The Canary in the Gold Mine

Submitted by Pater Tenebrarum  –  The Acting Man Blog

South African Gold Stocks Surge

Late last year we discussed one of the world’s most marginal mid-sized gold mining companies, South Africa-based Harmony Gold (HMY) (see “Marginal Gold Producer Takes Off” for details). We did so for two reasons: first of all, the stock has a well-established seasonal pattern – it tends to rally strongly from roughly November/December to January/February.

 

CanaryPhoto via hdwallpapersbin.com

 

Secondly, this pattern is not merely a statistical artifact, but it actually supported by a clearly discernible fundamental driver – namely, this is the quarter during which the group traditionally posts the strongest results of the year. Thirdly, recent fundamental improvements (stronger than expected earnings and guidance) and a breakout in the Rand gold price to new highs seemed especially supportive this year.

 

1-Gold-in-Rand-AGold in Rand, weekly. This is a rather bullish looking chart at this stage – click to enlarge.

 

At the time we wrote in conclusion that we wouldn’t recommend chasing the stock, because it had become short term overbought (it did in fact pull back shortly thereafter). However, we also noted that we personally believed that the rally was likely to continue.

This has in fact happened – and in the meantime, other South African gold stocks have likewise begun to move noticeably higher. In other words, the market is apparently not only reversing last year’s tax loss selling effects to some extent, it is also beginning to recognize the potential for sharp improvements in the earnings and cash flows of these companies. Most South African mines are fairly marginal, so even a relatively small rise in the gold price can have a big effect on their net income.

 

2-HMYHMY, daily – needless to say, we wouldn’t chase the stock here either, as it is once again quite overbought. However, it is worth keeping in mind that this stock traded at more than $15 at the 2011 USD gold price peak, at which time the company was operationally in worse shape than today – click to enlarge.

 

Another stock in this sub-sector that has managed to break out from a bottoming formation recently is gold tailings processor DRD. This is not really a mining company in the traditional sense, but it does produce gold quite profitably and has increased its year-end dividend five-fold last year – making it one of the highest-yielding gold stocks.

 

3-DRDSouth African gold tailings processor DRD – this one is also overbought in the short term, but is surely worth watching – a successful retest of the breakout would be an invitation, so to speak – click to enlarge.

 

A third stock we want to briefly look at is Goldfields (GFI), which is no longer strictly a South African mining company, as it has spun the bulk of its SA assets out into a separate entity, Sibanye Gold (SBGL). SBGL is a special case, as its stock has bottomed back in the summer of 2013 already. The reason why GFI is still worth grouping with the other SA miners is its mechanized South Deep mine, which will eventually produce up to 700,000 oz. per year (if everything goes according to plan that is. It is currently still far from that, but production has begun to pick up. The mine’s gold resource is easily one of the biggest in the world).

 

GFI moreover has assets in Ghana, Peru and Australia and benefits from weak currencies in all of these countries. Contrary to the “SA pure plays”, it hasn’t broken out just yet, but seems to be in the process of doing so (as a result it is also less strongly overbought). It is also worth noting that GFI’s management made the mistake of hedging oil prices just as crude oil was about to tank in late 2014 – these hedges are now running off, so the benefits of lower oil prices should begin to flow through to its bottom line. It also stands to reason that the recent improvements at South Deep are probably not a fluke: the company is implementing brand-new mining methods and employing new technologies, which seems to be working quite well.

 

4-GFIGFI – in November the company surprised the market by reporting a much better than expected quarter – click to enlarge.

 

As the title of this post already indicates, we are actually trying to get at a specific point here. In other words, we are not necessarily just beating the table for SA gold stocks; after all, positive currency effects are enjoyed by many producers at present. The market appears only slow in recognizing this fact (several Australian producers did get a currency-related boost last year).

 

Gold Prices and Leading Sub-Sectors

As to the gold price, late last year we have chronicled assorted technical smoke signals, as well as sentiment and positioning extremes in great detail, so this ground doesn’t need to be covered all over again so soon. Obviously, gold has recently turned up even in USD terms, and in the process has overcome an initial technical resistance level.

We generally don’t like it when gold rises for all sorts of supposed “reasons”, especially not when some of them concern geopolitical developments, but we can’t fault the advance from a technical perspective. Besides, the reasoning presented in the media seems spurious anyway. In reality, the most widespread assumption up until very recently has been that gold would fall because the Fed has begun hiking rates.

As our regular readers know, we have disputed this assumption for well over a year now. In our opinion it was mainly the threat of rate hikes that weighed on the gold price. It seemed logical that the actual implementation of rate hikes would be greeted with a relief rally. Lastly, when everyone is sitting on the same side of the boat, the boat is usually bound to capsize.

 

5-Gold in USDGold in USD, daily. So far the rally is still small, but gold has overcome the upper boundary of the most recent trading range. A great many speculative shorts have been added at prices below $1,100 – this provides a lot of potential short covering fuel – click to enlarge.

 

Here is a close-up of the action over the past week:

 

6-gold in nUSD close-upGold over the past week, 30 minute candles – click to enlarge.

 

The recent break-out in the Rand gold price and the action in South African gold stocks reminded us of the rally out of the low in 2000. We remembered that the SA miners were one of the leading groups at the time as well, similarly driven by a surge in the Rand gold price due to a sharp decline in the Rand.

So we took a closer look at what actually happened in the time period and found out something quite interesting. Between late 2000 and mid 2002, i.e., a period of roughly 18 months, SA gold stocks indeed moved up quite a bit. However, what is most interesting is how they behaved relative to the Rand gold price.

The chart below shows an overlay of the prices of HMY, DRD and GFI (which moved largely in concert at the time) as well as the Rand gold price from October 2000 to October 2002. Pay close attention to the leads and lags:

 

7-SA gold stocks vs Rand 2000-2002HMY, DRD and GFI in late 2000 – late 2002 compared to the Rand gold price (lower half of the chart). The red vertical line aligns with the peak in the Rand gold price at the time – click to enlarge.

 

The likely cause of this lag in stock prices vs. the gold price relevant for the underlying companies was that just as the Rand gold price peaked, the USD gold price really got going, while the Rand concurrently strengthened. As a result, the SA companies were able to maintain the higher margins resulting from the earlier Rand gold price rally, while the currency in which their stocks are priced began to improve.

At the same time, traders finally began to believe that the upturn in the gold price was for real, so market psychology changed significantly as well. A previously relatively hesitant upturn became far more vigorous as more and more investors suddenly piled in for fear of missing the advance. Not to forget, the rest of the stock market suffered a vicious downturn during this time as well – gold stocks were a great sector to rotate into because they were one of the few really cheap and beaten down sectors (a potentially significant similarity to today).

 

Conclusion

While one can never be entirely certain about these things, as they always play out slightly differently, it could well be that the upturn in the Rand gold price and SA gold shares is once again a leading signal for the entire sector. The canary in the gold mine so to speak, only this canary isn’t dying: instead it is a dead canary that is coming back to life.

As a final remark, the upcoming US payrolls data on Friday could well precipitate a correction, given that gold has been rising ahead of the release. If the gold price manages to withstand the data (especially if they are strong), we would rate it as an especially positive sign, but a correction certainly wouldn’t surprise us after the recent run-up. We would like to see the $1,080 level holding firm on a pullback.