A Big Relative Decline

Since April of 2011, gold stocks have entered a notable downtrend relative to the prices of gold and silver. Various theories have been advanced as to why this is the case and all of them have some merit (e.g. the fact that 'resource nationalism' is increasing all over the world, that costs are ratcheting higher, that metal-backed ETFs give investors exposure to the metals while avoiding the hassles gold mining companies have to deal with, and so forth).

The decline is depicted below, in terms of the HUI-gold and XAU-gold ratios:

The HUI-gold ratio versus the gold price over the past three years. Since the 2011 interim high, the ratio has been in free-fall- click chart for better resolution.

The XAU-gold ratio doesn't look any better. Note that the ratio was over 50% higher at the lows of the 1980-2000 gold bear market, after having been cut in more than half from its 1996 high around the 39 level. Compared to their 1996 level, gold stocks as a group have by now declined by almost 75% relative to the gold price- click chart for better resolution.

The HUI index closed last Friday at a mere 476 points, a level it first reached in the week of January 7 2008, when it closed at 475 points. So the index has de facto gone nowhere (in very volatile fashion) for about four years and three months, while the prices of gold and silver have roughly doubled over the same span.

The HUI (weekly candles) and Gold (green line), over the past three years- click chart for better resolution.

The HUI index first reached the current level in early January of 2008. At the time, gold was trading at about $850/oz. and silver slightly above $15/oz- click chart for better resolution.

It should be noted to the above that there are several large component stocks in the HUI and XAU indexes that suffer from their own company-specific issues, such as e.g. AEM, KGC, and HL to name three prominent examples, but even if one looks at the most heavily weighted bellwether stocks of the HUI, such as GG, ABX and NEM, it is evident that they have all declined sharply relative to gold. A list of the stocks in the index and their individual weightings is below (NYSE/AMEX reviews the index composition and the weightings of the component stocks every quarter).

HUI component stocks and their weighting in the index as of 12/01/2012:

Company Name	Symbol	% Weighting
Goldcorp Inc	GG	16.20%
Barrick Gold	ABX	15.37%
Newmont Mining	NEM	10.88%
Harmony Gold Mining Adr	HMY	5.21%
Coeur d'alene Mines	CDE	5.11%
Yamana Gold	AUY	5.00%
Anglogold Ashanti Ltd Ads	AU	4.88%
Gold Fields Ltd Adr	GFI	4.80%
Randgold Resources Ads	GOLD	4.71%
Iamgoldcorp	IAG	4.43%
Eldorado Gold Corp	EGO	4.34%
Hecla Mining	HL	4.14%
Comp de Minas Buenaventura Ads	BVN	4.08%
New Gold Inc	NGD	3.90%
Kinross Gold	KGC	3.85%
Agnico Eagle Mines	AEM	3.11%

The HUI index daily versus gold (green line above) – the index is tagging an important area of support at present- click chart for better resolution.

A Change in Perceptions

In part the decline in these stocks is probably due to recent weakness in mining stocks more generally. There is a lot of relatively mindless indexed investing going on, which has undoubtedly increased such correlations. Moreover, it is clear that sentiment is currently very bleak.

In part this can be explained by the recent increase in economic confidence (especially in the US), which has led to expectations that interest rates my be hiked earlier than currently envisaged by the Federal Reserve and that additional easing measures are a good way off or may not be adopted at all.

This in turn has made investors somewhat wary of gold: it is probably held that its price is more likely to decline than to rise in the near to medium term. As we have pointed out previously, Wall Street analysts have consistently underestimated the gold bull market. The difference to previous instances seems to be that this time, the market believes them.

What we can not know for certain is for how long these perceptions will predominate. The gold price itself however so far gives no indication that anything untoward is happening. The corrective phase that began after the September 2011 high in the gold price continues to look like a fairly routine triangular consolidation:

A weekly chart of gold in dollar terms with several important trend lines and lateral support/resistance levels indicated- click chart for better resolution.

Gold in euro terms, weekly. The current triangular consolidation looks very similar to the triangles built on previous occasions- click chart for better resolution.

While we cannot say with certainty for how long this change in perceptions is fated to last, it seems likely that economic conditions will weaken again faster than is currently expected.

The most recent trend in economic data is best described as a 'mixed bag' rather than unequivocal evidence of strengthening economic activity. In this context note that the ECRI (Economic Cycles Research Institute) has recently reiterated its recession forecast (see 'Why our recession call still stands'). ECRI notes that it can not be certain to what degree seasonal adjustments have influenced the data it collects in light of the sharp 2008 downturn, but the main effect seems to be that data have been skewed to the upside. ECRI makes the following observations regarding forward-looking economic indicators and seasonal adjustments:

“How about forward-looking indicators? We find that year-over-year growth in ECRI’s Weekly Leading Index (WLI) remains in a cyclical downturn (top line in chart) and, as of early March, is near its worst reading since July 2009. Close observers of this index might be understandably surprised by this persistent weakness, since the WLI’s smoothed annualized growth rate, which is much better known, has turned decidedly less negative in recent months. The unusual divergence between these two measures of growth underscores a widespread seasonal adjustment problem that economists have known about for some time.

Most data, both public and private, are seasonally adjusted. But the nature of the Great Recession seems to have had an unexpected impact on the statistical seasonal adjustment algorithms that are hard-wired to detect when the seasonal patterns evolve and change over the years. This is normally a good thing, but when the economy fell off a cliff in Q4/2008 and Q1/2009, it was partly interpreted by these procedures as a lasting change in seasonal patterns. So, according to these programs, data from Q4 and Q1 would be expected thereafter to be relatively weak, and therefore automatically adjusted upwards. Our due diligence on this subject indicates a widespread problem, resulting in many recent economic headlines being skewed to the upside.

However, we have no way to objectively measure the extent of these problems – either the upward bias for Q4 and Q1 or the downward bias for Q2 and Q3.”

Below is a chart depicting the year-on-year growth rate in ECRI'S weekly leading and coincident indexes for the US.

ECRI US WLI and US coincident indexes, year-on-year growth- click chart for better resolution.

As we have previously mentioned in this context, there is also growing evidence that the lengthy zero interest rate policy has once again shifted investment spending toward higher order goods production to the detriment of consumer goods production. This growing imbalance is typically observed prior to the onset of recessions as well, although this ratio can not be used for the purpose of precise timing.

Administered interest rates meanwhile remain near zero, with the effective Federal Funds rate relatively static below the upper boundary of its corridor:

The effective federal funds rate remains below the upper boundary of the Fed's official target rate of 0% to 0.25%- click chart for better resolution.

Inflation expectations have however increased lately – these are calculated by comparing the yields of treasury notes with those of equivalent 'inflation protected' treasury notes, or TIPs. Since they reflect expectations about the future rate of growth of CPI, we are putting 'inflation' in quote marks.

US 10 year inflation breakeven rates, via Bloomberg: back at the levels last seen in July of 2011- click chart for better resolution.

Interest rates have generally moved higher lately, with Federal Fund futures contracts indicating a likely increase in the FF rate to 0.50% by 2013, one year earlier than the Fed has officially committed to. Note here that this promise is not really taken seriously by market participants anyway: it is widely expected that it will be abandoned if the circumstances warrant it.

Meanwhile, the dollar index, which often (but not always) tends to move inversely to gold, has recently mainly strengthened as a result of weakness in the Japanese yen. However, if one thinks this through, it is difficult to fashion a bearish argument for gold from this development. After all, the main reason why the yen has weakened is that the BoJ has promised to inflate Japan's money supply more forcefully.

The dollar index DXY, daily. Lately it has been strong due to a sharp weakening of the yen- click chart for better resolution.

Similar concerns were a focus of the gold market from 2004-2005 and again from mid 2006 to mid 2007. The main difference was that at the time, administered interest rates were actually rising and money supply growth rates in the US and euro area both were in a declining trend. In spite of this, gold managed to rally significantly between the summer of 2005 and May 2006. We suspect this was mainly due to rising inflation expectations at the time, misplaced though they were. In reality, commodity prices in general were mainly still rising as a lagged effect of the extremely high rates of monetary inflation during the period 2001-2003. In the case of crude oil, this lagged effect played out until the price peaked in the summer of 2008.

As far as gold stocks go, it appears as though they are 'forecasting' a lower gold price – but we can not be certain that the 'market is right' about that. It would be better to say that they reflect the perception that the gold price is going to decline. Whether that will actually happen remains to be seen and is an entirely different cup of tea.

Gold Stock Valuations and Sentiment

From the point of view of holders of gold stocks the current situation means that the risks associated with holding these stocks have actually declined. They would still look cheap even in the event of a further gold price decline (of course in that case the market may begin to 'discount' even further declines).

As an interesting aside, although the HUI and XAU-gold ratios have just hit a new multi-year low, the same is not true of their ratio versus silver. Incidentally, the current level of the XAU-gold ratio is among the three lowest readings ever, with equal or lower readings only seen in January of 1980 and at the nadir of the 2008 crash. In 1980 the ratio fell mainly due to a gigantic blow-off rally in gold, the sustainability of which the market at the time rightly disbelieved.

Since there has neither been a blow-off rally in the gold price that would be remotely comparable to the 1979-1980 move, nor has there been a stock market crash lately, the current low in this ratio is actually a unique constellation of the data and seems mainly reflective of sentiment.

The HUI-silver ratio versus the silver price (green line above). After declining precipitously during the sharp rally in silver in Qu. 1 of 2011, it has lately fallen to a higher low, in contrast to the HUI-gold ratio- click chart for better resolution.

The ratio of the silver stock ETF SIL versus the price of silver. This ratio looks even stronger at the moment, i.e., the performance of silver stocks relative to silver has been better than that of gold stocks relative to gold. This jibes with the idea that economic confidence has been waxing of late- click chart for better resolution.

The notion that the HUI-gold ratio is mainly a sentiment indicator reflecting market perceptions about the future gold price is further buttressed by other gold-related sentiment indicators. For instance, assets and cash flows into the the Rydex precious metals fund have kept declining and are now closer to their 2008 lows than at any time since then or during the years preceding the 2008 stock market crash.

Mark Hulbert's HGNSI (gold newsletter sentiment indicator) has clocked in at a mere 4.3 points as of about a week ago, which means that gold timers in the aggregate recommended only a 4.3% net long exposure to gold. Since further price declines have occurred since this update, the indicator is presumably even lower now, as it tends to follow prices to some extent.

Likewise the NAV premiums on the Central Fund of Canada (CEF, a closed end fund investing in both gold and silver bullion) and the Gold Bullion Trust (GTU, a closed end fund investing in gold bullion only) remain at what are considered historically very low levels.

Sentiment among gold futures traders is also fairly subdued. The speculative net long exposure in COMEX gold futures has fallen substantially lately, while surveys of futures traders such as Market Vane show a very low level of net bullishness (as compared to recent years). However, the readings are close to the levels seen near previous correction lows.

Several charts illustrating this situation in detail follow below:

Total assets and cumulative cash flows of the Rydex precious metals fund, via Decisionpoint. As can be seen, both are currently at a multi-year low- click chart for better resolution.

A slightly longer term chart of Rydex pm fund assets via sentimentrader, which also shows what percentage of the total Rydex sector fund universe the Rydex pm fund's assets currently represent. This percentage is close to a multi-year low as well- click chart for better resolution.

We should point out regarding the Rydex precious metals fund data that near turning points, the cumulative level of cash inflows and total assets often tend to rise shortly before prices turn up. Such a signal is currently not in evidence, but on the other hand, current levels are historically extreme.

The premium to net asset value of CEF remains quite low. The chart of the GTU fund's premium looks very similar- click chart for better resolution.

The HGNSI as of mid last week. Note that this indicator can go even lower, as the gold timers watched by Mark Hulbert will at times recommend an aggregate net short position- click chart for better resolution.

Stock market sector sentiment as of Friday last week (via sentimentrader) – sentiment on gold stocks has followed prices lower and is now at the extreme end of the optimism/pessimism scale. By contrast, housing stocks and financials enjoy quite a bit of popularity at the moment.

Sentimentrader's 'public opinion' chart on gold. This is an amalgam of several sentiment surveys. As can be seen, it has occasionally been lower in recent years, but is fairly close to those levels- click chart for better resolution.

The sentiment data such as they now stand do not preclude further price declines, but they at least indicate that the remaining downside potential is probably fairly small. The risk-reward equation in gold stocks seems skewed toward 'reward' at the moment, but in all likelihood some patience will be required before a decisive turn happens (it is of course always possible that a different outcome awaits. There could be a swift turnaround, but there could also be more short term downside if support levels break. Very often such breaks of support will turn out to be 'false breaks' if they occur when sentiment is already very bearish).

One should however also not lose sight of the possibility that the relative weakness in gold stocks could also turn out to be a precursor to a more sizable correction in gold and silver. It seems not the most likely outcome, but one should keep in mind that the probability is definitely higher than zero.

Charts of the Four Highest Weighted Stocks in the HUI

Below are weekly charts of GG, ABX, NEM and HMY, the four stocks with the highest weighting in the HUI index. What is interesting is that the most recent decline has been accompanied by a spike in trading volume in all of them. This suggest a considerable amount of 'give up' has already occurred. Similar to the what is often observed in the broader stock market, volume explosions near price lows more often than not turn out to be 'washout' events. Once again this is not a guarantee of anything – it is for instance always possible that an even bigger washout lies ahead. Also, price lows that are put in place at high volume will often be retested later at lower trading volume.

Goldcorp (GG) weekly. It has recently reported record earnings- click chart for better resolution.

Barrick Gold (ABX) weekly- click chart for better resolution.

Newmont Mining (NEM) weekly. The trading volume spike was especially pronounced in this stock- click chart for better resolution.

Harmony Gold (HMY) weekly. Also a very notable increase in trading volume. Note that the company has just reported record earnings as well – click chart for better resolution.

Summary and Conclusion

From the above it appears that there is a fairly high probability that gold stocks are close to a low relative to the gold price as well as in absolute terms. The only scenario that could conceivably alter this assessment would be an unexpectedly large decline in the gold price. We don't believe that this is in the offing, as both fundamental and technical conditions continue to look constructive for gold, but one can not rule out that future conditions will turn out differently than we currently think. In that case the fundamental backdrop for the gold market could deteriorate significantly and it can not be ruled out completely that the market is correctly anticipating such a development.

However, that would amount to a triumph of hope over experience, as the world's monetary authorities continue to reliably react to any signs of economic weakness with further monetary expansion. Furthermore, the cumulative money supply expansion that has already occurred has yet to percolate fully through the economy.

One thing that gives us a bit of pause is that the above facts are well known and many others have been expressing similar opinions. There is a certain danger that this undercurrent of consensus about the medium to long term outlook will continue to weigh on the sector. On the other hand, data that show speculative exposure are what they are and one probably shouldn't over-analyze this point.