The Case For Precious Metals Miners

We explained in last week’s newsletter how the stock market, and in particular the US stock market, is showing signs of exhaustion while the precious metals complex is consolidating and, in doing so, it is forming a structural base (some like to call it a bottom, but that’s not entirely correct). Whether that base will hold or not remains to be seen, but the unfolding pattern is very healthy so far. This sounds like an opportunity for secular investors.

One remark we often get from investors who are not following precious metals is why in the world would someone put his money in an asset that is so out of favor. That is a very valid question and successful investors should look at the markets in an unbiased way, free of convictions and personal beliefs. So let’s try to answer that question by looking at the subject from different angles, in an unbiased way.

First, fundamentally, the gold mining sector is going through a period of ‘catharsis.’ That is a healthy step in the business cycle. The sector got an excessive inflow of money between 2004 and 2011 to such an extent that even unviable projects got financed, resulting in overcapacity. When we saw that, around the peak in 2011, we told everyone to be prudent.

Meanwhile, the precious metals sector got a lot healthier. Almost every project and mine has been revised in order to meet the ‘standard’ criteria of business viability, management teams have been restructured and their wages have been cut, raw materials like oil have gone down, etc. All those sanctions will be reflected in the earnings figures in the coming quarters.

From a supply/demand point of view, we the era of ‘peak gold production’ is upon us. Based on the calculation of Goldcorp (GG), the number of discoveries peaked in 1995. The development time between discovery and gold mine production is on average 20 years. In other words, gold production will peak in 2015, and the supply of physical gold will decline as of now.

Furthermore, from a market price point of view, today’s average production cost for an ounce of gold is $1050 to $1200. Markets are rigged, we agree, but somehow we believe there is still some ‘price discovery’ going on. All jokes aside, it is probably no coincidence that the gold price is stabilizing around this price level.

Chart-wise, miners arrived at a critical price point. Below is the monthly chart for the gold bug index, (HUI), a proxy for the gold mining sector, since 1997. It provides a ‘big picture’ perspective.

 The gold mining sector is at levels unseen since 2001. Note the long-term support on the chart, indicated in red. From a technical point of view, it is no coincidence that the sector is finding support there. Whether that support will hold or not, is another question. It is clear that this is a ‘make or break’ level for precious metals miners. Although we believe this level will hold, given that the sector is trading 80% below its peak, the market can always decide otherwise. Again, the jury is still out, but the downside potential is seemingly limited.

The picture becomes even more interesting when looking at the miners in ounces of gold, i.e. the HUI to gold price ratio. One has to know how to interpret this ratio, however. It is not a timing indicator, nor is it a technical indicator. The ratio puts the sector in perspective, as it reflects the relative value of miners compared to the underlying asset they are producing.

Currently, the relative value of miners is the same as during the secular bottom in 2000. In other words, either the price of gold is low compared to miners, or miners are cheap compared to the asset they are producing.

Both the price of gold and the miners can go lower, which would keep the ratio stable. But given that the price of gold is at its cost of production, knowing that a cleanup has taken place in the mining sector, and that miners are trading 80% below their peak, the key point is that the downside is limited. That is what is of interest to secular investors.

Additionally, the chart reveals several consolidation patterns that lasted 9 months and resolved in a continuation of the downtrend. We are now in the 6th month of the current consolidation. As we’ve said several times lately, the coming summer could be hot for the metals, in either direction.

In closing, we would like to provide some guidance to our readers, based on a chart from a respected market observer. Below is a picture of the 4-year bear market in the precious metals complex with an excellent rendition of the downtrend, represented by the dotted trend lines. This provides us information on the breakout points to watch (the annotations are ours): GLD $125, SLV $16.50, GDX $21.50, GDXJ $27. Those prices are valid for the coming one to two months, after which they should be revised lower. If all assets were to break their structural downtrend, by piercing through those price points and staying above them, then we can be confident that a trend change has taken place.

If you look closely, you will notice on this last chart how brutal the declines were in the early stages of the bear market, and how close prices are moving towards the trend line. That is undoubtedly a bullish sign, until proven otherwise. As always, we keep on monitoring the precious metals markets, and we will update our subscribers as required.