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Will the Miners Lead Gold Higher?


If yellow metal breaks to new highs, Newmont, other miners are sure to follow.


Minyan Jeremy writes:

Dear Professor Lewis,

I follow your posts on the 'Ville and enjoy them a lot. I know from your writings that you're still constructive on metal stocks. The other day you mentioned you added to your large miners. I was hoping that you could speak to your thoughts on how poorly these stocks have been trading. Newmont Mining (NEM) is a great case in point. I'm not a technician but it's obvious that the stock isn't loved. Look how many times it's been rejected at its 50dma. Today is a great example.

Do you believe the miners will lead gold higher?

There are many questions in this letter and I'm not sure if I can answer all of them, but I'll try.

First off, I said I bought calls on some of the seniors on the morning of the FOMC. I actually prefer the equities of the junior and intermediate miners, but most don't have options. However, I wanted to add a small amount of leverage via call options in addition to the stock I already own.

As for the gold stocks not leading the metal, that depends on your perspective, I guess. I prefer to use the XAU/gold ratio for this sort of analysis.

As you can see in the chart below, the XAU/Gold ratio has been steadily rising since hitting a record low in October of 2008 after hedge funds were forced to blindly deleverage during last year's global margin call. Thus, the gold stocks are in fact now "leading" the price of gold per this rising ratio relative to that low.

Click to enlarge

Now, if your definition of "leading" is for the gold stocks to make new highs before the metal, that's probably not going to happen. And that has more to do with market mechanics than any fundamental reason.

Just as many gold-mining stocks were tossed out the window in the fall of 2008 as hedge funds were forced to deleverage, even though gold remained basically range-bound and mining costs actually fell with the oil price, making gold mining even more profitable. A similar mindless mechanical function is likely to prevent the gold stocks from making new highs ahead of the metal. And that mindless mechanism is "overhead supply."

There are simply still a lot of investors trapped at higher prices in the mining stocks, and they'll represent selling pressure on the way back up. That may not make much sense, given the still-historic undervaluation of the gold stocks relative to the metal. But it didn't make much sense for many profitable gold miners with no debt to trade for below the cash on their books back in October, either. Nevertheless, many did.

If some fund needed to raise X in cash to meet margin calls or return investors' money, it didn't matter what he was selling. He just needed to sell something in order to return dollars to his investors or meet margin calls. Likewise, as investors get back to "even" as the gold stocks rally back to their 2008 highs, many people will simply sell them to get even.

As for Newmont, it has underperformed over the past couple months, for sure. But I suspect that has more to do with the large size of its market cap and its lack of production growth. It's simply a levered bet on higher gold prices, like Barrick Gold Corporation (ABX), at this point.

I actually like call options on Newmont, because the volatilities are very low relative to options on something like the GDX, which Newmont is the largest component of. I also think Newmont is undervalued relative to the other seniors and the GDX.

If gold finally breaks out to new highs in the coming weeks, as I've believe is likely, I feel fairly confident that Newmont and the gold stocks will also rally, regardless of "moving averages". Apparently, John Paulson does too, because he added to his Gold Fields (GFI) and AngloGold (AU) last quarter, too.

Other gold equities that are seeing significant production growth or are special situations have been trading quite well of late, even with gold still stuck below $1000. See the charts below (just to list a few). Like with any other sector, each gold miner is different. You can't assume they'll all trade together. Mining is one of the toughest businesses in the world. Pulling something out of the ground that you can't see isn't easy. "Stuff" happens that can be unexpected, both good and bad, as a result.

Some stocks can be long-term huge winners, while others can be dogs and only trading vehicles to gain exposure to rallies in the metal. It takes a lot of work to stay up on each name and determine which ones need to be sold and when, and which ones can be held. Nobody said this business was easy, after all.

Click twice to enlarge

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Positions in NEM, GFI, NXG, SA, NSU, GSS.

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