June 25, 2003
Will Gold Stocks Buck The Trend This Time?

As traders ready to pour over today’s FOMC Statement and draw inane speculations about what the ¼ or ½ point rate cut really means, there is only one conclusion that can be made beforehand:  at 2:15:01 PM today the financial markets are going to embark upon a violent few minutes of trading.

Notwithstanding the overt focus that will be on stocks and bonds following the Fed announcement, another market to watch is gold. Struggling to try and hold above $360 an ounce last week, August gold is having problems holding onto $350 early this week. To be sure, and despite rumors of central bank buying, funds have been liquidating positions for the last 3 sessions, and gold is trading below $350 an ounce this morning. 

What Are Gold Participants Looking At?

Those that believe the Fed will be successful at combating deflation often point to rising commodity prices (rising gold) to argue that investors are banking on inflation rather than deflation. This theory is not necessary a flawed, as historically gold is one of the better indicators of inflation.  However, it could be the case that gold investors have been purchasing the metal because of fears of deflation and/or as a hedge against a generally unstable pricing environment. 

Needless to say, focusing explicitly on the inflation/deflation themes has not been helpful in forecasting the price of gold. The gold market was previously kept under pressure by escalating central bank sales, producer hedging, and seemingly unshakable confidence in the U.S. dollar.  All of these elements have been reversed since 1999; and the argument could be made that each of these occurrences is more responsible for the price of gold we see today than any of the deflation/inflation arguments.

In short, all that can be assured is that gold is a hedge against financial market uncertainty.

Do Gold Stocks Track the Metal or the Stock Market?

There is a general belief that when the broader stock markets collapse that gold stocks are a safe haven. To back this theory many note that gold stocks outperformed the market during the great depression, and that gold funds handily beat every other fund class in 2002. Quite frankly, it is difficult to ignore the fact that if stock prices collapse gold stocks will likely outperform.

However, the term ‘outperform’ should be placed into context.  For certain, if recent history has taught the investor anything it is that optimism (euphoria?) in stocks can carry all stocks higher, including gold stocks, while pessimism in stocks also carries gold stocks lower.   As such, if the U.S. stock markets can be expected to correct by say 15% in the coming months and gold stocks only by 10%, the term ‘outperform’ becomes less attractive.


Using the above charts as a guide, the case could be made that gold stocks are just as susceptible to a stock market correction as normal stocks. To be sure, since a significant run-up in gold shares in early 2002 – a run-up wherein gold shares bucked the trend in the markets and the Wish List removed its last holding (MDG) – gold stocks have been mirroring the trend in the S&P 500. In fact, since mid-2002 the most opportune time to own gold shares was not before the price of gold rallied strongly, but before the stock markets rallied strongly (or when the broader stock markets hit their ‘bottoms’).

Conclusions

Gold stocks followed the metal lower yesterday, and if the price of gold continues to correct there is little doubt that gold stocks will decline. Incidentally, and although it may be too early to speculate, one has to wonder whether or not a period of calm in the financial markets – in particular a period of calm in the dollar – could rattle gold back down to the $320 an ounce area. This is something to keep in mind today, as at 2:15:01 the violent action in the financial markets could have immediate implications on the trend in gold. 

That said, rather than focus on the price of gold to concoct speculations about gold stocks, it may be just as important to consider the price of the stock markets in general. Quite frankly, I wouldn’t bet that the trend between gold stocks and the markets is about to end. Rather, I would speculate that if the U.S. stock markets are entering a correction phase leading into August/September that gold stock will also correct irregardless of what the POG does (the sole caveat being that if the stock market correction turns into a full fledged panic and/or the dollar collapses that gold stocks would likely follow the POG higher).

A company like Agnico-Eagle, which has long operational history and is currently encountering some production/cost setbacks, may be the type of gold stock to monitor if the correction in stocks continues.  Unlike investor favorites like Newmont, Agnico could potentially buck any downtrend in the markets (or the POG) if the company can remedy their operational setbacks. 

However, and much like speculations for $320 an ounce gold, it may be too early to be excited about owning the Agnicos’. The stock markets are still pricing in a terrific second half turnaround, gold stocks are still pricing in a higher POG, and today’s Fed decision may not immediately change this picture. In sum, for the sidelined investor attracted to the long-term advantages of being exposed to gold via equities, one question arises: will gold shares follow the markets lower again?