The week-long pullback in the gold prices is throwing pundits into yet another bout of déjà vu. Indeed, in the northern hemisphere, it is now summer, and a fairly hot one in most capitals. And every summer, far away from the Krishna-tinged dark monsoon clouds, the gold investor sets her nets as deep as the pool allows. Greedy simulacra of value investment are supposed to resurface with vengeance as soon as the days get palpably shorter and cooler, auguring well for a yummy harvest season in September and October.
Since last October, the gold market has experienced five significant pullbacks, the strongest of which occurred after the record highs of early December. Within two weeks, the profit taking and liquidation of spec longs sent the prices down 11%. Since then, a paradigmatic shift has occurred in the gold market. While the December highs were achieved with the then predictable 89% correlation to Euro, six months later, gold hit an all time high while correlating positively 90% to the dollar. Last week’s strengthening of the Euro in response to reduced perception of banking risks in EU is the mirror image of how dollar’s strength would have affected the bullion throughout most of the noughties. We humans like investing such turnarounds with meaning. And the meaning of this correlation flip can be reduced to a simple quip – gold aligns its destiny with what, at that point in time, is perceived as a “stronger” currency. There was nothing secular and eschatological about its long-term correlation to Euro. There is nothing unavoidable about its current relationship with the dollar either.
As is usually the case, gold equities have suffered during gold’s recurrent retracements, but the worst pullback in GDX index occurred in January. December was more damaging for large Canadian stocks, as if the specialist fund liquidation had waited for a confirmation of a trend-breaking pullback. At the time of writing it, it is the Canadian mid-sized stocks (between C$1m and C$5m market cap) that suffer mostly in the market, but this group has already notched an impressive 59% return year-on-year, performing twice as well as gold itself or as generic gold stock indexes. Such divergence is not necessarily surprising in light of the recent survey by FundQuest, which has found that only four types of active portfolio managers consistently outperform passive indices: experts on currencies, small-cap growth, Asia-Pacific diversified equities and… precious metals companies.
How much deeper should the current pullback dig? Over the last week, GDX is down nearly 8% and mid-sized Canadian stocks over 10%. If the experience of the last 10 months can serve as a guide, then another 4% to 10% drop would not be surprising. Yet if that happens, and the upward trend does not resume immediately, it could yet be one of the worst summers for gold equity investors.
In fact, with the exception of the memorable August of 2008, the July-to-mid-August losses on gold stocks have been less than dramatic and on average the 10-year seasonal negative performance is only 4.5% in North America and 6% in South Africa. Gold itself is known to have recoiled by little more than 1%, on average, during this period.
There are three factors that could pull the gold equity performance either way this year. On the one hand, the broader equity market is in shambles, scared of global deflation, stoked by fiscal retrenchment in Europe and increasingly aggressive interest rate activity in price-volatile emerging markets. Regardless of how resilient the gold prices stay throughout the summer, the gold stock holders’ fortunes are not immune to broader sell-out in the equity market. The analysts’ cry of “deeper NAV discount” could be comforting, but the reality is that such deep discount could itself prefigure poor future returns on the underlying asset.
This would be a real worry if gold’s forward curve and lease rates exhibited behavior of growth-dependent, mean-reverting commodities, such as copper, iron ore or metallurgical coal. This is not the case and the binary deflation/inflation cloud which hangs over the markets may explain to some extent why this year’s seasonal weakness may be less pronounced.
The answer, as it often is the case, has to be sought in India. As the wholesale price index jumped to 10.2% in May, the price pressures began to seep from the visible food and energy items, feeding back into the manufacturing processes. This week, the Reserve Bank of India has acted decisively and off schedule, jacking up the rates by 25bp. The inflationary vise has now led to a general strike and an even more general feeling of overheating unease. Not surprisingly, as gold approached $1200 for the first time in two months, Indian buyers resurfaced with volume orders unseen since last January. Such strong demand points to a very robust floor under what could be a less depressing summer.
What could make the bottom fishing even more promising this year is the general nervousness injected into the market after the revelations of larger-than-life BIS gold swaps. While it is true that the liquidity-seeking central banks are ready to go beyond money market activity, the fact that cash strapped monetary authorities use gold as collateral, rather than sell it outright within the constraints of CBGA, is a positive signal.
Happy fishing.
Tags: gold equities, gold seasonality, gold swaps