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A global research report from J P Morgan Equity Research says gold has shown two faces during these times of market crisis: while gold equities have underperformed the S&P500 since the beginning of this financial crisis, gold bullion has outperformed the general markets handily.
Here is an extract from the J P Morgan study on gold in market meltdown:
Gold equities have been underperforming when gold investors were expecting more. In this note we conclude that the gold equities face challenges that explain their weakness and our preference for the metal. However, the tighter gold supplies and counterparty risk could give gold (and thus indirectly the equities) a lift through year end.
The gold miners face a tough Q4. Even though fuel costs are falling, so are base metal credits. On the Q3 conference calls, mining companies were coy about the benefits of lower fuel costs since they still face cost pressures elsewhere.
While current market moves are consistent with 1930s deflation, the very aggressive stimulus packages raise a new issue of currency stability. In the 1930s the dollar was so strong that the government repriced gold in an attempt to devalue the currency. Excessive liquidity expansion was essentially an elixir that extended economic growth and now may threaten confidence in the dollar. The rise in the CDS on the 10 year Treasury is, in our opinion, an indicator to watch as “fire alarm” for investor sentiment toward the dollar.
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Is it safe to go back in the water? The gold equities are correlated with both gold bullion prices and the general markets. We suspect they have been (at least in part) depressed by general market weakness. While we continue to recognize the difficulties the gold miners face, we feel they have probably underperformed enough for now, and we’d be buying the
gold space for the run into the holidays.
Where’s the next Homestake?
The gold bugs enjoy pointing to Homestake as one of the best-performing Depression-era stocks, rising 500% as the Dow crashed to about 40% of its peak level in 1929. Gold has shown two faces to the market: gold equities have underperformed the S&P500 since the beginning of this financial crisis, but gold bullion has outperformed the general markets handily.
We continue to feel this results from the operational challenges the gold miners face as a group but points to upside potential for gold prices as mine supply continues to fall and now central bank sales diminish. Long-only funds can’t eat relative performance, and we can understand frustration with gold’s performance. Work we did on gold’s performance in the 1930s shows how gold was a strong relative performer.
With hindsight, the best decision in the 1930s would have been to liquefy investments and hold dollar cash, and many seem to be expecting this outcome now with the rush to US government debt.
History doesn’t repeat, but it does rhyme. The dollar benefited in the late 1930s and beyond as 1) it took over from the pound as the world’s currency; and 2) the US economy boomed, helped by strong demographics and technological leaps stemming from WWII. It’s difficult to know now how the current stimulus packages will be paid for as US demographics drive a switch toward consumption over investment and also as the technologies of growth are commoditized and their use is exported to reduce cost.
In the current environment, capital flows into the dollar make sense with carrytrade unwinds and generalized fear, and our favorite technician feels the dollar could strengthen further. However, gold should not be simplified to being the dollar-not.
Gold does diverge from its relationship with the dollar as it did in the late 1990s and, more recently, in late 2005-early 2006. We believe this occurs when the supply demand fundamentals of gold overcome the prevailing (price) relationship with the dollar. We see mine supply continuing to fall and now, with central banks depleting planned sales quotas, we expect official sector sales to fall quickly. Given the very large above-ground gold stocks, falling supply does not guarantee stronger pricing, but it does, in our opinion, create the right environment for stronger prices.
