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Melissa Duller

Why have gold and gold stock prices declined?

AdvantageVoice® Blog—4-19-13
Melissa Duller

Today we have a guest post by Michael Bradshaw, CFA, portfolio manager with expertise in investing in gold, other precious metals and gold-related stocks.

Gold has been on a wild ride in 2013, and lately that ride has trended downward. Since the end of March, a series of events triggered a substantial sell-off in the gold price. Gold dropped 14% over two days, which was the largest two-day drop since 1980. There was no one specific catalyst for the sell-off. Instead, it was the result of hawkish commentary from the Federal Reserve (Fed), weaker-than-expected first-quarter gross domestic product (GDP) numbers from China, an announcement by Cyprus that it was considering selling its gold reserves, the breach of previously supportive technical levels, and gold sell recommendations from various brokers.

Of note, the Fed’s minutes renewed speculation of the end of QE3 (the third round of quantitative easing) by year-end, and the weak China numbers put downward pressure on commodity markets. In addition, the announcement by Cyprus has led to speculation that other indebted European countries, such as Spain, Portugal, and Italy, might also consider selling their gold reserves. While this is a possibility, it is important to realize that gold sales from Italy and Spain would fall under the CBGA (Central Bank Gold Agreement), which limits annual sales to a maximum of 400 tonnes combined through the agreement’s expiration in September 2014 (the agreement is subject to renewal).

Plummeting gold prices in April have followed a downward trend that has been in place since the beginning of the year. During the first quarter, investors shrugged off inflation concerns in the face of stronger-than-expected economic data in the U.S., such as housing and auto sales, which resulted in a strong stock market and a strengthening U.S. dollar. Meanwhile, financial unrest in Cyprus led to a sell-off of the euro, fueling further strength in the U.S. dollar on a relative basis. Most other major foreign currencies also weakened relative to the dollar as weak economic data abroad pressured commodities and currencies alike. The South African rand declined approximately 8%, the yen declined 13%, and the Canadian dollar declined 3% year to date. As is often associated with the above trends, commodities and commodity-related stocks sold off.


Source: Bloomberg; data from 12/31/2012 through 4/17/2013
Past performance is no guarantee of future results.


Source: Bloomberg; data from 12/31/2012 through 4/17/2013
Past performance is no guarantee of future results.

At the same time, economic growth in China, which has been the big driver of commodities for the past decade, slowed from nearly 12% to just under 8%. China’s GDP growth remains strong, but not strong enough to maintain the prior tailwinds that fostered commodity demand and economic growth in commodity-dominant nations. 

As shown in chart above, gold was down 18%, copper fell 11%, aluminum declined by 9%, and zinc was down 10%. Meanwhile platinum and palladium declined 8% and 6%, respectively. During the first few months of the year, platinum and palladium prices were supported by a pick-up in auto sales (platinum is used in catalytic converters) and a reduction in industry supply.

Why have gold-related stocks suffered more than the underlying commodity?
While gold prices declined 18%, gold-related stocks declined 39%, as measured by the FTSE Gold Mines Index (as of 4/17/2013). The absolute relationship between gold and gold equities can best be measured by the gold stock’s beta, its relative performance to the price of gold. Gold equities have historically overshot movements in the underlying gold prices due to their enhanced sensitivity to the commodity, as shown in chart below. Beyond this relationship, investors have become concerned that earnings may have peaked for many commodity-related companies. Growing confidence in the U.S. economy, meanwhile, has led them to discount the perceived value of investing in precious metals as a tool to hedge other risk exposures. I do not share these concerns, but I believe the general perception has cast an overhang over precious metals stocks.


Source: FactSet 9/30/1998 through 4/17/2013
Past performance is no guarantee of future results.

We anticipate a brighter future for gold ahead
It is hard to find anything in the gold-stock universe that is overvalued these days. The whole sector looks cheap relative to gold prices, the broader stock market, or the value of corporate assets. The ratio of physical gold to gold stocks is the highest it has ever been. Many gold-related stocks are trading at 30% to 40% below what I believe are their fair values. Discounted valuations have resulted from a lack of confidence in future gold prices, because there is a dominant view that the U.S. economy will continue to grow and the U.S. dollar will continue to strengthen. Even if the gold price were to remain at current levels, gold stocks are still apt to have significant upside potential because they are so undervalued.


Source: FactSet 9/30/1998 through 4/17/2013
Past performance is no guarantee of future results.

Right now, the stock market appears to be much extended. In the short term, I would not be surprised to see a stock market correction, a rise in gold prices, and notable gains among precious metals—even if the dollar remains strong relative to other currencies.

Over a medium- to longer-term time horizon, I still believe there are many problems to be fixed domestically. Actions by the U.S. government and the Federal Reserve have thus far stifled any looming financial crisis, but at some point, U.S. debts will need to be paid, and the root of our financial problems will need to be addressed. I still believe the end result will be a weaker dollar, but we will likely see international currencies weaken first.

A key factor I’ll be watching is inflation, but not just inflation in the U.S. As long as the U.S. dollar remains strong, I do not believe that inflation is a short-term risk domestically. However, inflation may creep up in foreign countries before we see it in the U.S. As it does, the demand for gold is likely to rise in those areas of the world. Eventually, if and when the U.S. dollar does weaken, inflation will become a greater threat and gold prices should advance even more significantly.

The views expressed are as of 4-19-13 and are those of Michelle Duller, Michael Bradshaw, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

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