Precious Points: Inflation Hedge or Cutting-Edge, Old is the New New
It was a tough week if you were holding mining stocks. The 2% decline in the Market Vector Gold Miners index (GDX) indicates broad selling across a sector that was up just as much at midweek. One of the few stocks that avoided the carnage was Fronteer Resources Group (FRG), which is actually up more than 10% since we made it our featured mining stock in the November 15 update.
But all chest-thumping aside, sometimes it's not good enough to just be right. To successfully trade in the markets, you have to know when everyone else is wrong, which is certainly what happened on Thursday when investors sold precious metals and miners and bought dollars.
Traditionally, gold and silver aren't income or growth investments, but simply inflation hedges. That is, as the buying power of a dollar decreases, the dollar-denominated value of precious metals increases and vice versa. Following that line of thinking, if inflation is contained then gold should be sold. Well, if this were the whole picture, if the CPI really were the best measure of inflation rather than just the darling of the Federal Reserve, if inflation really was contained and if hawkish comments really meant the Fed was going to tighten, then the selling on Thursday would make sense. But it's not, and it doesn't.
Still, you might have thought, on Thursday, based on the market activity, that contained inflation and slower growth were going to evaporate all investment demand for precious metals and put a floor under the dollar. You would have thought bad news for oil meant gold and silver had to come down, too. But that's just old thinking that won't cut it for long in the new economy. The fact, as demonstrated by the chart above, is that, after the knee-jerk reaction to the economic data, the dollar and the metals ended the week mostly unchanged - silver actually closed up half a percent - leaving mining stocks one of the principal, but most undeserving recipients of the markets' punishment.
First, oil has been hopelessly plagued by high inventories and rig counts. Warm weather and insignificant production cuts from OPEC have done nothing to improve the picture. On a fundamental basis, it makes sense for money to come out of oil. But even with inflation contained and oil and base metals under pressure, gold and silver are in bonafide bull markets. Unlike oil, seasonality is still working in favor of the metals. Unlike copper, rising gold and silver prices are not producing a flood of new supply. Mining activity is increasing, but it's mostly the pursuit of lesser grade ore that wasn't profitable at lower prices. This new supply isn't keeping up with the increase in demand, let alone covering the already existing deficit. And unlike copper, the demand for gold and silver is not linked to housing and won't necessarily decrease in a contracting economy. Gold and silver, the metals themselves, made back all their late week declines because their fundamentals are actually as bullish now as they've ever been.
Second, with gold up 20% and silver up 40%, year to date, miners have demonstrated some of the most explosive growth and margins of any sector in the economy. The best miners are highly levered to the values of their resource assets and have built a strong pipeline of future assets on top of this ongoing asset appreciation, and from this perspective, the seemingly ancient and dull mining sector looks like the next big thing. Earlier this year, the Discovery Channel's "Daily Planet" program featured a U.S. miner using cutting-edge technologies to more effectively unearth metals. Another program traces the profound and transformative effects metals have had on civilization, from Bronze Age tools to steel skyscrapers and cars. While large caps rally and organic growth appears scarce, some mid and large cap miners could be the perfect blend of growth and value in the aforementioned bull market for gold and silver and with new technology lowering production costs. The old industry of mining is already giving us the next generation of sleepers, but novel business models and creative financing of exploration and development could further help make this much more than a seasonal play.
And finally, in a beautiful turn of irony, the hawkish commentary from the minutes is totally accurate, but incredibly misunderstood. As the Federal Reserve increases money supply and potentially prepares to ease rates, inflation risk would naturally be to the upside. The fact that the FOMC unanimously confirms this fact does not herald rate hikes or contraindicate rate cuts. The light shines in the darkness, but the darkness knows it not!
The Fed's activity since Ben Bernanke took the helm has taken it from a catch-22 between inflation and recession and put it in a position to actually cut rates if necessary and remain a credible inflation fighter. Given its precarious position, the Fed has hedged its bets by writing off commodities prices, and indeed virtually anything but government-issued data, as a relevant measure of inflation. It has also widely propagated the idea that growth causes inflation while overlooking the effect of its own open market activities, increasing the monetary base and lowering reserves. M3 is all but forgotten. President Poole's statements on Monday included a suggestion to lower the benchmark for "normal" GDP and job growth, an idea that's gained traction in popular consciousness and emphasizes the Fed's vigilance while downplaying economic weakness.
The stops have been pulled then, it would seem, in an ongoing effort to avoid the word "recession" and to spin what is at least an undeniable economic slowdown into a tolerable and even palatable "Goldilocks economy". And yet, it seems much more likely, at least to bond traders, that, in the short to medium term, some event or events will emerge to elicit a rate cut before the economy recovers to an extent that would recommence rate hikes. Defaults on adjustable rate mortgages over the next two years, for example, or ill-advised business spending could be the catalysts for renewed accommodation, but the Fed could be hamstrung if inflation is already perceived as high going into the rate cuts. A rate cut too soon could be catastrophic. But, in the meantime, if nothing else, a steady rate policy hardly compensates for the swell in money supply and debt.
Now housing is supposedly moderating and the fallout contained, but the dollar is still treading on thin ice and has been, at least since the Federal Reserve stopped raising rates in recognition of the housing market and slowing economy. Earnings look impressive nominally, but if we could adjust to reflect expansion of the money supply, probably not so. If inflation is the catalyst, precious metals should be bought, not sold.
Clearly, the Fed's posturing is consistent with a long-term bullish outlook for the precious metals. In the coming weeks, however, they will continue to be subject to larger market forces. Gold and silver have been trading with stocks under the increasingly questionable notion that a recovering economy will utilize commodities at a steady rate. Over the past year, the largest gains in the metals were concurrent with rises in the major indices. For the intermediate term, there is nothing to suggest this relationship will change. That the markets went into the weekend flat and are set for light holiday trading at least through the next week, probably signals minimal upside. But, the longer the Fed perpetuates the notion that inflation is contained despite rising action in the metals, the more we can assume the metals will continue to rise, if only gradually. Agree or disagree with the Fed's logic, but don't bet against them!
Thursday's action demonstrated the risk associated with using mining stocks to capitalize on the precious metals markets. While the miners can exaggerate the upside, they tend to exaggerate the downside as well. However, with the selloff coming as the product of misguided thinking about gold as simply an inflation hedge, and the GDX well below its level going into the bullish CPI release, several new buying opportunities have certainly been created. What was old is new again.
Featured Mining Stock
Teck Cominco Ltd. (TCK)
This Canadian company is truly a worldwide venture with operations too vast to be exhaustively described here. Still, this brief overview will be a summary of why Teck Cominco deserves the attention of any investor.
With earnings of more than $8/share, Teck Cominco trades at a paltry eight times earnings. And that despite reporting diluted EPS for 2005 that was double the previous year's and more than nine times 2003 earnings. As the company readily admits, most of this gain was due to rising commodity prices, but with Teck's deep and diverse portfolio of copper, zinc, nickel, lead, gold, molybdenum, and coal, the company is well protected against declines in individual commodities. The fact that its annual sales roughly match its production means Teck can fully realize gains in commodity prices without threatening its reserves or building too much inventory.
TCK's exploration and production occurs all over the world, but is concentrated in Central and South America, Europe and Australia, generally stable regions. Its priorities for future development are nickel, zinc, and gold all of which have seen substantial price increases in recent weeks. The company also boasts a state-of-the-art technology department that contracts with outside exploration firms and partners with universities and research organizations.
But if the company has an Achilles' heel, it is pollution and environmental lawsuits. In July, a U.S. court found Teck subject to the Superfund law, which would make it liable for cleanup of the Columbia River. Teck has appealed this ruling, unsuccessfully to date, claiming that its pollution occurred on Canadian soil, beyond the jurisdiction of U.S. courts and laws. The latest federal ruling, rejecting Teck's appeal, occurred on November 7th and marked a recent high in the stock. Since the company's case involves complex legal issues, it's possible it will seek a hearing in the U.S. Supreme Court, a move which may at least delay cleanup payments. Beyond commodity prices, this lawsuit is likely to be the most significant factor influencing TCK's performance. The weekly chart below shows that a decline to near $63 would test the lower channel of its recent uptrend from the July lows.
Also among the potential risks to Teck Cominco's future earnings are currency conversion rates. Since the company's earnings are priced in Canadian dollars, weakness in the U.S. dollar would eat into profits. It's difficult to predict the extent to which this loss would be offset by increases in metal prices. But, if the past two years are any indication, TCK should be able to capitalize nicely. For more information, help yourself to the company's website or join us on the forum.