The S&P 500/ XAU (Philadelphia Gold & Silver Mining Index) ratio chart below illustrates the extent gold mining shares are out of favor relative to the general equity market. The current ratio of 30.42 is close to the all-time high on the ratio set at the peak of dot com era in 2000 and the depth of the gold bear market. Contrarian investors and investors looking to rebalance diversified portfolios should appreciate the chart. This chart should be of particular interest to contrarian investors and investors looking to rebalance diversified portfolios.
Voices in the Wilderness
With central banks rewarding capital flows into financial assets, warnings of the risk of overheated markets fall on deaf ears for the most part. Last week recently retired Dallas Federal Reserve President Richard Fisher remarked equity markets were “hyper overpriced” and “vulnerable to a significant correction” in an interview with CNBC’s Rick Santelli. Joining the chorus was famed investor Paul Tudor Jones in a recent TED Talk, Justice, capitalism, and progress, “we’re in the middle of a disastrous market mania,” adding “one of worst of my life.”
Real Rates Tied to 10 Year U.S. Treasury Higher Correlation Than U.S. Dollar to Gold
Scotia Bank research shows US dollar strength is not the headwind market commentators and a number of analysts make it out to be. Historic correlation is 32%. The highest correlation is related to real rates tied to the U.S. 10 year Treasury at 80%. Negative interest rates across much of northern Europe are clearly supportive of gold prices. Further, with central banks competing to debase currencies and sovereign debt exploding over the past seven years, in our opinion, a less inverse correlation of gold to currency movements should be anticipated. Additionally, if deflationary pressures persist and asset prices decline, the fact that gold is not someone else’s liability becomes the most important driver for gold. On the flip side, if inflation becomes unleased, it is fiscally impossible, in our opinion, for the Federal Reserve to normalize rates to the extent real rates will not remain negative.
ANZ Bank Forecast Asian Demand to Double by 2030
In a research piece published last week by ANZ Research entitled “East to El Dorado,” Australian bank ANZ forecast Asian gold demand doubling to 5,000 tons annually over the next 15 years with the gold price trending to $2,400 per ounce as Asian per capita demand moves closer to Western per capita numbers. ANZ claims to handle 20 percent of China’s gold imports and 12% of global mine production. In our opinion, forecasting 15 years out is difficult as best, but assuming Asian demand growth put forward by ANZ, gold prices will have to be substantially higher to allow for lower grade deposits to become economic in order to meet the higher levels of demand. At $2,400 by 2030, production will decline from current peak numbers of 3,100 tons annually to under 2,000 tons by 2030 by our estimation based on current discovery rates and development cycles.
LBMA New Gold Fix Pricing Mechanism
The daily phone call London Gold Fix has been replaced with a new electronic system with the belief the new system will be less vulnerable to manipulation. Currently, the following firms participate: JP Morgan, UBS, Goldman Sachs, Bank of Nova Scotia, Barclays, HSBC and SOCGN. Chinese banks are anticipated to be joining the pricing process shortly which some believe will further facilitate the movement of gold bullion from West to East. Also, it is interesting to note JP Morgan joined the fix even though it sold its commodities business last year to Mercury. No doubt JPM joined to facilitate trading for client central banks and underscoring gold as a monetary asset versus a commodity.
Note: gold historically is considered money and not a commodity like oil and copper as gold is produced for accumulation and commodities are produced for consumption.
OCM Investment Thought Process Insight
We often get asked what gold price we utilize when analyzing gold projects for investment purposes. It is not a black box formula. We utilize a ten year trailing gold price average recalculated at the end of each year. The current number is $1,125. Why ten years? Mining projects typically are based on a ten year mine life plan for the simple reason NPV (Net Present Value) analysis gives little value to cash flow past ten years. We believe gold mining industry’s reliance on strict NPV analysis is one of the issues the gold mining industry has fallen trap to as it has tried to pigeon hole projects into ten year mine lives that would have been better off served with less up front capital, lower annual output and longer mine life.