While NCM are getting a bit of battering by the gold price I...

While NCM are getting a bit of battering by the gold price I just want to pick up on a line of thinking that I started last week.

I tried to put it out there that by buying NCM shares at current levels one would not be taking too big a risk for a long term portfolio investment because, irrespective of any real world macroeconomic arguments that can be made, gold is a cyclical commodity and we have just come off a cyclical bottoming of the gold price in December of last year.

This argument was swiftly disputed by another poster and on reflection I agreed that this argument was flawed and alone was not a very strong basis on which to form a view about the merits of buying NCM shares at the current prices.

I have been doing some pondering and I think the more sensible statement to make is that gold stocks have probably reached a cyclical low.

Below is my argument and I warn people that it is going to be particularly long winded, so before I get any complaints, if you are not interested tune out now!!

I have been an investor in gold mining and exploration companies for about 25 years, but up until recently haven’t really ever given much thought to gold itself, what influences its price or any so called price cycles. The recent fall in the gold price against a background of what can unarguably be described as “significant outstanding global economic uncertainty” has focussed my thinking on gold and I expect a few other peoples as well. I have been trying to pick apart the effects of what is moving the gold price for several months now with limited success. It is not hard to tie a particular event in the world to an upward or downward movement in the gold price, but trying to get a solid grip on the direction of the price movement is difficult.

If we are trying to see if there is a cyclical reason to buy into gold companies presently, the easier way and possibly more pertinent way to look at it is, not from the perspective of how is gold performing, but from the perspective of how are the gold companies performing relative to gold?

For those of you who are unfamiliar with the NYSE Arca Gold BUGS Index (also known as the HUI Index). It is a modified equal dollar weighted index of companies involved in gold mining. BUGS stands for Basket of Unhedged Gold Stocks. The Gold BUGS Index was designed to provide traders with significant exposure to near term movements in gold prices by trading on an Index which encompasses a basket of companies that do not hedge their gold production beyond 1.5 years. The HUI Index currently consists of 15 of the largest and most widely held public gold production companies. The HUI Index started with a base value of 200 on March 15, 1996. Below is snap-shot of the HUI index since its inception in 1996. I have added a few markers which I think are significant.

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Soon after the inception of the HUI index in March 1996 the gold price bottomed and at the end of August 1998 reached a price of about US$273 (green line). The HUI index went on to bottom in late 2000. From this bottom the HUI went on to be the top-performing US stock sector over the next decade, rising by about 1600%. The growth in the HUI also coincided with the invention and rise of large gold exchange traded funds such as SPDR Gold Shares (also known as SPDR Gold Trust) which in August 2012 rose to be the second largest exchange-traded product in the world. The growth of these gold funds after the GFC would have been helped by the liquidity that was created by the US government, but one must also remember that the rise in the HUI started 8 years before the GFC.

The price of gold peaked on 5 Sept 2011 at almost $US1900 and the a few days after, on 9 Sept 2011, the HUI index peaked reaching a closing high of 629 points (blue line).

So in summary (as represented by the HUI index) the big unhedged gold producers were the star performers of the US stock market between 2000 and 2011. One must also remember that during this period the HUI had to contend with the GFC and also compete with a growing army of great US tech stocks, many of which are now household names.

So what happened to the great growth story of the big unhedged gold producers?

Well like many great stock market stories it turned. But why?

Well I can’t give you the answer, but here are two interesting observations.

Observation #1

On 13 Sept 2012 Ben Bernanke announced QE3 a third round of quantitative easing (red line) at an open ended rate of $40 billion per month and on 12 December 2012 the amount of stimulus was increased to $85 billion per month.

Now if after the GFC the stimulus from QE1 and QE2 was a driver in the growth of the share prices of the big unhedged gold companies (and consequently the HUI index) then wouldn’t the logical conclusion be that more open ended stimulus would just have driven this growth story further.

If you look at the chart the announcement of QE3 (red line) corresponds to the start of a fall in the HUI index, which to date, roughly matches the size of the fall it experienced during the GFC.

Now what caused the HUI to fall is something that can be speculated about. Maybe the tide just turned for gold and gold backed ETF’s started selling and the HUI bubble burst like many bubbles do in markets. Maybe it had something to do with central bank selling I don’t know.

Observation #2

On the 19 June 2013 Ben Bernanke announced a tapering of the QE3 stimulus (yellow line) and the first actual taper of US$10 billion per month was announced on 18 Dec 2013 (pink line). This date coincides to within one day of the reversal in the gold price on 19 Dec 2013 and the apparent reversal we are starting to see in the HUI.

So based on pure observation alone the Fed Reserve's announcement of the taper and its implementations of the taper measures since December last year have acted to cause an upwards inflection in the price of gold and the HUI index. Now, whether or not this upwards inflection has been caused by the Fed Reserves actions, and whether or not the upward inflection in the gold price and the HUI can be maintained is arguable, but the observation is undeniable.

Now there is also a potentially more powerful way to look for a cycle in the HUI index.

This is by looking at the HUI/gold ratio shown below.

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The HUI-gold ratio is an expression which compares the relative quantities of the HUI Gold BUGS Index and the price of gold. The ratio is calculated by dividing the value of the HUI Gold BUGS Index by the price of gold.

The HUI-gold ratio illustrates the relative strength of the gold stocks in the HUI index to the gold price. I tend to think of it as a measure of how inflated the prices of the gold companies are relative to the price of gold.

If you look at the chart above two important observations stand out.

Observation #1

Although gold reached its high of US$1900 after the GFC the HUI-gold ratio shows that the index was far less inflated relative to gold than what it had been prior to the GFC. This is even despite the liquidity that had been pumped into the market place by the first two US Fed reserve stimulus measures after the GFC.

Observation #2

The HUI-gold ratio is presently sitting at just above its all time record low, near where it once was in late 2000 when the gold price was in the doldrums and trading under US$300.

On the basis of the arguments and observation presented above it is hard for me to believe that, from a cyclical point of view, the recent upswing in the price of gold and the HUI index could not represent the beginning of new mega cycle for gold companies. The last cycle having lasted for 13 years.

What you should also bear in mind is that after the GFC the big gold companies have had to adapt quickly to the falling gold prices. Many cut away non-core mines that they had accumulated either through direct acquisition or take-overs prior to the GFC. Take Barrick Gold’s recent divestment of assets that it acquired as part of its take-over of Placer Dome for example. Others like NCM have announced big write-downs and are cutting costs and deferring debt payments into the future.

I am heavily invested in gold companies and more than happy to be so.

SilentO