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Tuesday, March 25, 2014 - 14:30
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Tuesday, March 25, 2014 - 14:30

Gold Stocks Are Ready To Fall -- Sell Now

Tuesday, March 25, 2014 - 2:30pm

Few investments are driven by psychology and fear as much as gold. Concerns about ruinous inflation, global tensions or economic instability can send investors out of stocks and right into the seemingly safe harbor of gold.

Is the fear trade back on? A double-digit rebound in gold prices since the year began has led some investors to wonder if gold is poised for a great 2014 after a dismal slump in 2013 when gold prices fell more than $400 an ounce. Junior gold miners have fared even better: The Market Vectors Junior Gold Miner ETF (NYSE: GDXJ) is up roughly 35% in the past three months.

Much of the impetus for an upward move in gold prices was the building tensions in Ukraine, which led to concerns about potential military escalation. It's now apparent that financial sanctions, and not a deepening of a war posture, will characterize the hardening Russia/European Union relationship, and the risk factor is slowly receding.

Also, concerns had arisen that a slowing Chinese economy might create higher global uncertainty. China's economy is slowing, but the Chinese government will restore stability if necessary by increasing stimulus spending.

Yet the key reasons behind gold's massive slump in 2013 still remain in place. Massive sums of money were spent a few years ago to develop new mines, when miners salivated over very high selling prices. Even though prices have slumped, many of those mines are still in the process of development.

Capital Spending by Gold Miners in the XAU Miner Index ($millions)

As a result, gold supply keeps rising. According to Barclays, global gold mining output will rise 3.4% this year, to 2,787 tons, and to 2,838 tons next year.

The demand side of the equation is harder to quantify, as low prices lead to selling by leading gold exchange-traded funds (ETFs) and higher gold prices lead to ETF buying. Other factors, such as domestic consumption for jewelry, are more traditionally price-sensitive. For example, Chinese consumers tend to buy less gold when prices move higher.

The Rate Picture
In previous economic cycles, higher interest rates came in response to a firming economy. Eventually, stronger economic activity creates capacity bottlenecks, and signs of inflation emerge. And higher inflation is a good reason to own gold.

The key reasons behind gold's massive slump in 2013 still remain in place. Will a firming U.S. economy push gold prices down further in 2014?

Trouble is, there is so much slack in the economy that a return of price pressures is quite unlikely. As Federal Reserve Chairman Janet Yellen recently noted, even when short- and long-term rates do move higher, they still likely to remain below historical averages far into the future. The economy's potential growth rate simply isn't what it once was.

Goldman Sachs analyst Damien Courvalin thinks the U.S. economy is a key factor in determining where gold prices go from here. He sees a firming economy, which counterintuitively will push gold prices down toward his $1,050 per ounce price target.

Why would greater economic activity trigger lower gold prices? Because he believes that even as the economy strengthens, it will be accompanied by continuing very low inflation, which will prove to gold bugs, once and for all, that gold-hedged inflation fears are simply misplaced, as they have been for quite some time.

Chinese economic strategies may also play a role. In years past, China has signed massive commodities import contracts with gold used as collateral. Courvalin anticipates "a gradual unwind of Chinese commodity financing deals," which means China will need to hold less gold in its central banks.

Risks to Consider: As an upside risk, a re-emergence of global inflation or a deepening of tensions in the world's various hotspots, may lead to a perceived flight to safety that gold offers.

Action to Take --> The key takeaway is that few real reasons exist for a big move in gold. Indeed, in recent days we've already begun to see the process of profit-taking begin. If you've been fortunate enough to ride the recent mini-rally, this is a good time to get out of gold (or gold miners) now.

As I noted a month ago, if you do want exposure to the gold mining sector, it's wise to focus on the lowest-cost operators. These firms can still generate profits if gold slumps to Goldman Sachs' $1,050 target price. Goldcorp (NYSE: GG) remains as a top play for the low-cost production angle.

P.S. StreetAuthority's resident commodities expert, Dave Forest, knows how important it is for gold miners to control their costs. That's why he has two other low-cost gold miners in the portfolio of his premium newsletter Junior Resource Advisor. To learn more about Dave's deep field expertise -- and where he sees the biggest opportunities in the resource sector right now -- click here now.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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