Monday, 22 July 2013

The stealth gold recovery rally

Ever since bottoming in the morning of June 28, gold has been hesitantly drifting higher. The short first week of July, with American and Canadian exchanges closed for the national day, the yellow metal lingered on, apparently challenging its June 28 bottom. Gold closed the short week down 1%, however without closing below $1200. Ever since we seem to experience a stealth gold recovery rally. Until this morning, $1300 seemed to be a firm resistance for gold. After a few failed attempts, we're now vigorously steaming up higher.

I've been extremely cautious when hinting at this scenario possibly unfolding. Last month's posting "Depressive June endingwith a manic gold miner recovery rally" (June 29) ended with following perspective being drawn:
It 's always a risky business calling the bottom in for gold, especially at the start of what is known to be the seasonally weak "summer doldrums". However, we've been taken by surprise so often that the first upward blip of the eventual gold recovery rally most likely is going to be labelled a 'dead cat bounce'. I don't believe 3-digit gold prices (in USD) are looming behind the corner.
By now it seems to be increasingly obvious that the most lengthy and painful correction in the 12-year gold bull market is indeed behind us.

Mining stocks

Gold mining stocks have been sliced and diced, with many long term investors throwing the towel at a certain point. Many avoided the painful and sustained decline and a few unlucky may have exited at the very bottom.
However as gold climbs above $1300, many objective arguments against gold mining stocks no longer hold:
  1. With gold at $1200/Oz, about half of the operating mines are no longer profitable.
  2. Miners are turning to high grading whenever possible and are more quickly going to exhaust reserves.
  3. Miners are planning to mothball their development projects, as development costs are spiralling out of control and projected revenues dwindle.
  4. Explorers won't find any financing and will run out of cash within months.

There's a few more doubtful arguments claiming that subdued gold prices may hold longer:
  1. As gold became more expensive, gold miners have taken into production mines operating at much higher costs. High gold prices enable high cost mines and average production costs are therefore going to come down as lower gold prices hold on.
  2. Gold miners may operate a mine at a loss for some time, since the investment needed to restart a mine where operations have been stopped is higher than the loss incurred when continuing production.
  3. The above ground 'stock' of gold is manyfold the annual mine production and as such, the world is never going to run out of gold. 

The first argument is obviously true, however it comes at a "cost". Closing down the mines operating at a high total cost is going to result in a near 50% reduction of global primary gold output. Moreover several mining concerns are going to face stiff write-downs of prior investments, seriously challenging their financial health. Despite some mines still operating at a profit, gold mining companies may still face bankruptcy when closing down half of their mines.
The second argument cannot be denied either. However the challenge is to predict for how long sub-economical production is going to last. Since we're unable to correctly assess future gold prices even on the short run, making such long term assumptions is even more precarious. If the pain lasts too long, mine closure is to result.
As for the third argument, it somehow confuses physical flow with stock. The paper trade (of futures and leveraged products) exceeds total mine production manyfold.  However the physical flow is bound by limits. Much of the gold is immobilized in jewelry and works of art and is not traded any longer. Whereas Western central banks have been selling and leasing out gold, Asian central banks are stockpiling and less inclined to such practices. Several central banks (the German Bundesbank in the first place) have suspended all leasing activity and want to repatriate their gold. With ever more of the stock immobilized, the trade velocity of whatever remains needs to be quite a bit higher. The current reduction of the gold stockpile of certain ETF's (notably GLD, the SPDR gold trust) is temporarily increasing gold supply. However it also reduces the quantity of tradeable gold, since much of what is sold ends up in "strong hands" stockpiling for 'eternity' in the time perspective of a gold trader. Without sufficient gold mining output, commercial shorts are going to find it increasingly difficult to cover at least a certain fraction of their short interest. More naked shorting around is a recipe for a major short squeeze with gold spiking up. A more 'controlled' reduction of the short open interest will lead to a more gradual an sustained rise of the gold price.

The stealth recovery of gold miners (using the HUI index)

HUI index, daily observations from mid Jan 2013 till today, July 22nd.
For the first time this year, the HUI index is likely to close above the 50 days moving average. When comparing where we came from in January, this bounce up seems just a first step. Exactly that is what a stealth rally is all about. We may however soon be leaving the stealth phase behind.

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