Gold’s “Contrarian Moment”
Tuesday, May 29, 2012 at 07:00PM
Gold Prices

By David Galland, Casey Research

Glancing at the news most days, it's hard not to feel like Bill Murray's character inGroundhog Day. In the event you are unfamiliar with the movie, in it Murray's character becomes trapped in the same day… day after day.

In the current circular condition, we have the powers-that-be assuring us that the next high-level meeting will finally produce a permanent fix to the broken economy, essentially solving the sovereign debt crisis. Then, in no more than a few days, or at most a couple of weeks, the fix is revealed to be flawed and the crisis again sparks into flames... followed shortly thereafter by yet another high-level meeting – and the cycle begins anew.

While the characters may change – one week it is Greece, the next it is Spain, the next it is France, the next it is the US, the next it is Greece again, etc., etc. ad nauseam – the detached observer can only come to the conclusion that we are now well outside of the bounds of the normal business cycle.

As we at Casey Research have written on this topic at great length, I don't intend to dwell on this topic, but I did want to loop back in just long enough to comment on the recent price action in commodities, especially gold, in the face of the continuing crisis.

Today, a glance at the screen reveals that gold is trading for $1,565. For comparative purposes, as revelers warmed up their vocal cords to sing in the New Year on the last trading day of 2011, gold exchanged hands at $1,531. And exactly one year ago to the day, gold traded at $1,526 for a one-year gain of a modest 2.6%.

A year ago, the S&P 500 traded at 1,325, while today it trades at 1,318, a small loss. Yet, have you noticed we don't hear much about the imminent collapse of the US stock market, as we do about gold? This perma-bear sentiment about gold on the part of what some people lump together under the label "Wall Street" is especially apparent in the gold stocks.

Using the GDX ETF as a proxy for the sector, we see that the shares of the more substantial gold producers are off by an unpleasant 24% over the last year.With that "baseline" in place, let's turn to the current outlook for gold, and touch on some of the other commodities as well.

  1. Broad market movements. The saturated levels of analysis mean that, within a fairly tight range, all the stocks now move more or less together. Thus, with few exceptions, a big upswing or downswing in the broader market will send almost all stocks up or down together. To help make the point, I randomly pulled a chart of IBM and compared it against SPY (the S&P 500 tracking ETF) for the last year. Note the lockstep price movements:


    OK, IBM is a big company, so it will have a lower beta than many companies, but the point remains that saturated coverage of the stocks greatly reduces the odds of any one issue breaking free from the larger herd, unless there is…
     

  2. A surprise. All of these analysts, and all of their computerized analysis, help form a certain future price expectation for each security based on past financial metrics (earnings growth, return on equity, and so forth). Other than the broad market movement just referenced, or moves in line with a sub-sector of the larger market (e.g., if oil rises or falls, oil-sector stocks will tend to move up or down in sync), for a company to deviate in any substantial way from analyst expectations, by definition requires a "surprise" to occur.

    Of course, such a surprise can be positive, but because these companies are so closely watched, it is more likely to be negative. In the former category, a positive surprise might come in the form of an unexpectedly strong new product launch á la the iPad. In the latter, less happy category of surprise, it can be the blow-out of a big well in the Gulf of Mexico… or any one of a million other unanticipated vagaries of fate.

As investors, recognizing these fundamental realities is important because it points to where above-average market opportunities are most likely to be found (or not). And that brings us back to the whole idea of being a contrarian.

As mentioned a moment ago, "Wall Street" has never much liked the precious metals, and by extension the gold stocks. Given the length of the gold bull market – which, in our view, reflects systematic risk in all the fiat currencies, but which Wall Street views as an indication of a fatiguing trend confirmed by the underperformance of the gold stocks – traditional portfolio managers are unhesitant in giving the boot to the few gold shares that somehow made it into their portfolios against their better judgment.

If our thinking is not clouded by our own bias, then it would behoove us as good contrarians to buy these shares from the eager sellers at such unexpectedly favorable prices. By doing so, we are able to position ourselves to make a killing once the broader financial community realizes that the problems associated with fiat money, dramatically underscored by the intractable sovereign debt crisis, are only going to get worse. At that point gold is going to head for new highs and gold stocks to the moon.

That said, as we always should do, let's quickly assess whether our own bias is leading us astray in believing in gold and gold stocks when virtually the entire army of analysts won't even consider them. Some inputs:

Our study of corporate and bank balance sheets indicates that the bank loan and debt capital markets will need to finance an estimated $43 trillion to $46 trillion wall of corporate borrowings between 2012 and 2016 in the U.S., the eurozone, the U.K., China, and Japan (including both rated and unrated debt, and excluding securitized loans). This amount comprises outstanding debt of $30 trillion that will require refinancing (of which Standard & Poor's rates about $4 trillion), plus $13 trillion to $16 trillion in incremental commercial debt financing over the next five years that we estimate companies will need to spur growth (see table 1).

(Click on image to enlarge)

You can read the full article here. While the authors of the S&P report try to find some glimmer of hope that roughly $45 trillion in debt will be able to be sold off over the next four years – even their base case casts doubt on the availability of the "new money" shown in the chart above. Note that this is the funding they indicate is required to fund growth. Which is to say that should the money not be found, the outlook is for low to no growth for the foreseeable future.

It is also worth noting that the analysis assumes that something akin to the status quo will persist – which is very unlikely given the pressure building up behind the thin dykes keeping the world's largest economies intact. The landing of even a small black swan at this point could trigger a devastating cascade.

We have said it before, and we'll say it again: there is no way out of this mess  without acute pain to a wide swath of the citizenry in the world's most developed nations. While this pain will certainly be felt by sovereign bond holders (and already has been felt by those who owned Greek issues), it will quickly spread across the board to banks, businesses and pensioners – in time wiping out the lifetime savings of anyone who is "all in" on fiat currency units.

In this environment, gold isn't just a good idea – it's a life saver. And gold stocks are not just a golden contrarian opportunity, they are one of the few intelligent speculations available in an uncertain investment landscape. By speculation, I mean that, at these prices, they offer an understandable and reasonable risk/reward ratio. Every investment – even cash – has risk these days. With gold stocks, you at least have the opportunity to earn a serious upside for taking the risk… and the risk is much reduced by the correction over the last year or so.

Now, that said, there are some important caveats for gold stock buyers.

While it is hard to accurately predict the timing of major developments in any one economy, let alone the global economy, there are a number of tangible clues we can follow to the conclusion that the next year will be a seminal one in terms of this crisis.

For starters, there is the next round of Greek elections on June 17, the result of which could very well be the anointment of one Alexis Tsipras as the head of state. An unrepentant über-leftist whose primary campaign plank is to tell the rest of the EU to put their austerity where the sun doesn't shine, the election of Tsipras would almost certainly trigger a run on the Greek banks, followed by a cutoff of further EU funding and Greece's exit from the EU. And once that rock starts to slide down the hill, it is very likely that Spain and Portugal will follow… after that, who knows? As I don't need to point out (but will anyway), June 17 is right around the corner, so you might want to tighten your seat belt.

A bit further out, but not very, here in the US we can look forward to the aforementioned fiscal cliff. Or, more accurately, the political theatrics around the three colliding co-factors in that cliff (the approach once more of the debt ceiling, the expiring tax cuts and mandated government spending cuts). While the outcome of the theatrics has yet to be determined, it's a safe bet that the government will extend in order to pretend while continuing to spend – and by doing so, signal in no uncertain terms that the dollar will follow all of the sovereign currency units in a competitive rush down the drain.

Bottom line: Be very cautious about industrial commodities as a whole, at least until we see signs of inflation showing up in earnest, but don't miss this opportunity to use the recent correction to fill out that corner of your portfolio dedicated to gold and gold stocks.

To get more perspectives like this, plus sector-specific commentary in energy, technology, and precious metals, sign up for the free Casey Research daily newsletter, the Casey Daily Dispatch. It's a great way to be introduced to the world of contrarian investing.

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