ST. LOUIS (MineFund.com) -- Gold mining equity prices have a lot of gloss on them in nominal terms. Many stocks are running at or near 52-week and all time highs, and the sector boasts some spectacular individual performances. Returns for the most traded producing or near-production stocks for the twelve months to the end of August are running at around 50%, and about 15% for the year-to-date. That contrasts well with the gold price which has risen almost 30% over the last year and some 12% so far this year.
Compared with general equities, gold stocks are performing very well and providing the reciprocal advantages they are supposed to demonstrate. And yet MineFund's leading gold equity leverage gauge continues to flash conflicting signals as it trades one and half standard deviations below the recent long-term average.
The Gold Equity Leverage Index (GELXSS) provides one of two interpretations. Gold stocks are ridiculously cheap compared with the gold price; or the gold price is dangerously over-valued and gold equities are providing an early warning. It is certainly not clear which is the better case. The more important question to ask is why the market has whittled away the correlation between gold stocks and the metal they mine.
Best Performers
Expensive or Cheap?
The industry is presently trading at $509 per ounce of proven and probable reserves, and nearly $8,000 per ounce of annual production. That's not terribly impressive by historical standards, and it equates to stock prices trading at a steep discount to their Implied Reserve Valuations (IRV); currently around 68% of the total IRV per share.
While those metrics look cheap, prices are running at an average of nearly 70 times trailing twelve month earnings; considerably less (about half) for forward earnings estimates. That is far higher than the S&P 500 which presently trades at around 19 times historic earnings (P/E10). Likewise, price-to-book ratios are quite lofty at multiples of three and better.
Adding to all those mixed indicators, the gold sector is barely trading above levels it raced to in mid-2002 as the world woke up to the nascent bullion bull market.
As a proxy for global gold stocks, MineFund's Gold Equity Index (GEX*), a market capitalization weighted index that tracks 12 senior gold stocks, went on to peak in March 2008. Gold investors who had bought the bottom of the index in 2000 would have been able to cash out annualized gains of 30% in 2008. Those who bought after the crash saw annualized gains nearly 10 times larger.
The difference between the 2002 and 2008 peaks could not be more stark though.
In 2002 stocks showed incredible leverage to gold as they echoed the 1996-7 period when valuations soared prior to the Bre-X fraud. MineFund's Gold Equity Leverage Index (GELX) snapped to an all-time high in May of 2002 as investors dumped cash into the sector on the back of very mild gold price increases (~6%).
Stocks retained their leverage and responded well to changes in the gold price until mid 2005. As the gold price started to take off from the Fall of 2005 and went to an interim peak in May 2006, gold stocks faltered even as they impact was camouflaged by superficially higher prices.
Deal Mania
We've previously placed much of the blame on the World Gold Council sponsored Gold ETF [GLD], which launched in late 2004 and took off over the Winter of 2005-6. That clearly diverted investment away from gold stocks. However, the companies themselves aggravated the situation with heavy deal-making that exhausted and diluted their traditional investment base.
Through 2004-6 , investors were being stuffed with scrip they had insufficient time or capacity to digest. In some instances it was simply intolerable, notably the Gold Fields-Harmony debacle. Major transactions in the period included Goldcorp-Wheaton; Barrick-Placer Dome; Anglo American-AngloGold Ashanti; Glamis-Western Silver; Goldcorp-Glamis; illegal Kebble gang disposals of Randgold Resources stock; and Gold Fields-Western Areas. That's just dealing with the senior stocks.
There were dozens more deals among the juniors and in other minerals, especially uranium and molybdenum where the shills were feeding the bubble as fast as they could without blocking their own exits.
On top of that the sector was undertaking financings at a furious pace. Apparently the Governor of the Reserve Bank of Zimbabwe was hired to issue full and half warrants on mining stocks, such was the volume of paper pouring onto the market.
Who Benefits from M&A?
Dilution problems come to the fore here, but it also points to investors having a skeptical view of gold stocks buying their way to growth.
The latter period of the gold bull market would suggest that mergers and acquisitions have been a failed strategy for investors. This wasn't the case for the early mergers where leverage was retained even though the fruits of deals such as Newmont-Normandy and AngloGold-Ashanti were hard to find. However, there is no denying that insiders did very handsomely on fees, commissions, bonuses, options and sundry payroll puffs.
The confluence of the rising popularity of the WGC's gold ETF and the easy money atmosphere in gold stock board rooms has been most unfortunate in terms of the loss of leverage to the gold price.
Investors might hope that the decline in leverage would put the brakes on the pace and magnitude of deal-making, but there is little evidence to suggest that given recent activity. Most gold companies are addicted to printing their own paper, and the banking sector is only too eager to help.
Wallowing
Although gold stocks reached new highs during the gold price break out of 2007-8, most of them grossly underperformed bullion - by about 30-50% - when compared with prior up-cycles. In 2008, when gold prices went into deep retreat, valuations collapsed completely.
A marked recovery occurred off the bottom that was touched on Oct. 27, 2008, but it has been temporary and disappointing.
The leverage index today trades nearly two standard deviations shy of the long-run mean, and it has been oddly static for most of this year despite gold rising to a record high in nominal terms.
Meanwhile, SPDR Gold Trust has sustained and improved its leverage to gold. Its leverage ratio has also taken on a completely different character since April which we're at a loss to explain. It is odd for the ETF to be trading with such exaggerated leverage compared with its underlying commodity and given its own dilution factors. It certainly is a serious ongoing problem for gold stocks which currently provide less leverage to gold than the ETF. That is absurd.
Cheap or not? We would say gold stocks look very cheap compared with prior years - provided company managements provide more discipline on dilution, executive compensation, and operational costs. However, it is also clear that gold equities are not immune from the albatross of uncertainty that is swinging from the neck of equities generally.
When equities recover their appeal, we may look back at this period as truly extraordinary. If gold stocks are able to reacquire their traditional leverage the effect would be like releasing a tightly coiled spring. At this point the spring is coiled back to bullion prices below $800 per ounce. That suggests gold equities are sitting on potential gains - relative to the gold price - of nearly 80%.
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(GEX* - The MineFund Gold Equity Index is a US dollar market capitalization index adjusted to neutralize growth through mergers and acquisitions. There have been 27 significant transactions for the 12 component stocks since 2000. Weekly updates are presently available here. An interactive version of the chart will be available later this year. GEX stocks are: AngloGold Ashanti (AU); Agnico-Eagle (AEM); Barrick Gold (ABX); Eldorado Gold (EGO); Gold Fields (GFI); Goldcorp (GG); Harmony Gold (HMY); IamGold (IAG); Kinross Gold (KGC); Newmont Mining (NEM); Randgold Resources (GOLD); Yamana Gold (AUY).)
(GELXSS The MineFund Gold Equity Leverage Index is the GEX divided by the indexed US dollar gold price. It can be likened to the Dow-Gold or S&P500 ratios).
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