We have seen gold stocks absolutely destroyed this year beyond imagining, declining even more than bullion, with a 50% retracement of the prior decline in gold shares likely in the coming months. Such a sharp move in gold shares would not be surprising as the sell off this month has been overdone by any measuring stick with gold stocks currently presenting values never seen before.
Over the past year we have seen gold stocks underperform bullion with the trend accelerating to the downside since July as the credit crisis intensified. While the credit crisis explains the strong underperformance of gold shares recently, it does not explain the weakness seen in gold stocks relative to gold from November of last year until July of this year.
Figure 1
Source: Stockcharts.com
Perhaps the best explanation for gold share underperformance earlier in the year was due to rising oil prices that were cutting into gold producer margins. So, even though gold bullion was rising, it was not rising as much as crude oil because gold producer’s profit margins were getting squeezed. The ratio of gold to oil serves as a relative proxy for gold miner profit margins and has displayed a close correlation with gold stocks relative performance to gold bullion. As seen in the figure below, the ratio of gold to oil peaked last year and has been falling since then, until recently as oil prices have collapsed while gold has held up more strongly. Typically, turns in the gold to oil ratio mark turns in the gold stocks to gold bullion ratio, and the recent upturn in the gold to oil ratio is likely signaling gold stock outperformance relative to bullion ahead.
Figure 2
Source: Bloomberg
Not only does the ratio of gold to oil point towards a rebound in gold stock outperformance, but so too does the ratio of gold stocks to gold itself which hit a major statistical extreme this month. The ratio is currently nearly three and a half standard deviations (SDs) from its multi decade long-term average, the most extreme reading seen in the past 24 years. The ratio should stay within two SDs from the mean roughly 95% of the time which has indeed been the case. However, the current reading of 3.41 SDs away from the mean should only happen 0.06% of the time, or to put it differently, 99.94% of all observations should be contained within 3.41 SDs of the mean.
Figure 3
Source: Bloomberg
So you can see how extreme the current reading is from a statistical perspective, and readings roughly two SDs from the mean often mark peaks and troughs in gold shares. For example, the prior two lowest readings over the last 24 years in the XAU to bullion ratio have marked major turning points in gold shares. The -1.77 SD reading seen in 1986 marked a major move in gold shares with the XAU rallying 164% in just over a year. The -2.03 SD reading in 2000 marked the kickoff to the gold bull market this decade and the current reading also likely points to a major turning point in gold shares.
Figure 4
Source: Stockcharts.com
In terms of gauging a likely rebound in gold shares, a 38.2% Fibonacci retracement of the current decline would roughly coincide with the September bottom and an 84% move off the recent lows. A 50% retracement would put the XAU back to roughly 136 and mark a 111% move off the recent lows. Either way, the move in precious metals should be explosive as the downward thrust was exponential with the September lows likely marking the first line of resistance. A move back up to the September lows will be a welcome development for commodity bulls to recoup a significant portion of recent losses.
Figure 5
Source: Stockcharts.com
While the resource complex (and broad market for that matter) is likely to experience a sizable rally from oversold conditions, gold shares likely present the most attractive opportunity for several reasons. For starters, the gold to oil ratio is just off multi-decade lows with gold offering greater relative value than oil based on the historical relationship between the two. Reflecting the relative value between the two commodities is the ratio of gold shares (XAU) relative to oil shares (XOI), with the relative stock ratio also at multi-decade lows with gold shares representing a greater bargain relative to oil shares.
Figure 6
Source: Bloomberg
We have likely witnessed a major turning point recently in gold shares relative to oil shares. The trend in underperformance of gold shares relative to oil shares was broken last year as the Fed began to cut interest rates, which was the same backdrop for gold shares outperforming oil shares beginning in late 2000. Another similar development between the two time periods was the Federal Reserve expanding its balance sheet in a reflation effort. With the previous reflation effort paling in comparison to the current campaign, gold shares should outperform oil shares by a sizable margin.
Figure 7
Source: Stockcharts.com
Figure 8
Source: Federal Reserve
Additional support for gold share outperformance relative to oil shares is that all across the globe countries are debasing their currencies as seen in the table below of country monetary growth rates.
Table 1. Global Monetary Growth Rates (Y/Y % Chg)
Source: Bloomberg LP
Developments such as these will be bullish for gold long term, and with gold shares representing a bargain relative to both gold bullion and energy shares, investments in gold stocks at these depressed values will likely be rewarded in the years ahead.
