Breakout in the Bag

In our last update on technical conditions in the gold market posted on Monday, we discussed the potential for a breakout in both gold and gold stocks, as well as the near term targets such a breakout would imply. This breakout has subsequently come to pass. Both the metal itself and the stocks of gold mining companies have vaulted over important resistance levels and are now already approaching the next resistance zones.

Spot gold, daily: the resistance at $1,270-1,280 has been overcome, and a move to the initial target at $1,360 seems now likely. The former resistance should provide support in the event of a pullback – click to enlarge.

Gold stocks have in turn broken upward from the triangular consolidation we have highlighted several times recently. As we noted on Monday: “The triangular consolidation on the daily chart of the HUI continues to look encouraging to us”. More often than not, such triangles are continuation formations, and this particular triangle has now definitely turned out to be one as well.  

Of course, it is likely that the ride will be a bumpy one, considering how many potential resistance points await, but there can be no doubt that the rally that began in late December/early January looks like a much more solid and deliberate affair than the volatile bottoming phase between July and December that preceded it.

Needless to say, we continue to be happy with how the chart looks. The current rally definitely has a better 'feel' to it than the previous rally attempts since the late June 2013 low. That said, let us stress again that it is highly unlikely that there will be a 'smooth ride' from here on out. The sector is likely to remain very volatile.

The HUI – still looking good, although a few gaps have recently formed that may need to be filled in an upcoming pullback (note though that not all gaps get filled, and the gold sector has a tendency to produce more gaps than other market sectors as gold itself is traded around the clock) – click to enlarge.

Mining Costs Fall

In the context of gold stocks, we also want to point out that we are recently increasingly proven correct regarding a major point we have made several times in the second half of last year. Specifically, we averred that analysts who at the time simply extrapolated rising costs into the future forever and ever would likely turn out to be wrong; a turning point in mining cost inflation was in our opinion close at hand. We also felt that the changes at the management level at many senior and medium-sized gold companies and the new policies pursued by the new CEOs were not properly appreciated. For details see e.g. this article: “Are Mining Costs About to Fall?”

We have now received word from Barrick Gold, Goldcorp and Agnico Eagle that costs indeed continue to decline across the sector, a trend that already became evident in recent quarters. Bloomberg e.g. informs us:

“Barrick Gold Corp. (ABX) and Goldcorp Inc. (GG) reduced their fourth-quarter operating costs from a year earlier as the largest producers of the metal by market value adapt to the biggest fall in gold prices in three decades.

Barrick’s so-called all-in sustaining costs dropped 14 percent from a year earlier to $899 an ounce, the company today said in a statement. Vancouver-based Goldcorp’s costs fell 11 percent to $810 an ounce by the same metric.

Gold-mining companies are cutting spending, selling assets and reworking mine plans to lower costs and focus on the most profitable production after gold’s biggest annual decline since 1981. Their efforts are starting to pay off. The 10 largest producers may generate $3.07 billion of free cash flow this year and $5.03 billion in 2015, compared with negative $1.4 billion in 2012, according to analysts’ estimates compiled by Bloomberg.

“The industry is managing itself better, they’re running their businesses better, they’re being more disciplined,” Barrick Chief Executive Officer Jamie Sokalsky said today in a telephone interview. “We’re running the business to make higher returns and free cash flow.”

(emphasis added)

However, it is important to note that the decline in costs is not only a result of the actions taken by the new managements at the gold mining firms. In fact, it ties into the major topic of this article, namely what the recent rally in gold is probably telling us.

A major factor in the decline in costs is the fact that global economic activity is sluggish and likely to become more so. With commodity prices under pressure for the past two years or so, capital investment in many parts of the mining sector has ground to a halt. Coal companies are struggling mightily, and base metals and precious metals miners likewise have been forced to deal with a much more difficult pricing environment for their products. This is putting pressure on many of the items that represent major input costs for mining firms, hence there is an additional driver lowering costs that is independent of the cost cutting measures taken by individual companies.

In other words, the decline in mining costs is partly a reflection of worsening economic conditions in the world. As we have pointed out many times, this is the tipping point after which especially gold mining firms could be on the cusp of a 'sweet spot'. The gold mining sector is the only market sector that moves inversely to the broader stock market in the long term. This is so because the very conditions that are negative for the earnings of other companies are quite positive for the profit margins of gold miners, as the real price of gold tends to rise when the economy falters.

Gold's Message

Many observers must be scratching their heads by now. When 'tapering' of QE became a real prospect, many analysts concluded that the event would be a very bearish development for the gold price. By contrast, we wrote in these pages: “Bring it on!”.

It appears now increasingly likely that our pet theory with regard to 'QE tapering' is actually playing out.

The idea is as follows: gold has a habit of discounting the future far in advance. This is why its price inter alia actually fell in an environment that should have been very bullish. With the Fed and the BoJ both engaging in 'QE' to a never before seen extent in 2013, many people thought that gold should rise rather than fall in price. However, the gold market seemed more focused on the fact that the various actions by central banks (including the ECB) had removed quite a bit of the previously extant risk premiums from the markets. 'Safe haven' currencies like the Swiss franc and the yen began to fall when it e.g. became clear that the euro area would not immediately blow up.

Also, the gold market likely anticipated that there would be an increase in economic activity in the US (note: we regard 'activity' in this context not necessarily as a sign of genuine, sustainable economic growth) and that the federal budget deficit would as a result decline. This in turn made the eventual removal of the hyper-accommodative Fed policy more likely. Of course there was a long period of time when it seemed just as likely that 'QE' would be increased rather than reduced and we actually happen to think that the current 'tapering' phase will eventually be reversed. Alternatively, other major monetary pumping measures may eventually be taken.

One reason to believe so is precisely the fact that the gold price is now rising in the face of 'QE tapering'. It represents an early warning sign. Gold may be warning of a coming 'unexpected' reversal in economic activity as a result of the current sharp slowdown in money supply growth. There is also a possibility – more remote, but it cannot be dismissed out of hand – that there will be an unexpected increase in 'inflation expectations' not too far down the road.

So far, the huge increase in the money supply since 2008 has only affected asset prices, but there is no guarantee that this will remain to be the case. Admittedly, we believe it at the moment more likely that the economy will weaken and that the central bank will in reaction to that embark on another round of monetary inflation. In recent years, a weakening of economic activity has generally been associated with sharp declines in inflation expectations and the growth rate of official 'price level' measures such as CPI.

It is however also possible – this is something that was after all experienced in the 1970s – that weakening economic activity and rising inflation expectations will go hand in hand. What will precisely happen is a matter of contingent circumstances that cannot be foreseen with any degree of precision. What can be stated with a reasonably degree of certainty is only this: if money supply growth continues to falter, then a number of asset price bubbles as well as the economy will eventually falter as well.

All the economic activities that depend on continuing or even accelerating monetary inflation will have to be abandoned. Since these activities consume rather than produce wealth, this is actually a good thing, but it will register as a recession in the official data and hence be regarded as 'bad'. The Fed will undoubtedly swing into action if, or rather when, that happens.

Conclusion:

The recent rise in the gold price may well be an early warning sign that the currently extant asset price bubbles as well as the economy are set to suffer a sizable setback in the not-too-distant future. Admittedly, the recent rally in gold may yet be reversed, in which case these musings would no longer apply. However, if one puts the rally into context with recent developments (QE tapering and a recent slew of weaker economic data releases), it seems increasingly likely that this is precisely its message.

Charts by BarCharts, StockCharts