Gold fundamentals still positive

• Physical demand for gold still very strong
• Available gold inventory declining
• Extreme readings on all momentum and value indicators
• ASX Gold Index trading value and volumes increasing
• “V” bottom likely

The month of June 2013 in the future will be seen as a time of extremes.  Most of it extremely bad.  But the other side is that extremely good value has been created. The extreme fall of 76.7% in 26 months is a Crash all right, worse than 2008 and 1987, and right back to the 2004 levels but it is hard to see the reason for it.  Gold in A$ today is A$1377 which is just 2% lower than the A$1409 at the April 2011 XGD Gold Index market high.  Hardly extreme enough to warrant this selloff. Global equity markets are at or near all time highs and economic activity is still bubbling along steadily.  Bearish talk on the global banking system is still with us and the never ending reports on the collapse of China are still front page, so what are the key reasons?   And don’t tell me that gold is falling because of the Pollyanna global economy or that inflation is falling.  Just note too, that the oil price is through US$100 and breaking the 2008 downtrend as referred to in my last Dawes Points.  Egypt or not, this is not the sign of a deflationary environment at a time of accelerating global energy demand. The extremes are also notable in:

ASX XGD:A$ Gold ratio US XAU: Gold ratio US XAU: S&P 500 ratio

Extremes were also evident on the market sentiment levels with the whole world aggressively bearish on gold, major short positions in the COMEX gold futures and the lowest bullish consensus in this bull market’s history. Extremes were also seen in the investment patterns of Asian gold buyers and particularly from Chinese and Indian demand which showed physical delivery in the June Half of 2013 to be greater than global mine production over the same period.  The extremes continued in the US, Europe and Australia with mints working overtime to keep up with surging demand. This 28 June 2013 chart from Koos Jansen clearly shows the year to date delivery of gold from Shanghai Gold Exchange at 1044 tonnes was 80% of all world mined gold (~2700tpa) and with about another 800tpa from India the physical demand from these two countries alone is greater than annual mine production.   Reports still show strong demand for coin and bar in US, Europe and Australia and delays in delivery are being experienced everywhere. And inventories are drying up with COMEX warehouse gold down over 30% since end 2012.  The focus there is on JP Morgan which has had a disproportionate decline in its holdings as its clients have taken delivery. What are we to make of all this?   I can suggest that the market sentiment is just not right for a bear market to have happened nor to continue. Gold stocks in Australia (XGD) and North America (XAU) seem to be assuming a gold price under US$800/oz and that gold will stay down forever.   The XGD fell 76.7% to its low of 1984 and the XAU fell 64%.  XGD fell back to 10 year lows.   All of the efforts of the past 9 years have just evaporated. Yet gold is still US$1250.  Certainly it tripped under US$1200 for a moment and is now back up to US$1265.  Is US$1250 a good price for gold producers?  Ok for some, but new projects will need US$2000 to justify remote or difficult terrains. It seems that we investors in gold stocks have experienced the proverbial round trip in that the ASX Gold Index ran up 310% over 7 years from 2004 and as now given it all up in a 26 month debacle that brought the index down 76.7% to the lows there in late June . Gold company managers have received strong criticism from investors for cost overruns and technically affected projects and bear markets have that effect of providing no hiding place for problems in any operation.  So most companies are cost cutting, selling assets and deferring capex to optimize cashflows.  This will be beneficial for everyone, especially shareholders, in the future. The markets have declined but note the volume increases in XGD with both value and the number of transactions increasing.  This market is under accumulation.   Note that stale bull selling seems to also be increasing as the number of shares is rising but at lower prices.   The decline in average transaction value from A$20,000 to <A$3,000 also suggests not a lot of institutional interest yet. These 75% off lower prices must end very soon so you should take advantage of the opportunities.  It is hard to believe that entry prices will get any better. So what did we get for all that effort of the last 9 years? Looking at the 38 stocks in the ASX 300 Gold Index we find some interesting stuff. In 2004 only 8 of these 38 stocks currently in XGD were producers.  Today these 38 stocks include 21 producers and substantially higher aggregate resources, reserves and production. The whole Australian Gold Industry spent more than A$5bn in exploration in Australia over the next 9 years (ABS stats) from 2004 and probably >A$15bn (A$4.3bn in FY12) in mine capex.  It needs to be recognised that Australia’s large mines spent at large part of these funds but were sold off to North America and so are not in the XGD. So the round trip was all for nought. The collapse in the gold price from US$1400 to US$1200/oz seems to have made everything worthless.  The market assumes no one could be making money. It is strange that so many commentators are calling that the gold bull market must be over.  Despite all the physical gold demand from those Chinese and Indians who have recently been buying about 1300 tonnes per year and in the first half of 2013 at about 3000tpa rate that exceeds global mine production.  Despite all the public demand for coins and small gold bars. Despite the main reason for buying gold being continuing increase in fiat currency issue, continuing government budget deficits and growing government debt levels.  Some group is selling and it is not just from the North American ETFs.   Yes mine production has exploded to a ten year growth average rate of 0.7%pa to 2800t and all those central banks have stepped up selling such that this year is likely to be a net buying of about 400t and the highest in about 30 years. This is a huge increase in supply. Minus 400tpa. Yes all the key buyers who take up about 140% of annual mine supply have got it all wrong because the US investment banks and hedge funds just know better.  "There are 170,000 tonnes of gold out there in the market and we can sell it all at any time. We showed you what we can do.  We sold a year's mine supply (2800t) in an afternoon by just spinning our Rolodex!!  Yes and just as those 170,000 tonnes turn into 5.5bn oz of gold it shows that we have over US$7 trillion of fire power.    Yes, and we have US$17 trillion in bonds to protect so you guys can just sit back in fear." - major Investment Bank. "What's that?  You mean that just because we sold the gold futures contracts for gold we don't have and that because all the Chinese and Indians have given it out in 1 oz bars and as necklace jewellery to their families that we might not be able to buy it back?  No way!  You forgot that the ETFs have about 1000 tonnes of gold and we can buy it back from all these suckers!     Gotcha again!!" "So all you investors in gold stocks just better sell out now because you are going nowhere.  Oh, and by the way, if you wanted to sell your good stuff, but not the junky stuff, then I will help you by taking it off your hands right now. Just to help you out.  What are friends for.  No problem." Yes everyone, we have been conned. The proverbial price of everything and value of nothing has brought gold stocks to the level they were in 2004 when gold was US$400/oz. The issues are global. So let's look again at the relatives. Extremes here. In the XAU against gold it is at very long term lows and I have seen that it is the lowest level since the early 1970s.   The ratio is 70% lower than the average of the 25 years to just before the GFC in 2008.  And after outperforming the S&P 500 by 16%pa for 11 years until 2011 the XAU fell 72% against stocks. Long Term Relatives

XAU against Gold	XAU against S&P 500

So what are we to do?  The banking system problems haven't gone away and central banks everywhere are printing money like tomorrow won't come.  Physical demand is going gangbusters and mine supply is finding it very hard to match last year's level.  Low prices below US$1300/oz will mean some players might just not make it.  Overall though, C1 cash operating costs might still be below US$1000 and a bit of tweaking to treat higher grades might help for a while but if gold stays down for too long there would be more mine closures. Share prices at 75% off the April 2011 highs are very attractive and should be tempting everyone to come back to add to positions. But the more important questions in this market surround who are the sellers and who might be the buyers? What has happened here in Australia?  It is clear from reviewing the Top 20 shareholdings of most Australian gold companies that individuals (usually management) are the largest shareholders and, outside of the top 15 gold stocks, any institutional investors are rare inside of the top 10. The major funds are simply not there.  In hindsight this is wonderful.  Few losses in the past two years of misery.  But also few gains on the way up to 2008. I come back again to my pet issues of participation in the market and market breadth.  My assessment is that few players are in these markets and few players mean low liquidity.  And low liquidity means poor competitive valuations.   Few players mean a buyer cannot readily get volume and of course few buyers mean a seller can only move price.   The biggest gold stocks achieved premium pricing but most small companies were just ignored and were given big pricing discounts. My years managing the resources portfolio at hyperactive BT Australia thirty years ago and the subsequent years as Head of Resources Research at Deutsche Bank followed by the same position at Macquarie Bank gave good experience and insights to investment at the highest levels.  But things are different today. Far from being the drivers in investment in the mining, petroleum and agricultural sectors, the institutional fund managers are risk averse and seemingly at odds with their roles of taking long term views to match their risk maturities. Australia in June 2012 had A$1400bn in superfunds.  Contributions have been around A$115bn pa (A$85bn from the private sector) and investment earnings since must have been around 5% so another A$70bn increase is likely.  After subtracting the mining sector losses (only in the SMSFs) we must be closer to A$1550bn today. Paul Keating must be so proud of this massive bulwark of investment assisting Australian companies grow and compete in the global marketplace and bringing joy and wealth to all Australians. The APRA data for 2012 tells it all for default portfolio structures for a large portion of its members:- The default portfolio for APRA funds (making up about 43% (67% in industry funds)  of APRA's A$917bn share of the A$1400bn) shows 28% of asset are in Australian equities and 9% in Fixed Income.  Then there is 23% in overseas equities.  Wonderful.  Diversification into Google, Deutsche Bank and LVHM.  Oh, and there is 5% in overseas Fixed Income securities.  Hmmm.  That makes 28% offshore.  And there is 9% in cash but SMSFs have been much higher.  Probably as bank deposits to allow lending to grow and expand the Australian economy.  And are the banks lending to anyone at present? Did anyone think that taking out A$85bn (6% of GDP) as the Super Guarantee Levy tax ( yes it is a tax  .. no ..no.. it is a supplement to wages.. a tradeoff against higher wages... those union boys have really helped their members) might be contractionary in the economy?  Impossible.  No, how could it.  Think of the productivity gains and trade offs. And the reinvestment into the economy.  Well just look at the numbers. All of just 38% goes back into the Australian real economy. Fantastic.  That other 62% A$52bn that does nothing for Australia or goes overseas. Unlike ordinary taxes that go the government and straight back into the economy.  And so we have the development sector of the Australian economy deprived of funds.  So little for resources, technology, agriculture and biotech. Coming back to participation in the markets, it has been my assessment that the 1998-2008 bull market in commodities was not well supported at an institutional funds management level.  The US$10/bbl to US$147 in crude oil was just a ten year bubble. As for copper or gold or whatever, just not attractive enough. Hence my description of the Disbelief upleg.  Pessimism followed Disbelief and boy did we get it in 2008.  End of  the world stuff.  And "I told you so."  So low Participation and so no-one knew values on the way up and of course no-one wanted to know them on the way down. But after this disaster the ASX Gold Index rallied and went to a new alltime high in April 2011.  This has always impressed me. So looking again to the 75% sell off that has brought us back to the levels of 2004 and bouncing off major extreme technical support.  How can we view this other than as an opportunity of extreme attractive value? And if we decide this is an extreme value low in what in my estimation is a major long term bull market in gold then really, as an entry point, it simply just doesn't get any better. Sir John Templeton was one of the great money managers of the 20th Century (he passed away in 2008 at 95) and amongst his many achievements he was known for his many quotable quotes. One of his best known was Bull markets are born in Pessimism, grow on Scepticism, mature on Optimism and die in Euphoria. Juggled around this can become the first leg is Disbelief, followed by Pessimism with Optimism leading Opportunity and finally closing with Euphoria. Our model here clearly confirms the Pessimism and the subsequent extreme decline into Despair but the fundamentals from my perception still point to a bull market in gold prices and expansion in gold production and earnings.  So we can only conclude that the 75%-off sale is finishing something and morphing to starting something.  That something should be something very big as the opportunity is now there for new investors as trustees of SMSFs to embrace a rising gold market together with a better appreciation of the skills of the managers of this sector.  This will provide the previously missing Participation by more players and also give Market Breadth as more companies are appreciated across the sectors.   That would blend together to underpin the Optimism Upleg I refer to. The last Dawes Points on gold gave us a performance table that was very sad.  Lots of >80 and >90% price falls.  I can only conclude that extremes everywhere are just making for extreme value and strong buy signals. But the opportunity is here and now.  The stocks to play are NCM, EVN, MML, SAR, RMS, PIR, OGC, NST  and BDR.

Key Points

• Gold stocks 65% off April 2011 highs in End of Financial Year Sell Out
• A$ Gold price 3% higher than April 2011
• Tax loss selling period offers excellent entry point
• Probable low in place in US$ gold prices
• Major short covering rally likely
• New highs still expected by 2016 giving notional 250% Index gains

The market place certainly has ganged up on gold and gold stocks these past couple of years and put them both to the sword.  "Barbaric relic" they say and, anyway, the gold mining sector is full of poor managers with third rate projects and a egotistical drive to spend money on more third rate projects or even, shock horror, exploration to increase resources.  Costs have risen out of control!  Lifestyle companies, so sack all the CEOs!  Stop spending shareholders money there and give us dividends.  Now!  Don't you know that the global equity markets are only running on dividend paying stocks because interest rates are staying at zero and investors need income! Well, all thirteen fund managers who still had gold stocks in their portfolios voiced their displeasure at the lack of earnings and dividends and the thousands who didn't cheered them along anyway.  And those wonderful investment banks joined in with an orchestrated bear raid on gold and gold stocks. Yep, they knocked down the gold sector stocks 57% in North America and 66% in Australia in just two years.  And the US$ gold price then was US$1480 so is down about 5% from the April 2011 levels whilst in A$ it is 4% higher at A$1460 compared to about A$1400.  Go figure! So gold stocks at today's prices are indeed at bargain basement prices – don’t miss out of the June Sales! Reviewing the long term history of the North American gold stocks (Philadelphia Gold Index "XAU") it can be seen that it certainly is volatile and the past sell off has a manic character about it.  Sort of hate the sector.  Get me out!  And let's short them because gold has no place in the low interest rate environment that is encouraging global growth. So this price history shows that the index is back to the levels of almost 30 years ago despite gold being almost 300% higher.  And the reasons behind gold being in a bull market are still there.  Haven't gone away and indeed are even stronger. The momentum indicators on this index are deeply oversold and a rally is due. The two major gold indices in North America (the "XAU" and the Gold Bugs Index("HUI"))   are showing strong signs of reversal after their two year 57% falls. Note the "gaps" in the break us from the lows.  Up 10.6% and 12.2% respectively from the May 20 lows. And the two important ETFs GDX (almost the XAU) and GDXJ (gold juniors) are showing similar signs of bottoming with the same gaps and expanding volumes and up 12.6% and 15.6% from the lows. And the actions of big two, Barrick Gold and Newmont, up 14.9% (up 20.8% from its April low) and 13.1% from the lows respectively showing strong performances as market leaders. Spare a thought for the TSX venture Exchange Index ("CDNX") where it with all its small cap resources and other sectors is down 61%.  But it seems to be bottoming and note the declining wedge being formed during the decline from April 2011.  A great deal of improvement is required in this index but a 16% upmove would trigger a very sharp rise and it has already rallied 5% from the lows. Here in Australia the story has been the same only worse and we all know that as Newcrest fell 66% many other XGD stocks fell even more.  And we have also watched in disbelief as a few of our more speculative plays had a 9 in front of their falls.   Ouch indeed!  But if they have cash they should survive and their assets will eventually be recognised again.  Be careful but don't despair. The 66% fall by the Gold Index has been savage but note carefully that every sell off in this bull market since 2000 has been followed by NEW HIGHS!!!  In considering the state of the gold market itself I still consider that we will again see all time highs in gold stocks over the next couple of years. The performance of gold equities against gold is even more extraordinary.  After spending over 20 years trading about 0.25 against Gold (left chart), gold stocks are now just 0.07   - less than a third of what they were.  The issue of PE ratios and dividend yield are different matters but the PERs are now almost single digit compared to 40s and 50s in the 1990s. The picture is similar here in Australia.  After significantly outperforming both equities and gold itself we find gold stocks have fallen a long way.  Where was the gold boom? So now let's look at gold itself. You have all been told that gold is dead along with inflation and that 2% yields on 10 year US Treasury Bonds and 3% on 30 year Treasuries are the places to be.  Just don't worry about there being US$17 trillion of them and plenty more where they came from! It is hard to pass by the obvious that the Treasury Bonds are being defended by US investments banks loaded up to eyeballs in these bonds and funded by the US Fed's ultra low short term rates.   Sort of 1-2% “risk free” income and geared 100%.  Borrow short from the Fed at 0% and lend long at 2%.  Fine while rates stay steady and low.  Wildly leveraged when bond yields rise and bond prices fall. Imagine the capital losses on 2% 10 year bonds should yields be forced to 2.5%.  Try 5-8%.  And 100% geared.  Goodbye banks' balance sheets.   From the lows of 1.4% in July 2012 for 10 year Notes to Friday's 2.16%.  From a price of 135 to 129.88 is a 3.8% capital loss and about 2.6% net of income loss.  On a million that is OK but on 10 billion that is 260 million. How many 100 billion did these banks buy?  But of course it is US Government guaranteed!! How about on the 30 Year Treasury Bond? Down 8.1% from 153 in July 2102 to 140.6 on Friday.  Corresponding yield rise from 2.40% to 3.30% on Friday. Net capital loss over 5% in 10 months.   On 100 billion of bonds that is US$5bn mark to market loss.  So with a US$17 trillion bond market at risk it is worth having a $US150bn crack at selling 100m oz of gold as was carried out over two days in April this year.  Yields on 10 year Treasuries fell from 2.1% to 1.6% in a successful but short term move over all of three weeks.  Now back up to 2.16%.  So it didn't work.   Will have to buy the gold back. Gold bugs were heartened when the response in the physical market was so strong.  USA, Europe, Hong Kong, China, Middle East and India could not believe their luck.  Demand for physical gold went up strongly.  As gold is money (a currency really) here was free money.  What were they thinking? This cartoon explains it so well.  Thank you Merk Investments.      Junk currency for gold bars. What were they thinking?  It is easy to see who will win. The World Gold Council showed that March Qtr 2013 was very active.  Demand from China was strong at 110t and well above previous quarters.  Coin and bar demand was 12% higher at 378t and central banks acquired a further 109t.  Total gold demand was 19% lower than Dec Qtr due to the outflow of ETF holdings by a large 177t.  Bloomberg reported that China’s imports through Hong Kong in March alone was a record 223t, more than double that of a month earlier.  And this was all before the April sell down that has set off the very strong demand around the world for gold at discounted prices. We are also told that gold's 2009 uptrend in US$ has been broken and the US$ is king again.  Well maybe. The short term from 2009 was certainly broken in US$ but the seven year uptrend is still intact and markets are significantly oversold. But gold in so many other currencies has held the uptrends and in the case of Japan actually made a new high in March 2013.  The 2005 uptrend has broken in Swiss Francs but new monthly closing highs in 2012 were seen in both the Swiss Franc and the Euro but not in US$ after the September 2011 high so gold still has strength in these currencies. And two rather interesting histories of commitment of traders show record short positions in place (data from 2006) (courtesy of Tyler Durden)… … and a long term very low short position held by commercial users and producers(lowest since the GFC in 2008/09). Thank you Dennis Gartman.  Could be particularly unlucky for some holding those short positions. The market will do what it will do and we are just onlookers in these savage war games between buyers and sellers. Here in the Australian market we can view the XGD and its fall from grace from the April 2011 highs.  From the day of the high at 8499 on 11 April 2011 we have had the following performances.  There are certainly some bargain basement stocks out there.

	Max close	Date of	Price	Change
Ticker:	(A$)	Price Max	03-Jun-13	(%)
XGD	8,436	11-Apr-11	3,018	-64.2%
RRL	5.87	03-Oct-12	4.11	-30.0%
BDR	1.12	03-Dec-12	0.71	-36.3%
NGF	0.27	09-Aug-12	0.17	-38.9%
OGC	3.65	01-Jan-11	1.96	-46.3%
NST	1.57	27-Nov-12	0.80	-49.2%
MOY	0.04	17-Jan-11	0.02	-53.7%
PGI	0.21	27-Apr-11	0.09	-55.2%
UML	0.20	01-Nov-11	0.08	-60.5%
EVN	2.14	24-Oct-12	0.84	-60.7%
PIR	1.97	18-Oct-12	0.77	-60.9%
MRP	0.45	02-Nov-12	0.18	-61.1%
TRY	5.05	29-Feb-12	1.90	-62.4%
RSG	2.16	07-Feb-12	0.79	-63.4%
NCM	42.66	21-Apr-11	14.99	-64.9%
ABU	0.08	14-Nov-11	0.03	-65.0%
EVR	2.64	15-Dec-11	0.90	-65.9%
GDO	0.56	05-Dec-11	0.18	-67.6%
SIH	0.25	04-Jan-11	0.08	-67.6%
DRM	1.57	03-Nov-11	0.50	-68.2%
AZH	0.97	01-Mar-12	0.30	-69.1%
MML	8.71	31-May-11	2.57	-70.6%
SBM	2.52	14-Nov-11	0.68	-73.1%
PRU	4.00	09-Sep-11	1.06	-73.5%
RED	2.35	10-Sep-11	0.62	-73.6%
TGZ	2.89	21-Jan-11	0.70	-75.8%
SLR	3.96	10-Oct-12	0.82	-79.3%
AQG	12.10	14-Nov-11	2.30	-81.0%
PEN	0.15	17-Feb-11	0.03	-82.0%
KRM	1.83	11-Apr-11	0.31	-83.3%
KCN	10.88	01-Jan-11	1.80	-83.5%
ALK	2.61	15-Apr-11	0.42	-83.9%
SAR	0.93	08-Dec-11	0.15	-84.1%
IAU	2.34	12-Apr-11	0.33	-85.9%
FML	0.10	07-Mar-11	0.01	-87.2%
RDR	0.71	06-Jan-11	0.07	-90.3%
RMS	1.70	10-Sep-11	0.16	-90.4%
GRY	2.11	11-Apr-11	0.19	-91.2%
TAM	0.98	19-Sep-11	0.08	-91.8%
			Average:	-69.1%
			Median:	-68.6%

These certainly are bargains on relative performance and Paradigm recommendations here would be:-

• Evolution
• Kingsgate
• Medusa
• Northern Star
• Oceanagold
• Regis Resources

There are of course dozens on non-XGD gold stocks that might provide some better leverage and we will be happy to share them with clients. It is rare that one sector of the market should so significantly underperform the rest of the broad market (apart from XSR Small Resources) and I can only conclude that a 65% off sale is very attractive. Even better than buying on eBay or Grays Online!!