Precious Points: Bull in a China Shop
The past week played out very close to what we described on November 4:
Clearly silver was too cheap under $12 and gold under $600. Now that we've entered the strongest season for metals, historically, and the word is out that the metals are likely to be a hot sector over at least the next quarter, we're up above those psychological levels and close to near term resistance. Still, we should expect money to rotate into the metals and the miners at a fairly steady pace next week to help push them beyond. Over the coming weeks gold could be on its way to as high as $650-675 and I've already stated my expectation for silver to retest $13, probably by the end of the year. But, at this point, we simply don't have the underlying fundamental picture in place for either metal to seriously challenge the May highs.
The early part of the week saw the metals come under pressure from a strong economic outlook based on the strong payroll report, increased borrowing, and a shrinking trade deficit, but, as predicted, steady money buoyed prices in the metals and mining sectors, helping them preserve recent gains and even temporarily break through close resistance levels. Silver marched right up to $13 and gold got over $630 before both were hit with profit taking, sending them into the weekend retreating. Old rumors that China is diversifying its reserves away from the dollar helped boost the metals to these higher resistance levels, but dollar weakness at the middle of the week moderated on Friday to help bring them back down. Last week's featured mining stock, Couer D'Alene (CDE), reported the strong quarter we expected and closed the week up about 5% despite declining with the rest of the sector on Friday. Look for continued outperformance when the sector trades up again.
In the midweek update, we noticed that the pm's have largely returned to trading in line with oil. The main exception was the boost energy received Wednesday morning on lower than expected crude inventories, which we had alerted you to last week, and which, in all likelihood, had more to do with the early decline in stocks on Wednesday than the midterm elections. We also said that oil would vibrate close to $60, but that whichever way oil traded through the rest of the week, it would probably take the metals along for the ride, both of which it did. Our prediction was based on the dependence of the Federal Reserve's economic outlook on cheap energy; notice that oil was talked down this week as it began to turn bullish. While next week's inventory data could cause temporary volatility in crude, don't expect significant gains in the energy sector without some renewed geopolitical risks to oil supply. That said, rumblings in the Gaza strip could spill into the headlines if Palestinians take to the offensive.
After a nice run, the metals could still be under a bit of pressure in the week to come. The economy is in a delicate position that requires cheap oil and contained inflation to allow businesses and consumers to survive the housing slowdown and turn the direction back around towards growth. The market overall is not primed yet for more than incremental gains from the precious metals, which we've seen. Anything more and the bull in the china shop could bring interest rate hikes back down on our heads and smash everything.
The week ahead will be particularly significant and busy on the economic front, the obvious highlight being Thursday's CPI numbers, but with important retail sales data, the PPI, and the FOMC minutes all setting the tone early in the week. As of Friday, the bond market was not convinced of the expanding economy outlook, despite Chicago Fed president Moskow reiterating the forecast in the October FOMC statement for a rebound in current quarter GDP. Some now are even expecting the recent figure to be revised upward and for next quarter's growth to be back near 3%. A low or in line CPI, one of the Fed's primary inflation indicators, could strengthen that case, easing inflation fears and undoubtedly rallying the markets. In any case we could reasonably expect a return to a consensus outlook of an expanding economy, contained oil, and gently rising metals, gradually if not all at once in the next week.
While it's probably not a good idea to bet against the Fed long term, the fact that no one in the industry is yet calling the bottom in housing, regardless of the performance of housing stocks, the short term could tip toward renewed fears of a recession or of interest rate hikes. The primary factors effecting economic outlook and interest rate policy are the fate of the housing market, consumer and business spending, and inflation. The worse case scenario, while unlikely, is recessionary data coupled with high inflation, both of which would put heavy pressure on stocks and metals. Continued weakening in the housing market, though, could temper rate-hike expectations and prevent some of the selloff. Moderate housing and retail, with lower or contained inflation, would connect with this week's strong business and consumer borrowing to support an expanding economy and stronger metals prices. We should probably expect at least some new, informal statement from Fed officials in the coming days to help guide the markets through the data heavy week.
While gold could drop well below $600 and maintain its overall bullish technical picture, and the silver bull could dip to $11.50 and remain intact, I'm not convinced we'll see this much selling unless unbridled economic optimism becomes a sustained rally in the dollar or, conversely, unless we find an extreme bearish outlook exerting strong pressure on oil and the base metals. Uncertainty and economic slowdown, as long as sentiment remains biased toward eventual rate-cuts instead of hikes, will tend to favor the metals, but keep them rangebound. As the chart above shows, if macroeconomic factors remain beneficial, there's still some room to rise. $13.38 would be the next new high and will certainly act as resistance if we should reach it.
From a purely technical standpoint, the metals are trading in a triangle from the June lows. Silver, which tends make exaggerated short-term moves compared to gold, is a clear example. An alternate interpretation to the triangle is that the recent rally is a c of a B wave, with the next C wave down expected to put in a new low. A strong selloff would create an excellent entry point for the renewed bull market, but we don't currently view this dramatic of a selloff as anything more than a limited possibility in the intermediate term. We will continue to evaluate the week-to-week performance of the metals sector on a combined fundamental and technical analysis. As always, to get real-time market commentary, or to comment yourself on this article, you can join us in the forums at www.tradingthecharts.com, where your satisfaction is guaranteed.
Featured Mining Stock
This Canadian company is the world's third largest gold producer and, at times, a shining example of how to do everything right in this sector. Goldcorp generates huge cash flows from mines in politically stable countries. Its assets read like a list of the United States' military allies: Canada, Australia, Mexico. It maintains a low cost profile through the acquisition of smaller companies and the sale of excess property. The company has exposure to base metals and has spun off a secondary asset into a profitable subsidiary. In fact, through its deal with Silver Wheaton, it has helped to create a new business model that has revitalized the centuries old mining industry. Now, with metals prices rising and the company reporting third quarter results next Tuesday, the company's shares face a critical juncture.
Even though Goldcorp produces a significant amount of silver and copper, it considers itself a gold producer as evidenced by its business practice and financial reporting. In the second quarter of 2006 it posted a net cost per ounce for gold of -$123 after subtracting out revenue from silver and copper sales. In fact, the company produced a net profit on silver and copper alone, before its sale of some 74,000 ounces of gold. Capturing an average of $4.44 per pound on 41.8 million pounds significantly contributed to its $240 million cash flow for the second quarter.
Like most miners, the stock was cut in half from its May highs after a series of selloffs through September. It recent recovery is a credit to its excellent management and its significant production increase in a low cost structure. Going forward, the tremendous positives rallying the stock from its low could now be confronting a significant headwind.
(Chart by Dominick, aka Spwaver)
The recent selloff in copper, as according to the company's own financial reporting, will directly effect its cost per ounce of gold. It's not likely the company will continue its 35% increase of gold production quarter after quarter, and it's very unlikely that, on a percentage basis, gold can gain in price what copper can lose -- there's simply too much copper entering the market now after last year's run. As of Friday, copper was selling at a spot ask price of $3.17, 30% cheaper than GG's average realized price in the second quarter. While the full decline in copper will not appear in the third quarter figures, this pressure on the company's bottom line will certainly weigh on investor sentiment and outlook.
Silver, in contrast, has been rising significantly over the past five weeks, but Goldcorp will be largely incapable of capitalizing on this increase. It's silver sell price is capped at $3.90 through its partnership with Silver Wheaton. Goldcorp holds 57% of SLW stock, one of the hottest performing issues in the mining sector, but since the company deducts silver revenues from its average cost per ounce of gold, gains in silver will not directly translate to the company's bottom line.
Going into the earnings report on Tuesday, Goldcorp is likely to paint the best possible picture by emphasizing the positives of its recent quarter. It will undoubtedly have excellent earnings on low cost gold. The company will also continue generating significant cash flows and maintain a diverse portfolio of promising properties. As the chart above shows, however, shares are reaching the top of declining channel, and, trading at an EPS of more than twenty-three times earnings, there's not too much room left to run with copper prices in decline. It's subsidiary, Silver Wheaton, is probably the miner most leveraged to futures prices, but Goldcorp will not be able to capitalize on price rallies if copper continues to decline. While shares of the company will certainly be subject to prevailing macroeconomic trends, the sentiment of traders during precious metal rallies tending to boost the entire sector, its doubtful that Goldcorp will do better than market perform through the rest of the year.
Bema Gold (BGO), which also reports Tuesday, is still in the process of unwinding its silver and gold hedging contracts, but may be better positioned than Goldcorp (GG) to capitalize on rising precious metals prices in the near term if copper remains under pressure. At current prices, it's market capitalization is still well below the $3.1 billion buyout by Kinross Gold announced earlier this month.