Tuesday, September 2, 2014

Gold Stocks and Gold – Potentially Bullish Developments

by Pater Tenebrarum

Gold Stocks Reach New High Relative to Gold

As we have mentioned in previous updates on the gold sector, few things are more important for its likely future performance than how gold stocks are performing relative to gold. The action in the stock market this year is in many ways increasingly reminiscent of the final phase of the technology bubble of the late 1990s. Concurrently, the recent action in gold, silver and gold stocks is also exhibiting similarities to the lows that were made at the time.

To elaborate a bit on this: the action in the stock market and the fundamental backdrop are of course only similar to the 1999/2000 period in certain respects; no two historical periods are ever completely similar. From a technical perspective, the parallels are the following: relative weakness in small cap stocks, an increasingly narrow advance driven by fewer and fewer stocks during each new rally leg over recent months, new all time highs in the Rydex bull/bear asset ratio and a noticeable increase in volatility in the ratio, multiple intra-market divergences over recent months with strength focused on the tech sector, and extremely lop-sided bullish sentiment readings in both positioning and survey data over recent months.

Fundamentally, the main similarity is a tightening of policy by the Fed. Note here that even though the Federal Funds rate remains pegged at the 0-0.25% corridor (and due to the mass of excess reserved held by banks effectively trades just below 0.1%), the so-called “tapering” of QE still amounts to a tightening of monetary policy. However, while the Fed has reduced its monetization activities, commercial banks have stepped up their inflationary lending. As a result, y/y money supply growth (TMS-2) has oscillated around the 8% mark since mid 2013. This is still quite brisk, and as such is a fundamental datum that can be considered as supportive for the market. Note though that it represents a sharp slowdown from the peak growth rates recorded in 2010 (approx. 17%) and 2011 (approx. 16%) and that the willingness of banks to continue to expand credit greatly depends on the economy's performance (there is a feedback loop between the two).

We have discussed some of the parallels between today's and the 1999/2000 situation in the precious metals sector before (see “Gold and Gold Stocks – Looking Even Better” for details). The technical aspects appear highly relevant to the current situation. A chart showing the move beginning from the year 2000 low in the sector can be seen here.

Regarding the fundamentals, one must keep in mind that gold and gold stocks are highly sensitive to changes in the fundamental backdrop. This is to say, they often reflect future changes in the fundamental situation with a very long lead time. As a result, the long drawn out bottoming action in precious metals and gold stocks in 1999/2000 started while the stock market was still roaring higher and the Fed was actually in tightening mode. Similarly, the decline from the peaks in 2011 and 2012 (apart from the fact that it involved a pricing out of the euro area debt crisis premium) accelerated in 2013, even while the Fed was printing more money than ever before. In recent months, a bottom seems to be in the process of forming while the Fed is actually once again in tightening mode.

CHART-1-HUI and HUI-gold ratio

Gold stocks as represented by the HUI index and the HUI-gold ratio, which has just made a new high for the move – click to enlarge.

The fact that the HUI-gold ratio is making new highs even while gold and silver are under short term pressure is very important. As always, we must stress that we are only talking about probabilities here, not certainties. However, new bull markets in the sector tend to follow a certain pattern: First, the mining stocks strengthen, then gold begins to follow them higher, and after a variable, but often long time lag, silver also begins to rise and gain in relative strength. Other commodities tend to follow even later.

CHART-2-Divergences updated

GDXJ, GDX, gold and silver. The blue quadrangles show that while the metals have returned to the consolidation range of April-June, gold and silver mining stocks have established a higher consolidation range. Moreover, there is now yet another divergence between gold and silver in evidence at the most recent low relative to the preceding low. We have discussed this “multiple divergences” phenomenon previously, see this chart from June 21, which also shows the divergences with the 2013 lows – click to enlarge.

Why are these Divergences Occurring?

We now want to briefly turn to the reasoning behind the sequence of events that is usually observed when the precious metals sector bottoms out and turns up. In other words, there are fundamental reasons for the technical divergences mentioned above. In order to understand them, one first needs to consider what happens when gold has transitions from a cyclical bull market to a cyclical bear market. Gold miners begin to mine lower grade portions of their deposits during bull markets so as to extend the life of mines, which is in principle not a bad approach. However, as gold bull markets mature, mining costs tend to rise ever more, as other commodities prices are usually also rallying strongly at the time. This leads to a sharp rise in input costs, including labor costs (which are a very large part of total costs), for all mining businesses.

Pursuing mine plans that include low grade areas of deposits becomes more risky as a result – any unexpected price decline will immediately tend to squeeze margins, and it takes some time to alter mine plans. Near the peak of the bull market, the managers of gold mining companies also tend to become careless. Spoiled by high metal prices, they tend to invest large sums in development projects that would at best be considered marginal at lower prices. In other words, a lot of capital tends to get wasted in this phase. After the transition to bear market conditions, as a rule not only gold's nominal price, but also its real price declines noticeably. Margin compression sets in, and a period of losses and write-offs follows, as reserves are reevaluated to reflect lower prices. Development projects get shelved or downsized, managements are fired and replaced. In short, by the time prices hit their lows, everything has gone fully into reverse and the focus has shifted 180 degrees from production expansion to margin preservation and cost control.

In this phase managements act as if they are expecting prices to go still lower, and the market will also tend to discount this possibility. Prices of mining stocks collapse to very low levels relative to metal prices. As we have pointed out late last year already, the market for some time failed to acknowledge a beginning improvement in costs and the first signs of stabilizing margins. The notion that mining costs would just keep rising was firmly entrenched. Around the time when the reversal in costs took place, a great many downgrades were issued, and analysts were spilling a lot of ink on a trend that had already ended.

Consider now what motivates gold to enter a bull market phase. Usually this involves a budding decline in economic confidence. Subtle signs of this can usually be detected in other markets; e.g. credit spreads will tend to increase. Before nominal gold prices rally, there is usually a reversal in gold's real price. In other words, the margins of gold mining companies tend to increase even before there is a rise in the nominal gold price, as other commodities and various input prices decline relative to gold. This is why in the early stages of a new cyclical bull market, gold stocks tend to rise relative to the gold price, and will remain in a “sweet spot” in terms of margins for quite some time. Note e.g. in the above mentioned chart of the action from 2000-2002 that gold declined for a full four months to a new low for the move between November 2000 and April 2001, while the HUI actually rallied, sending the HUI-gold ratio sharply higher. An imperfect proxy for gold's real price is the gold-CCI ratio shown below.

CHART-3-Gold-CCI-Short Term

The gold-CCI ratio has bottomed in May and has trended upward since then. Moreover, gold stocks have diverged positively against the ratio in late May relative to the December 2013 low in gold-CCI

The above mentioned process also explains why silver tends to underperform in the early stages of a new cyclical gold bull market, only bottoms out with a lag and then takes longer before it begins to exhibit good performance as well. Although the two metals are closely correlated, silver has a large industrial demand component in addition to being a monetary metal. Therefore the very things that exert a positive effect on gold stocks and gold in the early stage of the bull market, initially tend to be a drag on silver. It is also worth taking a look at the long term chart of the gold-CCI ratio. This chart shows two things: gold remains fairly expensive relative to commodities, and its long term bull market against commodities appears to be intact. However, the chart also suggests that a retest of the lower of the two trend lines shown cannot be completely ruled out from a technical perspective (file under: potential fly in the ointment).

CHART-4-Gold-CCI Long Term

The secular uptrend in the gold-CCI ratio seems to be intact – click to enlarge.

To summarize the above: if a trend change from bear to bull market in the sector is indeed underway, then we are currently getting all the signals we would expect to see in this case. Multiple divergences between the sister metals gold and silver at their lows, divergences between the mining stocks and the metals, divergences of the mining stocks with their momentum oscillators (which were already established at the 2013 lows), and recently the strong upturn in relative strength in the mining stocks in the face of a correction in the metals. Moreover, the action fits with a possible road map for the economy and the stock market.

Regarding gold stocks, there is one more chart that shows an interesting development, namely the GDM bullish percent index. GDM is a very broad-based cap-weighted gold and silver mining index containing 29 stocks (very similar to the XAU). The bullish percent index shows the percentage of stocks in the index currently sporting a point & figure buy signal. This index has recently reached a new high for the move as well, which shows that the sector is internally even stronger than the cap-weighted indexes are indicating.


$BPGDM vs. the HUI – the bullish percent index has moved to a new high for the year, indicating growing internal strength – click to enlarge.

Potential Negatives, the Metals and the Dollar

We would be remiss not to mention the potential risks and negatives. In the near term, one risk is given by the fact that a number of gold stocks have in the meantime become overbought. This could be alleviated by sector-internal rotation, which is in fact something that has frequently happened during the recent consolidation period. Another risk is given by the still relatively large net speculative position in gold futures, which is somewhat balanced by subdued sentiment reflected by surveys. However, gold is relatively close to a support level, so one has to be aware of the potential for a break of this support.

As we have noted previously, it seems possible that a number of long positions have been taken on in reaction to the unstable geopolitical backdrop. This always creates potential downside risk. On the other hand, the recent move lower in gold consisted of overlapping waves and has a wedge-like shape. Still, there is no telling yet which way the cookie will eventually crumble. It remains to be seen how gold stocks will react if that happens (as noted above, in 2000-2001, they weren't bothered by gold breaking lower over a period of four months).

A potential danger is also that if there is a stock market decline, it could get out of hand. If the stock market falls slowly, it won't be a negative for the gold sector, but a very fast and hard decline would probably be a drag.

CHART-6-Gold and silver

Both gold and silver remain quite close to important support levels – click to enlarge.

The US dollar index is another conundrum. Its recent rally has been very strong and looks impulsive. It is now overbought and ripe for a pullback and curiously, gold has actually held up very well relative to the dollar. The dollar seems driven by the geopolitical news backdrop to some extent as well, but there is also the perception that the due to economic weakness and a sharp decline in inflation expectations in the euro area, the ECB will be tempted to adopt some form of “QE”. This may not happen right away, but there is a widespread expectation that it will happen sooner or later (the ECB is first likely to await the effect of the TLTROs which are scheduled for September and December though).


The US dollar index nominal and relative to the dollar gold price. While the rally in the dollar looks quite strong at present, it has not been confirmed by gold.

In the context of long term inflation expectations (5 to 10 years and longer), it should be mentioned that they are currently declining everywhere. However, nominal bond yields are declining even faster, thus real interest rates are driven lower in spite of the decrease in inflation expectations. Falling inflation expectations are generally a negative for gold, at least for its nominal price (not necessarily its real price – that depends on how other prices in the economy are affected). On the other hand, falling real interest rates are a bullish factor, so these two factors seem to cancel each other out at the moment (note that “inflation expectations” in this context refers to expectations regarding future CPI rates of change).


Many of the factors that usually signal that the gold sector is likely to strengthen remain in evidence, and have lately become more pronounced again. Since we mentioned that there were “signs of life” in the sector in early June, it has acted quite well – surprisingly well, actually. Of course the picture is not entirely clear-cut or without flaws, but uncertainties always exist. Since the sector has a tendency to be very volatile, short term head fakes in both directions can be expected to happen at any time.

The action following the late 2000 low in the gold stocks probably provides us with a good road map. Should gold stocks continue to hold up well relative to gold and silver in the event of a further decline in the prices of the metals, dips should be regarded as buying opportunities. Conversely, a significant weakening of the gold stocks on a relative basis would be a warning that the time is not yet ripe for a resumption of the secular bull market. Even though gold is close to a support level, gold stocks are close to breaking a level of resistance, so it is once again time to keep a close eye on the action.

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