Will Currency Wars Awaken Investor Interest in This Sector?

Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The news of the S&P 500 reaching a five-year high should lend a good feeling to investors.  Throw is news from CoreLogic that an estimated 1.3 million housing properties regained positive equity in the first half of 2012 and that 2.3 million borrowers are within 5% and you have one heck of a wealth effect taking place.  Ben Bernanke has been pushing the wealth effect as an effective policy tool for several years now and it may finally be coming to fruition.  Lost in all this positive shuffle has been gold.  The yellow metal remains in a bull market after recording its 12th consecutive year of gains in 2012.  But gold investors aren’t cheering.  The SPDR Gold Trust ETF, the largest gold ETF in the world, registered a 6.6% gain in 2012 compared to 16.0% for the S&P 500.  And the situation has worsened in 2013 with the S&P already 5% ahead. 

Trapped Miners

The underperformance of ETFs that track the price of the physical metal hasn’t been devastating, but this is an entirely different story for investors in gold mining stocks.  The world’s largest gold producer, Barrick Gold (NYSE: ABX), underperformed the S&P 500 by 37% in 2012 and is already in the hole by 9% in 2013.  And we are still in January!  Gold miners have seen their profits squeezed by rising costs.  This is associated with elevated energy prices as well as lower grade ores. Newmont Mining (NYSE: NEM), the second largest gold producer, saw their 3Q12 EPS drop 31% versus a year earlier.  The company generated $1.7 billion in free cash flow before dividends in 2010, but this will be negative in 2013 as operating cash flow declines are coupled wth capex increases.

I penned a bullish thesis for Kinross Gold (NYSE: KGC) back in July and despite some significant ebbs and flows it has worked out well for investors.  The stock has returned 19% since the article versus 12% for the S&P 500 and 9% for a market-cap weighted benchmark of gold stocks- the Market Vectors Gold Miners ETF (GDX).  Maybe most central to the outperformance has been a factor that wasn’t detailed in the article-the realization of declining cash costs in recent quarters.  Sure Kinross Gold’s cash costs are elevated when looking at year-over-year numbers, but the graph from the company’s website highlights the sequential improvement. 

<img src="/media/images/user_36/pic3_large.PNG" />

Kinross at this point remains one of the higher return opportunities in the gold mining space, but their reliance on Western Africa does elevate the risk profile.  For other gold miners to see similar outperformance, it will be imperative that cash costs stop climbing and start showing sequential declines as evidenced by Kinross Gold.  This may lead to lower production, but that may not be such a bad a thing as reduced supply should be a tailwind for gold prices.

Extremely Cheap Valuation, But…

Gold mining stocks remain at historically cheap levels relative to the spot price of gold.  The graph below plots the price of gold (white line) and the EV/EBITDA ratio (orange line) of a basket of large-cap gold mining stocks. 


<img src="/media/images/user_36/picture0002_1_large.png" />

One can see the valuation improve with rising gold prices from late 2008 to early 2010.  But from that point on there has been an incredible divergence.  Has a bottom been reached?  It looks like one might be forming, but it is likely too early to make that call. 

Bullish Themes

The most bullish thesis to the continuation of rising gold prices had been negative real interest rates.  According to Ned Davis Research, spot gold prices have historically averaged an 18.8% yearly advance when the 10-year Treasury yields less than the CPI year-over-year percentage change.  This situation has ceased to exist, if ever so slightly, with CPI currently at 1.7% and 10-year Treasuries at 1.8%.  But gold has historically thrived in the current environment as well- rising 11.6% on average when real interest are between 0% and 3.5%. 

While the negative real interest rates persisted in 2012 with little upward movement in gold prices, there have been some recent development that may return focus back to the yellow metal and its favorable economic environment-  CURRENCY WARS.  Japan’s new commitment to monetary stimulus has started to make an impact on other central bankers.  First, Germany criticized Japan on their unlimited stimulus plan to target a 2% inflation rate and the obvious follow on effects of a weaker Yen.  Japan’s Economy Minister responded by saying,

Germany is the country whose exports have benefited most from the euro area’s fixed exchange rate system. He’s not in a position to criticize.

According the Financial Times, Europe’s single currency has risen almost 7 percent on a trade-weighted basis since late July. It is up about 25 percent against the yen and 10 percent against the dollar.  The article later had this to say about the current situation-

Even Germany’s resilient exporters have reason to worry – the euro/yen rate matters for the country’s powerful car manufacturers. Jean-Claude Juncker, Luxembourg’s prime minister, who has just relinquished his chairmanship of Eurozone finance ministers meetings, warned last week that the euro’s level was “dangerously high”.

 And from the Bank of England-

“Substantial headwinds to recovery remained, including the drag to activity from fiscal consolidation, a further squeeze in household real incomes, and the deterioration in U.K. competitiveness over the past couple of years,” the minutes said. “The sterling real exchange rate might be above the level compatible with the necessary rebalancing of the economy.”

The Foolish Bottom Line

Rhetoric regarding currency valuation is heating up from financial officials across the globe.  Could this be the impetus, along with depressed real interest rates, that allows gold prices to push back toward historic highs?  Will this translate into rising prices for gold mining equities?  It seems much more plausible that gold prices will push higher as the year progresses than gold miners break out of their valuation funk.  Gold miners have started to question some capital projects, but probably not enough to drive down cash costs in the next several quarters.  It will take a trend reversal in the valuations of gold stocks for a bullish outcome to unfold in 2013.  Watch for gold stock valuations to start moving higher before committing to this space.  However, there is a lot of mean reversion potential in gold stocks so don’t think you missed the boat if you sit out the first 20% of the rally. 

market8 owns shares in Kinross Gold. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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