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Gold and the Dollar

Steve Saville
Posted May 28, 2013

Gold and Silver

It currently looks like gold and silver successfully tested their April lows on Monday 20th May, with gold making a slightly higher low and silver spiking below its April low before reversing course. Gold needs to close above $1400/oz in the near future to confirm that a successful test of the April low has, indeed, taken place.

In addition to testing its April low in US$ terms last week, the following chart shows that gold also tested its April low in GYX (Industrial Metals Index) terms.

The gold/GYX ratio is an indicator of economic confidence. It trends downward when economic confidence is on the rise and trends upward when economic confidence is waning. Note, though, that the general perception of the US economy's prospects will not necessarily be the primary driver of this economic indicator. For example, gold/GYX rose sharply during 2011 and also trended higher during March-August of 2012 in response to escalating worries about the euro-zone's economic prospects.

The following weekly chart shows that last week's downward spike in the silver price not only tested the April-2013 low, but also tested major lateral support dating back to 2008.

During April-August of 2011 a few TSI readers cancelled their subscriptions because we were too bearish on silver. During the April-2011 moon-shot in the silver price we warned that a spectacular price decline was coming, and then, after a top had been signaled, we warned that the overall corrective process was likely to last at least 18 months due to the rare sentiment extreme that had been achieved in April-2011. However, it turned out that we were actually too bullish! We weren't surprised that silver's correction from its 2011 peak lasted two years, but although we warned that it could happen we certainly didn't anticipate the break below $26 and the subsequent plunge to $20.

Sentiment in the silver market is now 180 degrees from where it was in April of 2011, so we are now warning that a large price advance is coming. That being said, silver's initial rise from the bottom won't be anywhere near as fast as its initial decline from the peak. Major advances in both gold and silver tend to gradually build momentum over time.

Lastly, everyone involved in the gold and silver markets should be cognisant of the possibility that the overall bottoming process in the precious metals will extend into the final quarter of this year. In fact, a rounded bottom in the precious metals that takes at least 6 months to unfold would be consistent with what we consider to be the most likely stock market scenario.

Gold Stocks

Current Market Situation

The gold-mining sector began last week on a positive note in response to what appeared -- and still appears -- to be a successful test of the April low in the gold and silver markets, but there was no follow-through to the upside over the remainder of the week. As a result, we lack evidence that a multi-month low is in place for gold-stock indices such as the HUI (see chart below).

This is the month when important turning points often happen in the gold-mining sector, but this month continues for one more week. We could therefore get a spike to a new low for the year this week and still get a traditional May extreme (in this case, an extreme low).

As things currently stand, the two most likely times for a major bottom in the gold-mining sector are May of 2013 (that is, now) and October-November of 2013. If the latter, there will most likely be a 1-3 month rebound and then a decline to the ultimate low.

Be aware that once a major bottom is in place in the gold-mining sector, the initial multi-month advance is likely to be fast (the equities are different to the metals). For example, the only two lows of the past 13 years that are comparable to the low that will be put in place in 2013 are those of October-2008 and November-2000. The HUI doubled within three months following the 2008 low and 6 months following the 2000 low. So, don't be thinking that it's going to take forever to make up the lost ground.

Gold stocks that made higher lows

The gold-stock indices and ETFs briefly traded below their April lows during May, but some individual gold stocks made higher lows in May. Almost all gold stocks have very low valuations right now, but the ones that held above their April lows during the May sell-off are exhibiting relative strength. These stocks have a decent chance of out-performing once a meaningful sector-wide rally gets underway.

Here are charts of some of the gold stocks that made higher lows in May:

a) Almaden Minerals (AAU). A low for this stock would be confirmed by a decisive move above US$1.80.

b) Asanko Gold (AKG). A low for this stock would be confirmed by a decisive move above US$2.80.

c) IAMGOLD (IAG). A break above resistance at US$6.00 would suggest short-term upside potential to US$7.50-$9.00.

d) Kinross Gold (KGC). A break above resistance at US$6.00 would suggest short-term upside potential to US$7.50.

e) Pretium Resource (PVG). For this stock, the May low was well above the April low and the pattern of the past three months now looks like a base capable of supporting a rally to US$11-$12. Short-term resistance lies at US$8.00.

Why gold mining companies shouldn't hoard their gold production

There's a line of thought that instead of converting all of their production into money (US dollars, etc.), gold producers should keep a significant portion of their cash in gold. This could be achieved by simply holding onto some of the gold they extract from the ground. The thinking is that gold is a safer store of purchasing power than any fiat currency, so why not use it for working capital rather than relying on the paper spewed forth by central banks?

Although we have some sympathy with this line of thinking, our view is that it generally doesn't make sense for gold producers to hold gold bullion on their balance sheets in lieu of money. The main reason is that while gold is the liquid asset with the best long-term record as a store of purchasing power, its purchasing power often undergoes large swings over short periods. For example, gold's purchasing power has fallen by more than 30% since August of 2011. Over the next 12 months it could easily gain 30% or more, but it could also suffer another significant decline.

A gold miner that denominated a large part of its cash reserve in gold bullion could therefore end up doing very well or very poorly during any given year. In effect, the miner would be using its cash reserve to speculate on short-term changes in the real price of gold, which is not a sensible way to use cash reserves.

In our opinion, if a gold producer has cash that it will likely need within the next two years to cover its expenses, then most of this cash should be denominated in the currency in which most of its expenses are denominated, with no concern for yield. Excess cash that a gold producer is unlikely to need within the next two years should be returned to shareholders, who could then, if they so desired, use the cash to buy gold.

The secondary reason that it generally doesn't make sense for gold producers to hoard gold bullion is that the senior managers of gold-mining companies are notoriously poor market timers. For example, they were big-league hedgers of their production when gold was bottoming during 1999-2001 and had sworn-off hedging by the time that gold was making a multi-year peak in 2011. For another example, they tend to be aggressive acquirers of assets (projects and companies) when valuations are high and to have no interest in buying when valuations are low. Consequently, it's reasonable to expect that their eagerness to hoard gold would rise and fall with the gold price, resulting in most of the hoarding being done at the least opportune times.

Currency Market Update

Even if the US$ is destined to move much higher over the coming year, the Commitments of Traders (COT) data and other sentiment indicators are saying that a multi-month US$ correction/consolidation could soon begin. Of particular note, there are now large speculative net-short positions in euro futures, Yen futures, A$ futures, C$ futures and British Pound futures. To put it another way, speculators are now betting heavily that the US$ will rise against all other major currencies over the next few months. Such unanimity of opinion within the speculating community paves the way for something different to happen.

The lopsided sentiment creates the potential for significant counter-trend moves in the major currencies (down for the US$, up for the others), but it doesn't mean that short-term extremes are already in place. There is a realistic possibility, for example, that the Dollar Index will surge to 85-86 before a multi-month correction gets underway.


Steve Saville
email: sas888_hk@yahoo.com
Hong Kong

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