- 13 November, 2002

The US Stock Market

Current Market Situation

Just a few brief comments on the stock market today because nothing of significance has happened since our previous commentary and we want to devote most of today's commentary to the gold and currency markets.

First, short-term sentiment indicators such as put/call ratios and volatility indices have not yet reached levels that would normally be associated with a peak. As such, we would not be surprised if the stock indices exceeded last week's peaks before the next major decline got underway. However, a concern we have, and the reason we have already established some put option positions, is that we are 3 years into a bear market and, therefore, the market might not get as 'overbought' as it has in the past before resuming its downtrend.

Second, short-term sentiment indicators might not have reached extremes, but some medium-term indicators certainly have. For example, after hitting an 8-year low of 28% just 4 weeks ago, the sentiment survey conducted by Investors' Intelligence shows that the percentage of investment-newsletter writers who are bullish is now above 50%. This means that investment advisors are now more bullish than they were at the time the market was peaking in August, even though the S&P500 Index is presently well below its August peak.

Third, Japan's Nikkei225 Index closed at 8,322 today, a new 19-year low on a daily closing basis (note that the below chart doesn't show today's trading). It is still marginally above its 10th October intra-day low, so at this stage an optimist could suggest that we are just seeing a test of the October low. However, the rally off the 10th October low was weak - the Nikkei was unable to surmount its 50-day moving-average during the rally and began to roll over after heading higher for only a few days. So, the price action certainly does not provide any evidence that 10th October gave us anything more significant than an interim low. At this stage US market participants are doing a good job of ignoring the goings-on in Japan. We think they are making a big mistake.

Finally, below is a chart of the NASDAQ Composite Index. The most bullish argument we can come up with for the US stock market is the NASDAQ's price action. The NAS recently broke its medium-term downtrend and moved up to its August peak. It then commenced what appears to be a normal breakout pullback. The thing is, as mentioned in the latest Weekly Update the early stages of a new downward trend are often indistinguishable from a normal pullback within an on-going uptrend. In order for the market to keep most people 'in the dark' most of the time, it couldn't be any other way.

Gold and the Dollar

Gold Stock Valuation Comparison

Below is an updated version of the table that last appeared in our 7th August commentary.  It is a rough valuation comparison of twelve (previously eight, but we've now added DROOY, GLG, LHG and MDG) large and mid-sized gold producers, ranked in order of PE ratio (lowest to highest). The figures have been updated, wherever applicable, based on the September-quarter reports that have been issued by all the companies over the past few weeks.

Note that:

a) Estimates of annual production, revenue and earnings are either based on forecasts provided by the companies or have been calculated by annualising the results from the September quarterly reports.

b) The figures for Kinross Gold assume that the takeovers of TVX, TVX Newmont and Echo Bay have already been completed, that is, we've assumed that TVX and Echo Bay will make a full year's contribution to KGC's results. The KGC earnings estimate is therefore very 'rough' since we have no way of knowing how the combined company will perform or how long it will take to fully integrate the separate companies into one.

c) We calculate a mining company's cost to produce an ounce of gold as follows: We subtract reported earnings from reported revenue to get a total, all-in cost figure. We then divide this total cost by the number of ounces produced to get a cost per ounce. This is a much fairer way to do a cost comparison than using the cash costs or production costs reported by the mining companies.
 
Name Symbol Recent Price (US$) Market Cap (US$M) Annual Prod (Koz) Annual Rev ($M) Annual Earnings ($M) Cost per oz prod (US$) Reserves (M oz) Mkt Cap $ per oz reserves Price/ Sales Price/ Earnings
Anglogold AU 28.62 6,354 6,348 1,924 404 239 59 108 3.3 15.7
Harmony Gold HGMCY 15.75 2,756 3,200 1,016 160 268 49 56 2.7 17.2
Gold Fields GFI 11.54 5,424 4,520 1,488 284 224 79 69 3.6 19.1
Lihir Gold LHG 0.69 788 600 200 40 300 15 53 3.9 19.7
Kinross Gold KGC 1.96 1,776 2,000 620 80 270 19 93 2.9 22.2
Durban Deep DROOY 3.59 714 912 268 32 259 16 46 2.7 22.3
Goldcorp GG 11.06 2,289 652 200 72 196 5 458 11.4 31.8
Meridian Gold MDG 17.9 1,718 416 134 37 233 2 818 12.8 46.4
Barrick Gold ABX 15.86 8,596 5,700 1,892 184 300 82 105 4.5 46.7
Newmont NEM 24.28 9,712 7,500 2,912 160 367 97 100 3.3 60.7
Agnico Eagle AEM 12.50 1,163 320 100 12 275 4 291 11.6 96.9
Glamis Gold GLG 8.88 995 250 80 10 280 5 195 12.4 99.5

Here are some of our thoughts on the information presented in the above table:

1. The South African gold stocks (HGMCY, GFI, AU, DROOY) do, in general, offer much better value than their North American counterparts. This is, of course, partly due to the greater political risk associated with South Africa. However, as we've mentioned in the past this political risk always seems less important to international gold-stock investors when the gold price is in a strong uptrend than it does at other times. When the gold price is perceived to be in an uptrend the overriding motivation changes from wanting a safe play on the gold price to wanting a highly-leveraged play on the gold price.

2. Taking into account P/E ratio, price-to-sales ratio, and the price the market is currently putting on reserve ounces in the ground, Harmony Gold offers the best value out of the 12 stocks considered in this analysis. Amongst the North American contingent the 'new' Kinross appears to offer the best value, although we are yet to see how the combined company performs. The lone Australian entrant - Lihir Gold - is reasonable value and has, by the way, recently increased its near-term exposure to the spot gold price by postponing delivery into some forward-sales contracts by 3 years.

3. The market assigns the lowest prices to the reserves owned by South Africa's Durban Deep (US$46/ounce) and Australia's Lihir Gold (US$53/ounce). There are reasons for this. For example, both are marginal producers, Durban has suffered more than its fair share of problems over the years, and all of Lihir's reserves are located on an island in Papua New Guinea.

4. Equity investors are obviously enchanted with both Meridian and Goldcorp. Why else would they pay an extraordinarily-high $458/ounce for Goldcorp's reserves and an eye-popping $818/ounce for Meridian's reserves? We are, of course, assuming that the gold these two companies dig out of the ground is no different to the gold that can be purchased for less than $325/ounce from your local bullion dealer.

Below is the same comparison, but this time based on a gold price of $420. The earnings at a gold price of $420 have been calculated by assuming that the cost to produce an ounce of gold will remain at its current level and that 70% of the increase in revenue resulting from the higher gold price will drop through to the bottom line. These assumptions may or may not be valid but for our purposes they are reasonable because we are trying to assess the relative merits of these 12 gold stocks, not determine accurate earnings figures. Once again the companies have been ranked in order of PE ratio. Note that we haven't accounted for the adverse effects that hedging will have on the earnings of ABX, AU, NEM and LHG if the gold price rises to $420. We also haven't accounted for exchange rate changes (e.g., at a gold price of US$420 the SA Rand would likely be stronger than it is today).
 
Name Symbol Recent Price (US$) Market Cap (US$M) Annual Prod (Koz) Annual Rev ($M) Annual Earnings ($M) Cost per oz prod (US$) Reserves (M oz) Mkt Cap $ per oz reserves Price/ Sales Price/ Earnings
Harmony Gold HGMCY 15.75 2,756 3,200 1,351 395       2.0 7.0
Anglogold AU 28.62 6,354 6,348 2,559 848       2.5 7.5
Durban Deep DROOY 3.59 714 912 356 94       2.0 7.6
Gold Fields GFI 11.54 5,424 4,520 1,979 628       2.7 8.6
Lihir Gold LHG 0.69 788 600 293 91       3.0 9.1
Kinross Gold KGC 1.96 1,776 2,000 825 223       2.9 11.6
Newmont NEM 24.28 9,712 7,500 3,873 833       2.5 11.7
Barrick Gold ABX 15.86 8,596 5,700 2,516 621       3.4 13.8
Goldcorp GG 11.06 2,289 652 266 118       8.4 17.6
Meridian Gold MDG 17.9 1,718 416 178 68       9.6 25.3
Agnico Eagle AEM 12.50 1,163 320 133 35       8.7 33.1
Glamis Gold GLG 8.88 995 250 106 28       9.3 34.9

Based on the figures in the above table, the companies that would show the biggest improvement in earnings as a result of a $100 increase in the gold price are NEM (+420%), ABX (+238%), DROOY (+193%), and AEM (+193%). However, this is because the current earnings of these companies are at depressed levels. Of the companies that are currently very profitable we calculate that the biggest percentage increase in earnings due to a $100 increase in the spot gold price would be generated by HGMCY (+147%) and the lowest increase would be generated by GG (+64%).

The greater leverage to the gold price provided by HGMCY relative to GG is illustrated in the below chart. The chart compares the HGMCY/GG ratio with the gold price. The HGMCY/GG ratio trended lower until early-September 2001, at which point a trend change occurred. At around that time more investors began to believe that the up-move in gold that had begun earlier in the year might be 'real' and more money started to flow towards the major gold stocks that provided the most leverage to the gold price. Between September 2001 and May 2002 the HGMCY/GG ratio trended higher with the gold price (HGMCY out-performed GG as the gold price rose), and when the gold price began to consolidate in late-May of this year so did the HGMCY/GG ratio. It is highly likely that an upside breakout in the HGMCY/GG ratio will occur at around the same time as an upside breakout in the gold price.

Gold Stocks, Interest Rates and the US$

In recent commentaries we've spent a lot of time discussing how interest rates influence the prices of gold stocks. In particular, we've explained that it is the level of long-term interest rates relative to short-term interest rates (the 'yield spread'), rather than the absolute level of long-term interest rates, that is of greatest importance to the prices of gold stocks. 

When we talk about the 'yield spread' we are referring to the yield on the 30-year T-Bond minus the yield on the 13-week T-Bill. Since 1982 the correlation between the yield spread and gold stock prices (as represented by the Barrons Gold Mining Index) is +0.29. This is a significant correlation and, in rough terms, implies that the yield spread and gold stocks trend in the same direction about 65% of the time. In recent years, however, the relationship has become even stronger. In fact, since the beginning of 2000 the positive correlation between the yield spread and the Barrons Gold Mining Index (BGMI) has been an extremely-high 0.77 (implying that the 2 sets of data have trended in the same direction about 88% of the time). 

We can't be sure that the higher correlation over the past 3 years means that there is now a permanently-stronger relationship between the yield spread and the gold sector of the stock market. However, since the relationship has been so strong during recent years it is certainly worth paying close attention to the behaviour of the yield spread when attempting to assess gold sector's risk/reward ratio.

While the correlation between the yield spread and gold stocks has varied widely over the past 30 years, the inverse correlation between gold (and hence gold stocks) and the US$ has consistently been strong since gold and the Dollar were officially de-linked in the early-1970s. This is the case almost regardless of what period we select. For example, over the past 30 years the correlation between the SF/US$ exchange rate (the number of US Dollars per Swiss Franc) and the gold price was 0.79, whereas the correlation between the two over the past 12 months was 0.74. In other words, the correlation between gold and the Dollar over the past 12 months has not only been very high, it has been almost perfectly in line with the long-term average.

The below chart shows how the Barrons Gold Mining Index, the SF/US$ exchange rate and the yield spread have moved in synch with each other since the beginning of 2000. 

We are certain that the gold market is manipulated and we are quite sure that some of the world's major central banks and governments have a hand in this manipulation. However, it is clear that the manipulation has not prevented the inter-market relationships that have worked well for the past 30 years from continuing to work well. Therefore, although it is certainly possible that the gold price could move higher for reasons that have nothing to do with the US$, it is highly improbable.

At this stage the US$ appears to be headed much lower. This, in turn, is a good reason to be very bullish on the prospects for gold and gold stocks. When bond prices fall, thus causing the yield spread to widen, this will create more upward pressure on the prices of gold and gold stocks.

Current Market Situation

Below is a 6-month chart of the Dollar Index. The Dollar fell in almost a straight line from its peak of 108.74 on 21st October to its low of 104.12 on 11th November. The rebound over the first half of this week is therefore not surprising. At this stage the bounce over the past few days looks like a rebound within a continuing short-term downtrend. This rebound will probably fail at, or below, 106.50.

Wednesday's sharp drop in the gold price wasn't significant, and neither was the previous day's bounce. As the below chart shows, December gold continues to trace out a consolidation pattern that began in May. Tuesday's rally fell short of the upper trend-line while Wednesday's plunge simply brought the price back to the middle of its consolidation range. If trend-line support at around $312.50 is broken then the target of $300 that we first mentioned in early-October would come back into play. However, with the US$ likely to resume its decline within the next few days we doubt that a downside breakout in the gold price (a drop below 312.50) is on the cards in the short-term.

Wednesday's gold market action highlights the risks posed by small traders being heavily net-long gold futures. The news that Iraq was going to comply with UN demands regarding weapons' inspections was taken as meaning that a war now has a lower probability of occurring. Whether this is correct or not the Iraq situation has almost no relevance to the gold price, but the news did provide an opportunity to shake the 'weak hands' (the small traders) out of some of their long positions in the futures market.

Below is a 12-month chart of the Amex Gold BUGS Index (HUI). The September-October plunge in the HUI resulted in a short-lived move below the 200-DMA which, as we mentioned at the time, will probably turn out to have been a good buying opportunity. However, although the HUI briefly moved below its 200-DMA it held above the uptrend-line dating back to the November-2001 low. This trend-line, which would currently be hit on a drop to around 108, should continue to hold during pullbacks. 

As has been the case over the past 2 weeks, the gold and currency markets are at critical junctures. If not for the weakness in the US$ we would be confident that gold was about to work its way down to around $300 over the next several weeks. A drop of this magnitude would probably be needed to eliminate much of the large net-long position in COMEX gold futures accumulated by small traders and thus to set the stage for a major advance. The reality of the situation is, though, that the US$ is weak and there is a distinct possibility that the Dollar's current rebound will be followed by a drop to new lows for the year. 

In our view, the approach with the best risk/reward balance is to 'buy the dips' in the gold stocks. We bought in mid-October when the HUI dropped below its 200-DMA and tested its uptrend-line and we would be buyers again if presented with another test of the uptrend.

Schedule Change

Due to family commitments the next Weekly Market Update will be up to 24 hours late. It will, however, be posted well before the US markets open next Monday.

Chart Sources

Charts used in today's commentary were taken from the following web sites:

http://www.futuresource.com/
http://stockcharts.com/index.html
 
 

 
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