Friday, 7 January 2011

Did you say leverage?

A myth often heard is that precious metal miners offer a good leverage over the price of the metals. With precious metals rising the PM miners see their cash flow multiply at constant mining costs. I'm not digging into why this isn't always the case, I just show some evidence rising when comparing the HUI index to Gold.

HUI relative to Gold

Both graphs below show the HUI (basket of unhedged gold miners), relative to the continuous contract price of gold. High values mean miners are relatively more expensive.

daily (6 months) chart, click to enlarge
Weekly (3 years) chart, click to enlarge. The 200 moving average refers to 200 weeks or close to 4 years. The HUI:Gold ratio consistently stays below its 200 weeks moving average and is about to drop below its 50 weeks moving average. 
We saw excellent gold rallies over the past six months with gold strengthening by $200/Oz between mid July and end December. Gold mining earnings being leveraged to the price level of their output, you could expect a stellar performance of the HUI, with an increase of the HUI:Gold ratio. In the midst of the rallies this indeed worked out.
However, over the short term (graph over a 6 months lapse, daily observations) you'll notice the HUI turning weaker relative to gold during any correction, amplifying the decline of Gold. There is some support at the 0.37 level. We're still above that one. The HUI/Gold ratio dropped below its 50 days moving average (dma). It's about to drop below the 200 dma if weakness continues today. We find pull backs towards a support for the HUI:Gold ratio, despite stronger gold prices. (top graph)

On the long term (graph over a 3 years lapse, weekly observations) you can still notice the Oct 2008 cataclysm with the HUI imploding on a 15-20% loss for Gold. It took about 6 months for the ratio to get back to 0.35. This offered the opportunity of the century to multiply your capital invested. The HUI/Gold ratio seldom dropped back below that 0.35 support since May 2009 (and when it did it was marginally). Nevertheless, the HUI never regained its pre-crash ratio relative to gold (ranging 0.45-0.6), despite much higher gold prices. PM miners underperformed the precious metals over the long run. Did you say leverage?

Two more graphs to put it all in evidence: Gold weekly over 3 years. The 2008 stock market crisis merely seems a major correction within a secular bull trend: a temporary lapse of reason.

Gold weekly Jan 2008-Jan 2011. The 200 moving average refers to 200 weeks or close to 4 years.
The HUI over three years: the stock market crisis made PM miners implode as if it were bankers loaded with junk mortgage backed securities. The recovery has been spectacular, but we are barely 15% higher than in Jan 2008 despite a gold rally by 40%.

HUI, weekly observations over 3 years: Jan 2008-Jan 2011
The 50 and 200 moving average refers to 50 weeks and 200 weeks or close to 1 and 4 years.
This is by far not an outside opinion on the gold mining industry. In a recent article on "the gold report" I found following quote attributed to Steve Saville (2010):

Too often we hear about how gold stocks are cheap and how they are priced for $1000 gold or $800 gold. Just because the HUI:Gold or XAU:Gold ratio is low doesn't mean the sector is at a bottom. The reality is that large gold stocks have consistently underperformed gold over time. Steve attributes the poor performance to rising costs, management errors, environmental and political factors but most importantly, depletion. Just to stay in business gold companies have to consistently find new deposits, mine those deposits and add to reserves. The larger a company is, the more difficult it is to do these things. A junior company can grow by building a few small mines. A large cap needs to find huge deposits that can become huge mines. It is simply a more difficult business for the larger sized companies.
An update of gold miners valuation relative to gold can be found at the gold miner pulse page on this blog.

1 comment:

  1. After a recovery attempt, the HUI/Gold ratio fell back below its 200 days moving average today Jan 13. The HUI itself is well below the 50 dma (but still comfortably above the 200dma). Leveraged longs are going to end up cornered and broken at expiration next week.