The aggressive play is gold

The case for buying gold and gold mining stocks.

Summary: The gold bear market could well be over, with some encouraging price action seen after it fell below US$1,200 an ounce. Gold mining stocks are also long overdue a recovery and could be a buying opportunity.
Key take-out: The price of gold has been savaged in recent months, but there are some promising signs that it has reached a turning point.
Key beneficiaries: General investors. Category: Commodities.

There can be no doubt that the recent sharp decline in the value of the Australian dollar is good news for Australian mining companies, particularly gold miners. The price of gold has been savaged by a combination of factors: Originally there had been fears the 'QE' program in the US would spark inflation, there were fears also that hedge funds might attack the metal. Now, however, the  market is at last showing some encouraging price action. Could it be time to buy?

There is no doubt a lot of investors the world over bought gold on the basis of “fear”: The fear of Greece leaving the Euro and the disintegration of that currency, or fear that the US would go into deep recession, or fear that Cyprus would bring down the global financial system. There were also worries that sequestration would ensure a recession again this year, and even more recently that tapering would also bring the financial system to its knees. All such suggestions were fiction, of course, but those research papers that suggested so sold like great novels over the past few years.

Having bought for the “negative” reasons outlined above, most investors felt they had to exit their gold holdings. Large institutions began advising their clients to sell gold as all that was previously feared was no longer likely to occur. There was no need to hedge against inflation or the end of the world after all. At the same time it has become abundantly clear that there were significant investment opportunities flourishing the world over, as in most parts of the world economic trends are clearly improving. With far less reason to be fearful, and with other opportunities presenting themselves, we have seen this avalanche of gold sales..

Just like all major bull markets however, bear markets also must some day come to an end. The end is always similar in that the market has significantly overshot the fundamental value that should exist even if the bulls, or as in this case the bears, were correct. Markets keep going in one direction until everyone who wants to sell, has sold.  At that point even further bad news may not be enough to get the market any lower. What has happened at that point is that all the bears have simply become nothing but a sea of potential buyers. With only buyers about, those who are bearish in view and short gold on this occasion, but who are in fact now buyers, the market can in fact only go up!

Graph for The aggressive play is gold

I believe we have reached such a point in the price of gold, and that gold never belonged below US$1,200, hence the strong rebound. The significant consolidation now occurring in the US$1,240-US$1,250 area suggests there are no new sellers. Without a fresh wave of selling interest from someone, the bears will now be left to compete to take profits. This is what happened at the bottom of the equity market sell-off in 2009, perhaps what we are close to in the Australian dollar now as well, but definitely already seems to be occurring in gold.

For Australian gold miners, we are presented with a situation where the investment market had been bearish the mining sector for many months. In fact the market was almost non-existent as investors the world over shunned anything to do with mining on the basis that China was slowing and increased supply was in the pipeline. Even if this were true on both counts, those scenarios are now already fully priced into mining company stock prices.

The interesting perspective that I would argue, is China has slowed but demand for resources will continue to increase just the same, while the volatility in commodity prices has scared mining companies off from increasing production.

Even if commodity prices recover, as I believe they will, the miners are unlikely to launch headlong into increased production for fear of prices being able to fall again at any time. Supply will therefore remain restrained, and this reality extends to the gold sector. Should demand continue to increase, as I believe it will, and were China to return to above 8% GDP growth, global commodity markets would have to move significantly higher than where they are now to reflect this more robust outlook.

With the gold price bottoming right now, and with potential for all commodities to begin to rise in a few months, many of Australia’s gold mining companies look particularly cheap. As I started this article however, the real accelerant comes from the decline in the value of the Australian dollar. While I believe the Australian dollar should rally from here, it would be unlikely to keep pace with the rise in the price of gold which could reach back to US$1,650 within twelve months. Should I be wrong on the Australian dollar and the great consensus proven correct – that the currency is still headed lower – then the argument for the gold miners becomes even more compelling.

Perhaps the most valuable point of all however is that one should not buy gold for the reasons of “fear”. It has been my position over several years now that it was indeed incorrect to buy gold for those reasons above, but I have consistently argued that gold is a buy nonetheless. Gold is still a buy and at these levels represents a remarkable opportunity. One should buy gold for the “good” reasons of continued strong global growth, and exponential prosperity expansion across the two most populous nations in the world, which also happen to value gold more highly culturally than anyone else. The cultural significance of gold in China and particularly India should not be under-estimated.

With supply now likely to be held at current levels for many years to come, prosperity continuing to spread across China and India, not to mention other parts of the world, and after all those investors who bought gold for the wrong reasons seeming to have now exited the market (as well as huge speculative short positions remaining in place), gold would appear to be glittering rather more brightly than ever before.

Gold mining stocks that are in production and have been driven to ridiculously low levels by both bearish sector sentiment and commodity price panics are at least being rescued by the Australian dollar, and would probably be strong buying opportunities in any case. There is a very clear prospect for a long overdue recovery in the sector to get underway almost immediately. This is, as per the title, a slightly aggressive view and therefore tread lightly, but do tread.

Clifford Bennett is chief economist of the White Crane Group at http://www.whitecranegroup.com.au/eureka/