22 May 2012

Equity Comment Gold & Mining Shares Better To Travel Than Arrive!

Philip Morrish

philip.morrish@intellisys.uk.com / +44 (0) 20 3239 8994

There is an old stock market say, it is better to travel than arrive and it is one that every investor should heed. Bull markets do not run indefinitely, most especially if the trajectory is near vertical and, in our opinion, gold has run its course. The following chart clearly shows that gold (bullion) has enjoyed a stratospheric rise since its bull run started in 2001/02. Chart: Gold Bullion (Troy ounce)

Source: Intelligent Analysis

Remarkably, the market remains divided. Gold bugs (bulls) continue to believe that the run is sustainable (currently, only pausing for breath) and that gold will touch the giddy heights of $3,000 because the global economic crisis is not resolved and there remain too many uncertainties. Moreover, they assert that mining shares have yet to fully participate in this bull-run as was the situation during the 1970s when, apparently, there was a delayed response. While the bears, and I count myself as one, argue that gold has run its course and will continue to underperform from here. It also means that mining equities have either fully participated or missed the boat. For the record, we are not recent converts to the bearish camp, on the contrary, we were one of the first to publically state that the gold bull run would blow out during the second half of 2011 and when the bubble burst it would fall sharply (see our note: Gold and Other Commodities Hold the 2011 Capital Markets Key, January 2011). The standard gold bug arguments are that gold is a safe haven investment because it is a limited resource, which makes it a good investment to preserve capital, particularly during periods of economic uncertainty. While also being a good hedge against inflation an interesting concept because gold would need to rise to around US$2,400 per troy ounce to match its inflation adjusted 1980 high. Moreover, Central Banks are going to hoover up hundreds, if not thousands, of tons of gold to provide support for their valueless paper currencies, particularly the US$! They also assert that, as in the 1970s, mining stocks have not yet fully participated in this bull-run.

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Gold & Mining Shares Better To travel Than Arrive

22 May 2012

That latter argument is frighteningly asinine! Financial markets and asset classes are significantly better connected than during the 1970s and information is more effectively disseminated and acted upon. The following chart dispels that urban myth because it clearly shows that mining shares were rising about 2 years in advance of the meteoric ascent in the gold bullion and other commodities prices during the well-publicised super cycle. Indeed, the ratio of FTSE Mining index/Gold Bullion (ratio) widened from an historic average of 10.1x (20/4/1994 21/4/1999) to a peak of 32.9x on 19 May 2008, since when the ratio has contracted to 11.1x on 15 May 2012. It is important to note that the ratios sharp fall during 2008/09 more accurately reflects investors heightened concerns about the depth of the synchronised global recession and the emerging scale of the financial crisis, i.e., a short-lived flight from equities. Nevertheless, the overall steady decline from the ratios peak reflects the dual influences of mining equity earnings growth being dampened by substantial capital raising exercises as well as gold (and other commodity) prices catching up with equity investors. Chart: Gold Bullion and Ratio of FTSE Mining/Gold Bullion (ratio)

Source: Intelligent Analysis

We maintain our view that gold will reassume its previous role as a minor asset class because contrary to popular opinion the global economy is in relatively good health and growing, which is consistent with our view that a tactical asset reallocation began during 2011 (see our note: Tide has turned in favour of risk of 6 October 2011). Indeed, it is only the economies of the UK and our urozone partners (with the exception of Germany) that are contracting and/or stagnating. The Greek drama will have its final curtain call soon while southern urozone states will be sufficiently protected. Nevertheless, we continue to believe that future economic growth rates for all developed and emergent economies will be less than their historic trend rates as a result of the dampening effects due to the progressive rebalancing of the developed economies through exacting deficit reduction programmes. Major currencies, with the exception of the uro, should remain relatively stable. The uro will continue to be volatile until the Greek crisis has been resolved. Thereafter, it should begin to strengthen as the urozone member states continue to progressively realign their economies with that of Germany.

Intelligent Analysis Limited

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Intellisys

Gold & Mining Shares Better To travel Than Arrive

22 May 2012

The following two charts clearly demonstrate that there is a good correlation between gold bullion and the FTSE Mining index. The unadjusted chart is a plot of the data from 20 April 1994 until 15 May 2012. While the adjusted chart provides a clearer picture of the correlation because it shifts the Gold Bullion time frame back two years to align it with the start of the equity advance as well as excluding the 2008/09 flight from equities data from the FTSE Mining Index. Charts: Gold Bullion & FTSE Mining Index (20 April 1994 15 May 2012) Gold Bullion & FTSE Mining Index (unadjusted) Gold Bullion & FTSE Mining Index (adjusted)

FTSE Mining Index (LHS) Gold Bullion US$/Troy ounce (RHS)

Source: Intelligent Analysis

There are no fundamental economic arguments that can support either a sustained consolidation let alone a further rise in the Gold Bullion price. While an early and constructive solution to the Greek drama and Eurozone debt problem would kick away any support. Equity markets appear to have begun to discount this with the FTSE Mining Index appearing to struggle to hold its current levels. Moreover, the substantial issuance of new equity by opportunistic mining groups, especially the explorers, will increasingly act as an earnings drag resulting to longerterm underperformance. Therefore, we would anticipate the index to initially test the 15,000 level before moving down to consolidate at the 10,000 level. Therefore, on the assumption that the FTSE Mining/Gold Bullion ratio sustains its traditional 10.1x multiple then the gold bullion price could readily fall to US$990 per Troy ounce.

Intelligent Analysis Limited

www.intellisys.uk.com

Intellisys

Gold & Mining Shares Better To travel Than Arrive

22 May 2012

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