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Why gold stocks should go higher
(Page 2) of 2
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But these two trends -- higher prices and heavier volume -- had hit a critical patch in December 2005. When gold broke $500 an ounce that month, two things happened.
- First, the press treated us to a constant stream of stories about gold hitting an 18-year high. Each day that the metal nudged higher, the next day's headline hammered away at the fact that we'd just hit another 18-year high. The thrust of these stories was that gold was expensive and investors might be looking at the end stages of the boom.
- Second, the gold bulls came out of the woodwork predicting $800 or even $1,000 an ounce gold. Yes, gold was near 20-year highs in nominal dollars, but if you corrected for inflation, the historical high was closer to $1,500 an ounce. It certainly didn't hurt the gold bulls' case that they could point to the 21% return on Newmont Mining in 2005 or the 2005 return of 50% for Gold Corp. shares.
I think the battle between these two points of view was destined to be settled in the bulls' favor even before the pullback in gold prices this month. Gold is in short supply in the world -- physical demand for gold for jewelry in 2005, thanks to growing demand from India, amounted to 110% of global gold production. (Re-melting old jewelry and sales from the gold stockpiles of the world's central banks made up the difference.) Supply from the world's gold mines, JPMorgan calculates, peaked in 2001, and the low prices of the 1990s resulted in underinvestment in new production that should keep supply constrained until new projects come into production in 2008 or 2009.
And that's just the physical supply-and-demand story. The world's investors are putting gold back into their asset-allocation mix. You can track the effect in the growth of exchange-traded funds (ETFs) that specialize in gold. The first fund, StreetTRACKS Gold (GLD, news, msgs), was listed only in March 2003, but gold demand from ETFs has climbed to 145 tonnes in 2005 from 39 tonnes in 2003. (A tonne is a metric ton of 1,000 kilograms or approximately 2,204 pounds.)
But the drop in February gold prices swings the battle between these two opinions even more toward the gold bulls' position. The drop in price takes the sting out of the "gold hits historic highs" camp and the argument that gold is too high. Instead, for those who have noticed the returns reaped by investors in gold in 2005, the drop creates a buying opportunity. Investors itching to get into the sector but hesitating because of gold's price now have the perfect "reason" to buy.
Wall Street doubles down
You can even find this logic reflected in the opinions of Wall Street analysts. In any drop like the one gold has suffered recently, investors should check out Wall Street's reaction. If analysts react to a decline in the prices of the stock they cover by cutting target prices and slashing recommendations to hold (almost no one ever says "sell") from buy, it puts more downward pressure on stocks already tumbling in price. (This is classic "Close the barn door after the horse has run away" logic.) If, on the other hand, analysts use the drop as an occasion to raise targets and recommendations, it proves that they believe they see this drop as a chance to make money for clients. And, of course, by recommending that clients buy these shares, they increase buying volume, pushing up prices and generating exactly the effect they predicted. Examples:
- Exhibit 1: Citigroup has raised its gold forecast to $540 an ounce for 2006 from $470 an ounce.
- Exhibit 2: Merrill Lynch has raised its gold forecast to $500 an ounce from $400 an ounce.
I think all this turns the recent sell-off in gold and gold stocks into one of those declines that provides a rally with fresh fuel by bringing in new buyers who have been hanging on the sidelines into the market.
I can't say how long any gold-sector decline will run -- the price of gold on a daily basis is set by speculation on such imponderables as whether the Japanese will buy more or less gold as their economy recovers.
But the turn in the gold sector will come. When it does, the move up will be strongly fueled by the big build-up in short positions in the sector. (In a short position, a trader sells borrowed shares of a stock, betting the stock will go down in price and that he'll be able to buy shares at a lower price to replace those he borrowed.) According to Prudential Equity Group, in January, investors added $183 million in Newmont Mining to their existing short positions (total $1.2 billion), $470 million to existing short positions in Barrick Gold (ABX, news, msgs) and $137 million to existing short positions in Freeport-McMoRan Copper & Gold (FCX, news, msgs). Any rally that makes shorts nervous enough to buy shares in order to cover their positions will get a boost from that fuel.
Next column: Why the trend for all stocks is up -- but more so for some oil stocks than others.
New developments on past columns
Stocks for the 2006 commodities crunch: It's hard to imagine how earnings growth of 140% could cause disappointed investors to sell your shares, but that's exactly what happened to Grant Prideco (GRP, news, msgs) when it reported earnings before the market opened on Feb. 8. By the close on Feb. 9, the shares were down 14% from the $51.15 close on Feb. 6. Exactly what was so disappointing? Not fourth-quarter earnings: the company beat Wall Street estimates by 3 cents a share. Not record revenue of $390 million, an increase in operating margin to 24%, or another 10% jump in order backlog of $814 million. No, chalk up the disappointment to the company's guidance for 2006. Wall Street prefers its managements to be optimistic boosters. Grant Prideco instead played it close to the vest, projecting 2006 earnings at $2.40 to $2.60 a share. That was well below the Wall Street consensus at $2.56. But before you get your knickers in a knot like Wall Street investors, consider this: Grant Prideco started 2005 the same way with a projection of full-year earnings of 95 cents to $1.05 and then proceeded to produce earnings of $1.75. The company's projected rig count for 2006 -- a big deal for a company that sells cutting-edge technology to oil drillers -- is lower than industry forecasts, so the company based its earnings projections for 2006 on a very modest increase in drill-pipe production capacity of 17%. I'd also like to point out that even the company's conservative projections call for 37% to 49% earnings growth in 2006. Not bad for a stock that, after the sell-off, is priced at 17 to 18.4 times the company's projected 2006 earnings per share. As of Feb. 14, I'm raising my target price on Grant Prideco to $54 a share by December 2006. (Full disclosure: I own shares of Grant Prideco.)
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For suggestions to help navigate the treacherous interest-rate environment see Jim's new portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: Glamis Gold, Gold Corp. and Grant Prideco. He does not own short positions in any stock mentioned in this column.
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