can be certain of what the market will decide on a day to day basis, an investor can determine the fundamentals of a company (or sector) and base their long term outlook on those expectations. Despite the recent dollar rally, we believe that all three factors that have historically determined the value of gold continue to paint a very positive picture for the medium term outlook. With strong growth and increasing demand expected to continue in the emerging markets, there is a general expectation that inflation will continue to trouble world banks. With the effects of the credit crisis only beginning to show up in financial reports around the world, there is a very real chance of continued write downs. And, with the US promising to print its way out of its current problems there is every reason to believe that the dollar will return to its down trend. While these factors may be cause for broader concern, the gold industry should be well placed to become a significant beneficiary.
And shares? At such a time that fundamentals are once again appreciated by the market and companies go back to being priced based on their earnings outlooks, we would expect that there are a vast number of companies (both gold related and otherwise) that will have some - price appreciation - catching up to do. In the mean time we are using these times to invest in companies in which we have high conviction, companies that have become grossly undervalued based on their fundamentals.
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I tend to agree with the auther. I think gold has a long way to go (up).
