This summer saw the biggest decline in the gold price since the infamous collapse of the early 1980s. In the last few months, one key technical support level after another has been not simply broken, but smashed. So much so that you could justifiably argue that the bull market in precious metals is over. Gold and silver (especially the latter) have fallen off a cliff and are clinging by their fingertips to one small outcrop.
The problem with precious metals is that they generate near-religious fervour among their investors, many of whom are ardent conspiracy theorists. "We're protecting ourselves against the paper-printing central bankers," they say. "The financial system is about to collapse." "Zimbabwe, Argentina, Weimar Germany, here we come." And so on. An end-of-the-world, siege mentality has developed.
But regardless of the rights and wrongs of these views, it doesn't do to become emotionally attached to any investment, be it stocks, property or gold. The best financial decisions, especially in a volatile market, are usually made in the cold light of day, particularly when wedded to a tried and proven investment method. The worst are made in a fit of greed or fear. Yet the fervour gold stokes makes it hard to make a detached decision about the metal.
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Gold is in a bear market
The hard, honest technical reality is this: gold has entered a bear market. It has fallen more than 20% from the highs, key support at $850 an ounce (the 1980 high) has been broken and is now meeting resistance (in technical analysis, this is a price level that an asset is likely to have particular trouble breaking through). Meanwhile, the important 200- and 300-day moving averages the average price over the last 200 or 300 days have not held. Price action (the trend, basically) is down.
What's more, we have a major credit contraction on our hands. We're entering a period of perceived deflation, which means we are seeing a huge flight to cash, the most desirable form of which will always be the global reserve currency. That means the dollar is rallying, which has hit gold.
Demand for physical gold is soaring
However, elsewhere something very different is going on, something unprecedented. August saw the biggest correction for a generation in the futures markets, yet on the street, buying is rampant.
In the Middle East, Tushar Patni, chairman of the Abu Dhabi gold and jewellery group, reported August as "the best month the market has seen in almost 30 years". Abu Dhabi, a major trading centre for precious metals, has seen gold sales rise by 300% in volume and 250% in value in August, from a year ago.
In South Africa, Rand Refinery, the world's largest gold refiner, was cleaned out of its gold stocks as an "unusually large" order for 5,000 Krugerrands (£2.25m) came from a buyer in Switzerland. That an order of this size was able to wipe out the stock of the world's largest refinery is, to me, astonishing. It demonstrates just how little physical metal there really is.
In America, the US Mint suspended sales of one-ounce American eagle gold coins. "Due to the unprecedented demand," said a spokesman, "our inventories have been depleted. We are therefore temporarily suspending all sales of these coins." Johnson Matthey, one of the world's largest silver refiners, stopped taking orders for 100-ounce silver bars at its Salt Lake City refinery because, according to one of its employees, they "don't have the capacity to meet investor demand".
In Vietnam, demand for gold is so high that bullion dealers are charging a premium of up to $100 an ounce. The government has imposed restrictions on gold imports and gold smuggling is rife. In Europe, Heraeus, Germany's largest refiner, had a waiting list as long as two weeks for orders of gold bars in Europe. And here in Britain a quick look over the weekend at the website of Baird & Co, one of the UK's largest bullion dealers, revealed shortages too. Investment bars of silver, in sizes ranging from 100 grams to 500 grams, were out of stock, with delivery times of three weeks being reported. Even on eBay, metal is trading at a huge premium to its spot price.
It seems there is a huge disconnect between the paper futures markets, where we have furious selling, and the market for actual metal, where buying is going wild. Why? It's surely a contradiction that can't go on forever.
Sometimes retail investors are right
For the most part, the man buying precious metals on the street is a private investor. There are very few funds and institutions that will buy physical metal. They prefer exchange-traded funds (ETFs), equities and futures. So you're looking at a situation where the retail investor is at odds with the institutions. Now, there's a common perception that the retail investor is stupid, and that they are always the last to the party. So it could be this old chestnut again: perhaps private investors have simply got it woefully wrong.
However, I don't know of too many funds and institutions that were buying UK property between 1993 and 1996. But I know plenty of individuals who were I was one of them. The retail investor is not always stupid. On the other hand forgive me but fund managers often are. There are plenty of fund managers who have been on the wrong side of the market these past 12 months, despite having ample warning. Only time will tell who's called this right.
A global margin call
People don't usually borrow to buy physical metal. They pay cash. Futures, however, are leveraged instruments on which you might only put down 10%. Those investors who were buying physical gold at $800 an ounce, or silver at $13, won't care so much if it goes down another 10%, or even 20%. It's a long-term investment and they will see this as a chance to get in cheap they just got their timing a little wrong.
But a 10%-20% correction on a futures contract will result in a margin call, where your dealer phones you up and demands more money to cover your losing position. And that is what is behind this huge sell-off: a global margin call. Many funds will leverage up their investment from 30-1 to 100-1. If you're leveraged 100-1, you only need a 1% move to kill all your capital. Ospraie, the commodities hedge fund that was recently shut down, was long gold, long silver, long oil, long natural gas and short the dollar. All those positions are going to get hit if the dollar rallied which is just what happened. (As an aside, this dollar rally began shortly after Paulson's June trip to China. One has to wonder what deals were done there?)
Just a small move of a few percent to the downside can trigger a wave of stops, selling, margin calls and forced liquidations. The leverage in the system exaggerates all moves. Retail investors are taking advantage of this and picking up physical metal at bargain prices (for more on how to buy the physical metal, see: How to buy gold). In short, the correction in gold and silver looks more like a case of deleveraging than the end of a bull market. That's not to say that gold's woes will end anytime soon. We are in a credit contraction and, as market historian Bob Hoye points out, "credit contractions can go on for far longer and be far more painful than anyone thinks". It may be that the dollar continues to rally, and gold and silver go on sliding. In the great precious metals bull market of the 1970s we had an 18-month, 50% correction. But long term I remain bullish on precious metals and believe that now is a good time to at least buy some.
I do not see any imminent big moves to new highs. I don't see a retest of $1,000 before late 2009. Rather, I expect a year or so of whipsawing action much like late 2006 to mid-2007 as we consolidate at these higher levels. But I do anticipate a good 10% gain before year end. Gold typically hits a low in August. In six of the past seven years gold has rallied from August to January. And many of the weak hands must have been flushed out by now.
Too often we think of gold as a commodity and we measure it in dollar terms. It's seen as a bet against the dollar, while futures, ETFs and spreadbets are all measured in dollars. But all commodities have a use and gold's function is as a store of wealth. It should be viewed as another currency and currencies fluctuate. While gold is currently falling against the dollar, it is actually rising against sterling. If you purchase physical gold, as I have forever advocated, the dollar has nothing to do with it. It is a straight pound versus gold transaction. Measured in pounds, gold remains in a bull market and none of the above technical damage has been done. Year on year, gold is up some 40% against the pound, while silver is also well ahead (see the charts below). Perhaps that is what is behind much of this buying of physical metal it's a flight from other currencies.
Gold miners look very cheap now
So what's been happening to gold stocks during this roller-coaster ride? In gold's massive upleg from August 2007 to March 2008, the stocks lagged. Usually, they will outperform bullion by three times, but this time they didn't. Being stocks, they don't always trade with the underlying commodity. In this case, they have performed more in line with the general stockmarkets, which have been down. Money that might otherwise have gone into stocks went into the gold ETFs, pushing up the price of bullion instead.
However, my focus is on juniors, which tend to move later in a run. This sector has taken a beating. It's been hit by the credit crunch almost as hard as banking. Sentiment is low, liquidity has dried up, any rallies are beaten up in a torrent of selling pressure, companies are finding funding harder and harder to get, appetite for speculation has disappeared altogether and funds and institutions have been fleeing the sector.
But even in this nasty market there have still been gains to be had, such is the potential of the juniors. And as they move into production, some of these firms are going to be earning so much money the market just won't be able to ignore them. Take Gold Resource Corporation (US:GORO). The group was aiming for production in Southern Mexico by year end, although red tape is likely to delay this to 2008. But it's fully funded and has been returning one bonanza grade after another. It could easily be producing as much as 200,000 ounces a year by 2010 with a cash cost of zero, by the time you offset its base metal production. Yes, zero.
At $800 an ounce gold, that's $160m profit. The firm's current market cap is around $110m. If the average p/e for the sector is 12 times, you're looking at a potential 10- to 12-bagger within two years, even if you bought in at the recent high of $6 a share. The market can't ignore those kind of returns. If it does, the firm will simply return the profit to shareholders via dividend. Of course, Gold Resource Corporation will have to achieve those targets, but they are not pie-in-the-sky. For an update on the rest of my tips, see below.
One last point the junior miners' worries could actually be bullish for the gold price. Mining is a highly cash-intensive business. That's corporate lingo for 'you have to spend a hell of a load of cash before you see any cash flow'. Money is so hard to raise now that loads of explorers even those at a late stage of development are going to go bust. In fact, they're already going bust. What's the consequence of all this going to be? You guessed it. No matter whether the metal is base or precious, production is not going to meet demand in the coming years and there are going to be more metal shortages, which will lead to yep higher prices. So hang in there.
How my metals tips have played out
Most of my tips from last year were up 50% by the spring. If you were ruthless about taking profit which I wasn't you would have made some money. But the sell-off since then has been brutal. This is not a sector full of old duffers who plod along with 10% gains or losses. You have to be prepared for corrections of 50% or worse, even if you bottom fish, as I do. But the stocks can also go up in multiples. Swings of 20% in a week are not unusual. So if you're going to have a flutter, only risk money you can afford to lose if there is such a thing. Disclaimers out of the way, here are updates on some of my tips, with my November 2007 prices also mentioned. I own stock in all these companies.
Gold Resource Corporation (US:GORO) is one of my favourite stocks a tightly and loyally held family company. I first tipped it as a buy below $3.50. It went to $6 and has slid back to $3.20 in this latest sell-off on worryingly-high volume. I suspect a fund is bailing out. If you can buy it at $3 or below, it's a no-brainer, even if gold itself falls. I tipped Capital Gold (US:CGLD) below 50c. It went to 95c, but is now back at 50c. This firm is a rare thing: a junior that has actually met every target it said it would, and is now in production (at a cash cost of $250 per ounce). It's making pots of money and will make loads more as production gets ramped up. Great management, great mine, but we want to see the chart turn back up here. It's a huge buy below 50c.
I tipped Olympus Pacific (CA:OYM) in the spring, thinking it would stabilise around 40c. It hasn't. The management insists all is well with the company. But all is not well with the share price. The lesson to all mining CEOs here is don't rely on drill results get some proper production. Peak Gold (tipped below C$0.70) merged with Metallica and New Gold in the spring to form New Gold. There was a nice rally into June, which I sold into as I didn't really know this new company. But it was followed by a nasty sell-off. I have no real view on the stock now, although it has an all-star team behind it.
I tipped Chinese gold miner Jinshan (CA:JIN) below $2 and again below $2.50. It rose as high as $3.25, before a brutal early August sell-off took it down to $1.15. Now that's volatility. The group has had some teething problems with its mine, but I have confidence in the management and feel that it's a buy down here.
Pan African (UK:PAF) I tipped in Money Morning at C$2.30. It was bought out a few weeks later. Shareholders eventually received C$4.50 cash and a share in a soon-to-list spin-off, African Queen, worth between C$0.50 and C$1. Nice work if you can get it. The entrepreneur behind Pan African, Irwin Olian, is also behind my new tip, Sacre-Coeur Minerals (CA:SCM). This one is highly speculative and early stage, but it looks like they might have not one, but two or even three elephant (multi-million ounce) gold deposits in British Guyana. It's just raised C$9m at C$1.50 a share, which in these markets is nothing short of miraculous. The market cap is below C$40m. Given Olian's superb record, this must be a takeover candidate, and I reckon it could be a three-bagger by next spring. Buy below C$1.30.
For those who prefer Aim stocks (although I can't think why), I tipped Leyshon (UK:LRL) below 24p and again at 21p. It went as high as 30p now it's at 18p. It's targeting production by late 2009. This is another China gold play, less advanced than Jinshan, but if either make their proposed Hong Kong listings, we should see a nice rise. Another Aim stock, Emed (UK:EMED), keeps recording spectacular results from its Slovakian gold mine. But the fireworks will come if it confirms 100% ownership of the Rio Tinto copper mine in Spain. That could happen fairly quickly. Even if you don't like copper, it'll be worth several times its current market cap. Tipped at 18p last year, it went to 32p, and is now at 22p. Also look at sister company Kefi (UK:KEFI), which is exploring for gold in Turkey.It's still at the 3p I tipped it at, having briefly touched 5p. I like Kefi's management a lot, but the company is high-risk. And don't pay the huge Aim spreads buy it on Plus.
The silver companies all took massive hits this last month, particularly when silver sold off last Friday. Many silver firms are uneconomic at $12 silver and will go bust but this will lead to yet more shortage of physical silver! I still like First Majestic (CA:FR), Great Panther (CA:GPR), Excellon (CA:EXN) and Aquiline (CA:AQI). But silver is notoriously volatile. If it's platinum you're after, consider Platinum Australia (Aim:PLAA), below £1. Rusina (Aim:RMLA) is also worth a look as a non-South African play on platinum group metals.
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