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09 June 2016

Gold: Are we where we think we are?

Charles Russell Speechlys hosted a breakfast seminar event this week, exploring the current ‘gold price cycle’, presented by expert mining analyst Charles Gibson, of the Edison Group.

The subject of mining commodity prices could hardly have been a more topical issue, as the front page of City AM heralded a rally in the sector on the morning of the seminar.

The mining sector has faced a torrid few years, particularly following its ‘supercycle’ slump in 2011, yet gold has been the outstanding performer in recent months. Charles Gibson, a world-renowned gold analyst, was able to provide a wide array of in-depth statistics showing gold, though not consistently, has been the strongest performer in metal prices over the past 14 years. Notwithstanding its performance however, many analysts and fund managers remain transfixed by the experience of 1980 when, after a similar bull run, gold then entered a 21 year bear market.

Charles demonstrated that, were the same to be true in this cycle, gold’s relationship to inflation and general prices would suggest a price today of around US$1,033/oz. However, he also showed that the gold price since 1959 has always been closely correlated with the US total monetary base (i. e. the circulation of money and US federal bank reserves) and that if that relationship is to be maintained at a time when quantitative easing has increased the total US monetary base fivefold, then gold should be no less than US$1,246/oz and, not unreasonably, as high as US$1,682/oz.

In Charles’ view part of the reason for the discrepancy is that there has been a complete breakdown of the previously near-perfect relationship between the monetary base and inflation. Nevertheless, it would also seem to be the case that there still exists a post-2007 hangover from the previous methods of gold valuation.

Relating the gold price to the price of gold stocks, Charles explained that “the problem with the market at the moment is that it often misprices the risk factors involved in gold mining. ” With his statistics providing a strong backing to his research for the period 2007-2016, when the market appeared to incorrectly value the risk involved in transitioning from exploration to production, in particular, he was able to demonstrate an extreme skew in investment returns, which rendered asset allocation in the sector among the most challenging in the market (and not, perhaps, what the experts think it should be).

Among the explorers by contrast, Charles was able to demonstrate that up to 90% of their valuation can be attributed to ‘sentiment’ related to the direction of gold price movement, rather than the actual level of the gold price itself. Nevertheless, the improvement in market conditions in recent months has increased the valuation of resources to the point at which greenfield exploration can yield a return to investors which is once again attractive to investors.

As well as the opportunity created by the break between the correlation of the monetary base with prices and inflation, companies also need to be aware of the sensitivity of the market to changes in the perception of risk and the extent to which this can affect their share prices. As such, companies need to persuade investors to focus on their fundamentals – their management structures, their mining capabilities etc. , rather than old benchmarks.

A lack of media consensus on the value of gold and gold stocks has done little to aid gold companies. What was certainly evident from the seminar is that gold stocks remain an attractive investment and Edison projects they are set to become an increasingly attractive option for investors to take advantage of in the years to come.

Update - 13th September 2016 :

Edison estimates that Brexit has added c US$80-160/oz to the price of gold, which has somewhat counteracted the effect of recent Fed pronouncements. In the event of additional shocks however (e.g. bank failures, renewed financial crisis in Europe and/or emerging markets, reduced western world interest rates, a violent hurricane season, Donald Trump winning the US November election, a further fracturing of Europe and renewed crisis in Greece potentially taking in Portugal, Spain, Italy and France etc.), we think that it could hit US$1,580/oz.