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Archive for January, 2010



   Posted by: Mr. Gold    in Uncategorized

On Monday, Greece successfully attracted bids worth of EUR20bn for its syndicated loan issue, at spreads below the alarmist levels registered barely a week earlier. A collective sigh of relief resounded in European capitals, echoed by the market, equally encouraged by Ben Bernanke’s ‘guaranteed’ re-election vote tally.

Yet the Greek episode is worth considering from the perspective of a gold investor. Since the Greek deficit problems were first revealed to the market in late November, the trade-weighted dollar has strengthened 6%, Euro has lost 7% to the dollar and MSCI world equity index has lost almost 1%. Meanwhile, gold (in dollar terms) has lost 9%. The market’s disaffection with the Euro’s prospects has, by default, strengthened the dollar despite lingering doubts about the very sustainability of the US banking system and the rapid recovery of the economy’s growth engine – the home-owning, middle-class consumer.

Over the last year, bouts of dollar strengthening have been highly correlated with periodic returns of risk aversion. Indeed, since September 2008, the negative correlation between the performance of US equity market and the trade-weighted dollar has been maintained at over 50% – the longest such uninterrupted period this century. The bouts of stronger dollar were invariably negative for SPX index and for gold. Remarkably, the Greek episode and the subsequent wobble in Euro have changed this. The negative correlation between the dollar and the US equity market has now dropped to 30% – the lowest level since the Lehman Brothers’ collapse.

Fundamental analysts scratch their head over the dollar’s recurrent attractiveness and its gold-smashing power. After all, US deficit as a % of GDP is higher than most European countries’. US debt as a % of GDP is also heading fast towards the levels of more profligate European states. Even though EU may have been deeply troubled by the drama in Athens, the Greek economy represents less than 3% of Eurozone’s GDP, a small fraction of California’s 14% contribution to US economy, to mention only the most fiscally troubled of America’s States. Then, there is Washington’s political disarray – with popular backlash against an administration which inherited the worst recession in more than a generation, the unstable positions of both the US Treasury secretary and (until recently) the Chairman of the Federal Reserve, the stalled health reform, the dysfunctionality of campaign contribution system which further entrenches vested interests, the populist agenda targeting the Wall St banks, the widespread (and commonly resented) gridlock at the Congress and the public finances which will click at $1 trillion deficit per annum even before the Medicare problem and other entitlements kick in around 2019. But, much to chagrin of DeGaulle and his anti-American successors, the US continues to issue debt in what still is the deepest bond market in the world. For other central banks, the liquidity remains the chief attraction of the dollar. As the recent announcement of Russian Central Bank testifies, the diversification into other currencies (in this case Canadian dollars) has its limits – especially if you sit on half a trillion US dollars worth of reserves.

What is, therefore, the lesson from the Greek episode for gold investors? It remains the same. The bouts of dollar strength should be viewed as buying opportunities for gold. However, two words of caution are necessary.

For the first time since last August, gold in US dollar terms has now dropped to the 100 day moving average. If long liquidation continues, further support level would be reached at around $1036/oz. There are signs that it could. After briefly touching 17, last week the VIX index of market volatility jumped to 28. Although the index has since eased somewhat, in the process it broke through 200 day moving average, a technical event last observed in very different market circumstances in March 2009.

Secondly, further dollar volatility should be expected as the prospects of changing short term interest rate differential between dollar and euro change almost daily. But, outside China, where lending spree only intensified this month, the recovery remains brittle and the inflation expectations relatively benign. German economy unexpectedly stalled in the fourth quarter and the US data remain patchy. Even though the very poor US home sales in December (down 17%) could yet be reversed by new tax credits for the hobbled consumer, a bet in favor of higher short term interest rates in the US could be premature.

In dollar terms, gold is now over 10% off its December peak. In the drachma-fearing, weakening Euro, gold has barely lost 4.4%. If the dollar continues to strengthen in synch with further sell-off in the equities, the spread between the Comex gold price and the physical gold clearing price in Asia may close further, offering a healthy entry point for gold investors even before the seasonally stable second quarter. How quickly this happens will also depend on how robust gold sales will be ahead of the Chinese New Year, which this time falls unusually late in the calendar.

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   Posted by: Mr. Gold    in Uncategorized

With the GFMS figures out now, it has been confirmed what we suspected since October – global investment demand for gold outstripped jewelry demand for the first time in three decades. The traditional relationship between the price driver – the Comex trading, and price floor (determined by the physical demand) has been transformed by the success of the ETFs and increased interest in other gold investment products. In the first quarter of 2009, gold price advanced in synch with the strengthening dollar as record volumes of gold had to be stored to respond to the 13moz worth of new ETF demand. Then, in September, the gold option volatility skew suddenly flattened, the market went short gamma and – most unusually – never corrected after record increase in net long Comex positions. The goal posts of this market had shifted.

Investment demand is a game changer. Just witness the spectacular success of the new platinum ETFs in the United States since the beginning of 2010. In just two weeks, the market added the equivalent of 30% of last year’s global ETF demand… The picture for palladium is even more dramatic. There is little doubt that the autocatalyst and jewelry demand will have to respond to new price range and the PGM market may be testing how far the spread tolerance can go between the various market participants.

Platinum has a track record of taking some shine off gold. The market is about a tenth of the size of the gold market and the white metal lives a constructively schizophrenic life as an industrial and investment product at the same time. Although precious metals also tend to affect each other’s fortunes, an argument could be constructed on the basis of anecdotal evidence that the PGM ETF rush has led to some ‘gold fatigue’ among investors wobbling unsteadily into 2010.

But the clues to gold’s fortunes in 2010 have to be sought elsewhere. Yes, ultimately, gold market specific expectations will play the determining role – expectations surrounding central banks’ intentions, further growth of investment demand, recovery (or not) of Indian jewelry demand and the liquidity of the secondary market. Yet, I would argue that some of the main drivers of the gold market will come from the outside – determined by the broader risk perceptions, the shifts in the currency market, the anticipation surrounding relative interest rates and the bond market performance. Here is a short list of signals which may have consequences for the gold market.

1. Pay a close attention to the decisions surrounding the phase out of qualitative easing in the US. Although Bank of England has already begun to sell corporate bonds, the exact exit by the US monetary authorities remains uncertain. Any indication that the market could benefit from a significant drop in liquidity could be damaging to commodity market and to gold.

2. Watch the spread between US and Japanese 3-month Libor. Although carry trades are notoriously under-reported, there is little doubt that the spell of ultra-weak dollar since last summer correlated with the 3-month Libor falling below the levels of two classic funding currencies – JPY and CHF (Swiss National Bank has since intervened in the markets to weaken the currency). Any indication that the short end interest rates recover in the US could strengthen the dollar. And when it happens – while you may not necessarily be tempted to sell your gold jewelry or knock out your gold teeth just yet – you’d do well buying Japanese stocks.

3. Follow inflation-linked bonds. Any indication that US TIPS offer 2% or higher would mean a global recovery and possibly further inflationary pressures. How gold recovers will depend on market expectations for real rates going forward.

4. Further intervention by emerging markets in foreign exchange markets. Towards the end of 2009, emerging markets spent $150bn strengthening the dollar (and renminbi). Renewed bout of dollar buying would be gold-negative, ceteris paribus.

5. Treasury market balance in government budget deficit countries – not least in the US, UK, Japan and Euroland. The irony of 2010 is that the countries with the highest debt/GDP also enjoy the highest sovereign debt rating. But the demand for $4 trillions of new issuance from the G7 nations will depend on the appetite for other funds, velocity of money and inflation expectations. Any indication that Central Banks are reluctant to foot the bill could lead to rate spikes, affecting real interest rate – to which gold remains eminently sensitive.

These five signals are not mutually exclusive. It is also important to keep in mind that many of the arguments could function counter-intuitively. With 36% of investors based overseas, a US bond sell-off could initially be damaging for the dollar, yet the resulting increase in yields could dampen interest in commodities, including gold. On the other hand, an intervention by ECB to weaken the Euro (now less likely) could initially help the dollar, but the long-term effects would be liquidity-boosting – and therefore positive for risk assets and commodities.

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   Posted by: Mr. Gold    in Uncategorized

In the years since the vertigo-inducing success of gold ETFs – currently accounting for around 40moz of gold investment – the question of the continued relevance of gold equities has been raised on several occasions. As the platinum market is now bracing for the potentially game-changing effects of introducing a new platinum ETF on New York market, the issues of comparable risk, leverage, beta and relative merits of ETF vs. equity investments in the precious metals space are resurfacing again.
Arguably, the platinum market has always suffered from equity under-representation. The production of this metal is highly concentrated in the hands of 3-4 miners, the largest of which has only a limited free float. This relative paucity of investment vehicles may not be unique to PGM space, but can hardly be compared to the wealth of choice offered to a global gold investor. The geography of gold equities largely reflects the geological ubiquity of the product. The question remains, however, whether the equity market served with highly liquid gold ETFs is large enough to accommodate hundreds of producing, near-producing and exploring gold companies.

If recent capital-raising offers any clues, then the answer to this last question is an emphatic “yes”. In 2009, gold companies raised an unprecedented $18.5bn in financing for exploration, expansions and operations. This number dwarfs the previous record (in 2007), but has not prevented gold stocks from outperforming the commodity, for the first time in 5 years. While in 2009 gold notched a respectable 25% increase in dollar terms, gold equities ran up between 44% (HUI index) and 39% (GDX index). This was a far cry from 2008, when the extreme deterioration in the liquidity conditions reduced annual return on gold equities to negative 31%. Over the same period, gold held relatively well, becoming a rare asset above the water, albeit only at 3% annual return.

In fact, the high-beta characteristics of most gold equities are usually reflected in negative returns for the indices whenever gold fails to achieve at least a double digit return. Such conditions occur with surprising regularity, at about 4 year intervals (2000, 2004, 2008). However, since the advent of the ETFs in the middle of the last decade, it was not until last year that the gold equities benefitted from the tsunami of liquidity, offering returns above those ‘guaranteed’ by the underlying commodity.

Where do these precedents leave gold stocks for 2010? The good news is that after two years of liquidity-driven trading, fundamental analysis may finally come back in fashion. The bad news is that the investors must now do their homework properly, rather than hoping for momentum trading and another bandwagon liquidity event.
From this perspective, gold stocks that offer potentially attractive returns fall into two categories. On the one hand, there are stocks with very comfortable operating margins, owing to favorable cost environment. While they may not be the cheapest equities on near term multiples to cash flow, they offer attractive returns on equity in the months to come. The exposure to this group is not riskless, as most of them (e.g. Alamos, Kingsgate) are one-mine wonders, and should only be considered in the context of a larger, diversified gold portfolio.

On the other hand, there are stocks characterized by considerable growth in cash flow per share. Large expected volume increases offset somewhat these companies’ slightly higher costs. Despite the promise of significant earnings increases, their multiples are low, both in terms of EV/Ebitda and price to cash flow. Here, the most typical examples are Great Basin Gold and Jaguar Mining. The relative undervaluation of both stocks may owe something to the market’s nervousness regarding the structurally overvalued operating currencies – South African Rand and Brazilian Real, respectively. In 2009, the US dollar may have lost only 4% to Euro, but the greenback continues to wobble in relation to emerging market (and especially commodity-exporting) currencies, whose movements now determine most of the changes to the value of trade-weighted dollar (DXY).

Betting on the former group would align an investor with the dominating theme in the equity market today – disciplined growth. The latter group, on the other hand, falls into “contrarian value” category, which enjoyed an enormous success in broader equity markets since March 2009. Interestingly however, neither of the two stocks mentioned above have benefited from this run.

Astonishingly, the same applies to gold companies with significant copper by-products, despite the fact that the red metal outpaced gold five times over the period, keeping the lid on production cost creep. But should China become serious about reining the credit binge, copper prices may suffer soon, exposing these gold-copper producers to even higher discount. It is as if the gold equity market was alone in anticipating such a turnaround for several months now.

The above opinion does not represent investment advice and is not subject to FINRA or NYSE rules.

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Gold in balance sheet recession

   Posted by: Mr. Gold    in Uncategorized

The year 2009 is behind us.  For gold investors this was a year of decent returns.  Yet the 24.8% increase in dollar-denominated gold price pales in comparison to more volatile commodities, with lead, sugar and copper all gaining over 140% year on year.  The last-minute dash by the dollar/euro in December also put to sleep the argument commonly repeated among English speaking observers that the gold price is a tributary of dollar’s weakness.  In December gold may have steadied somewhat, but the year-on-year increase in EUR/USD exchange rate of mere 3% bears little resemblance to gold’s annual performance.  Indeed, if the dollar has lost some of its trade-weighted value, the loss has been registered mostly against commodity currencies, rather than the Euro, with the collateral damage registered by some of the gold mining companies whose margins are often at the mercy on the strength of the Rand, Aussie dollar or Brazilian Real.

But, as we are entering the new decade, the old paradigms may require a revision.  The received wisdom of perpetual Chinese growth, the permanently hobbled Japan, the happily overleveraged US and the haplessly uncompetitive Eurozone may need to be rewritten sooner than many expect.  After a consistently rewarding decade for gold investors, longer-term questions mount for them as well.

On December 16, FOMC announced that as of February 1 this year, liquidity swap arrangements will be discontinued.  The market briefly reacted pushing up the dollar against Euro, but with little immediate effect on dollar-denominated commodity prices.  Indeed, the Euro’s slide may have owed more to the nervousness surrounding the Greek situation.  Still, outright defaults are not a near-term option for Eurozone members.  Rather, the global investors’ environment will more likely range between robust growth (in Brazil or Indonesia), continued balance sheet recession and deleveraging (with potential bouts of deflation, as in Japan), asset bubbles (which are notoriously difficult to spot, but near-certain in Shanghai and Beijing property markets today) and increased inflationary pressures in some less developed markets (especially if food prices accelerate again this year).

Of the five sets of economic conditions listed above, the most relevant for the developed world’s investors is the third (continued deleveraging), and possibly fear of the first (sovereign bond market stress, rather than actual defaults).  The latter has been highlighted this week by the decision of several large bond funds to reduce exposure to US and UK paper.  In future we will return to this topic and its significance for gold investors.   In the meantime, let us review potential gold price scenarios in the former scenario (balance sheet recession).  To do so, it is illustrative to dwell for a moment on Japan’s plight of the last two decades.

Balance sheet recession takes place when there is a shortage of aggregate demand and surplus of funds to lend.  Such a borrower-less economy suffers from near zero interest rates, large-scale deleveraging and lack of spreads for banks to recapitalize.  The most important lesson from the experience of Japanese investors over the last 20 years is that deleveraging is bad for corporate returns and dismal for the stock market.  Since 1989 Nikkei 225 has lost nearly 67%, or the annualized 5% per annum, permanently forcing many investors from the market.  Meanwhile, the gold investment, as denominated in the local currency (the Japanese Yen) has gone through several stages, with remarkable reversals in terms of its correlation to the FX market.

As the Yen initially weakened to 160 vs dollar in 1990, the gold price in Yen terms increased, but then fell as the Japanese currency gathered strength (hitting an all-time high of 80 Yen to the dollar in the Spring of 1995, with gold as low as Y35000/oz). Importantly however, when the currency intervention saw the Yen swing back down to nearly 145 per dollar, the gold prices remained flat in Yen terms until 2000.  Then, in another reversal of fortunes between 2002 and 2004, a stronger Yen was accompanied by a steadily strengthening gold price (in Yen terms).  Later, the weakness of the Japanese currency may have contributed to an even faster upswing in Yen-gold prices between 2005 and 2007.  Finally, in the most recent period, gold-Yen outperformed the Yen-Dollar.

The above history of the (dubious and unstable) correlations between the currency of a balance-sheet recession-plagued economy and the performance of gold prices in the same currency shows that there is nothing deterministic about the gold price behavior in a deflation-prone, deleveraging environment.  However, preliminary conclusions can be drawn from normalized returns during the 20 years of Japan’s unhappy experience with the financial markets.  Over this period (using monthly returns):

  • The Yen has gained 54% to the dollar
  • Gold in Yen terms has gained 77%
  • Nikkei 225 has lost 66%.

In light of the above, in deflation cash may well be the king, but gold is the emperor!  By comparison, over the same 20 year period:

  • The trade-weighted dollar has lost 16.5%
  • Gold in dollar terms has gained 173%
  • SPX index has gained 215%

Arguably, the experience of the Western economies is somewhat different from Japan’s balance sheet recession.  For one, unlike in Japan, it is mostly not the corporations, but rather households that are in dire need of repairing their balance sheets.  Unfortunately, the slow pace of deleveraging (around 6% between 2008-2009 in the United States) would indicate that the sluggish credit growth may remain the defining feature of the markets once the Central Banks deliver on their recent announcements and limit the liquidity mechanisms.  Such premature, anti-inflationary measures are not per se a reason to shy away from gold.  But they could become a good enough reason to run away from inflated equity valuations.