Why gold bears are emerging from hibernation

After racing ahead, top gold stocks are under price pressure.

Summary: Gold stocks have been among the star performers for investors but many appear to have run too quickly, too fast.

Key take-out: Many gold stocks have outpaced the growth in the gold price itself, and now they’re coming back to Earth.

Key beneficiaries: General investors. Category: Commodities

Difficult as it might be for true believers in two of the Australian stock market’s favourite gold producers, Evolution Mining and Northern Star, are a few cents away from entering what is technically classified as a bear market – a time when prices fall by 20 per cent, or more.

Since August 1, the opening day of the gold-heavy Diggers and Dealers conference in WA’s mining capital of Kalgoorlie, Evolution’s share price has dropped by 17.2 per cent. Northern Star is down by 18.6 per cent.

The potential for falls, such as the $2.90 to $2.40 in the case of Evolution (EVN) and the $5.43 to $4.42 in the case of Northern Star (NST), was flagged in my August 3 report from the conference (Wealth warnings abound on gold).

Chart 1: August blues

Source: Bloomberg, Eureka Report

While it’s unwise to forecast what comes next, there is evidence that even with the sharp share-price falls a disconnection remains between the underlying price of gold and the share prices of the companies which produce it.

To emphasise the extent of the disconnection, the price falls by Evolution and Northern Star, together with falls of 7-10 per cent falls by other favourite gold stocks such as Newcrest, Saracen and Gold Road, the price of gold itself has fallen since August 1 by 1 per cent in US dollars and 2 per cent in Australian dollars.

What’s happened is that a market which rose too quickly is in the process of correcting, leaving open the question of how far will the correction go and when, if at all, will it be worth returning to goldmining stocks?

The answer to the first question – how far? – is tricky because once a correction starts it can overshoot on the way down, just as most gold stocks overshot on the way up.

The second question is easier because the factors underpinning gold have not disappeared and could get stronger. They include the lead-up to the November US presidential election, and the potential for a fresh outbreak of European uncertainty around its future as a unified bloc with a common currency.

When mixed with other critical factors, such as tensions in Ukraine and the South China Sea and the wealth-destroying effects of negative interest rates, gold’s appeal as a safe haven remains intact.

The same can be said of gold equities, although perhaps only once they’ve settled back to more realistic values. That was a point made forcefully by US investment bank Morgan Stanley in a research report headed, 'Gold equities: the big disconnect'. What Morgan Stanley did, two weeks after Eureka Report’s warning from Kalgoorlie, was calculate the gold price inferred by the share prices of leading goldminers.

“We estimate that equities are discounting a gold price that is more than 20 per cent above spot through perpetuity,” the bank said.

What triggered that observation from Morgan Stanley was a comparison of the boom in gold equities since the start of 2016 with other gold-stock booms since 1972, the year after then-US President, Richard Nixon, cancelled the convertibility of the US dollar into gold, which ended an era when the price was pegged at $US35 an ounce.

“Total shareholder returns for precious metals equities have so far (as at August 17) exceeded 169 per cent year-to-date,” Morgan Stanley said.

“This has propelled valuations to levels that are at or above historical peaks for most equities under our coverage universe. Our analysis suggest that the market is paying a 32 per cent premium to what it has historically paid for (gold) reserves and resources.”

Chart 1: Gold's tiny stumble - spot price, year-to-date ($US)

Source: Bloomberg, Eureka Report

Morgan Stanley’s analysis shows that when Newcrest was trading at $23.32 on August 17 it implied a gold price of $US1710 an ounce versus a gold price on the day of $US1342/oz. Northern Star’s gold price on August 17 of $4.63 implied a gold price of $US1546/oz and Evolution’s gold price on August 17 of $2.50 implied a gold price of $US1498/oz.

The bank looked at six gold rallies in the past 40 years when equities had risen by more than 60 per cent, noting that the current rally stands out in that it has occurred in a relatively short time.

In effect, investors have just enjoyed what could be sharpest and shortest boom in goldmining stocks since gold was liberated by President Nixon.

Other observers of the gold market are starting to publish similar warnings about gold, including one from a long-term gold bull, Warwick Grigor, chairman of the boutique investment advisory firm Far East Capital.

Grigor’s view, in a report to clients, was dominated by an observation that: “There could be a profit-taking wave in the golds”.

Noting that the dramatic upward surge in mining company share prices since the start of 2016 had been stronger, and lasted longer than he expected, Grigor said it was likely that the first wave of the new bull market had run its course.

The challenge now, he said, was for investors to adopt a more prudent approach to the mining market.

“During the first wave many hasty investment decisions can be made as optimism overrides caution,” Grigor wrote. “Optimism is still the dominant sentiment as so many more investors have a vested interest in seeing the market move higher, but we’re starting to enter the phase where promises need to be delivered.

Grigor noted that a number of gold stocks have come off their highs and are at or near their support lines, warning that if enough institutional investors decide it is time to take profits you could see an aggressive short-term sell down as big money moves around.

Not everyone agrees with the warnings about gold equities over-shooting and the likelihood that they will now spend some time correcting.

Macquarie Bank remains optimistic, singling out two gold stocks, Gold Road and Dacian, as significant beneficiaries of the high gold price in Australian dollars and lower costs, a situation summed up as “never a better time to build a mine”.

Gold Road is moving towards a development decision on its Gruyere project in WA and Dacian was expected to enjoy additional discoveries at its Mt Morgan project, also in WA.

Macquarie’s optimism about the outlook for gold equities sits at odds with the warnings from Morgan Stanley.

Someone is right, and someone is not, but on balance it’s easy to see gold equities taking a breather after a helter-skelter upward run that appears to have been the best ever.