A DEFLATIONARY IMPULSE WOULD BE A CATALYST FOR GOLD STOCKS
By Jordan Byrne, CMT:
While Gold is a hedge for inflation and deflation, that doesn’t mean that gold stocks are a hedge or outperformer in either environment. As we wrote last year, gold stocks tend to perform better when deflation is the concern.
The reason is two fold. First, Gold is a leading indicator of inflation and commodity prices. Gold outperforms ahead of actual price inflation. The second reason is that Gold’s outperformance, allows margin expansion for the gold producers. When inflation hits the economy, commodities (and sometimes stocks) will outperform Gold. Also, the inflation (especially rising oil) cuts into the margins of gold producers.
All of this is very obvious when looking at some charts.
In the chart below we show two ratios: Gold Stocks/Commodity Stocks and Gold Stocks/Gold. Note the strong outperformance of gold stocks during periods of economic contraction and/or deflationary concerns.
We can get an idea of the outlook for the HUI/Gold ratio by tracking some ratios. In the chart we show Gold/Oil and Gold/Gyx, a proxy for industrial-related costs. Note that while these ratios usually trend in the same direction (with HUI/Gold), they actually can be a leading indicator.
In terms of the technicals, the gold stocks are in position for a major breakout sometime this year. In the following chart we show the HUI index along with the XGD.to (Canadian ETF).
Conclusion
The gold stocks are in position for a major breakout in 2010. For a sustainable breakout, the current trends in the capital markets need to at least shift, if not change. The precious metals sector has held up well as stocks, commodities and corporate bonds have recovered and sustained their recovery. However, as long as those assets continue to be strong, how will the gold stocks forge the type of breakout suggested by the charts? Hence, a deflationary impulse, even a slight one, could serve to be a major catalyst.
Such an impulse, while initially positive for Treasuries, would exacerbate the medium to intermediate term outlook, as deficits would worsen. Meanwhile, the margins of gold producers are already strong. A deflationary impulse would ultimately result in Gold outperforming its “input costs” and so margins would expand even further.
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Jordan@TheDailyGold.com
http://www.thedailygold.com/
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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3 Comments
What is missing from this assumption is that economic contractions(deflationary concerns) in the past(1970s & 2002) have lead to CREDIT expansion. Gold follows credit expansion (aka risk) which leads to fluctations in inflation and deflation. Is credit going to EXPAND or contract going forward? Put on your thinking cap and look at the governement and consumer debt levels to get that anwser. Thats what should be considered more so than fluctuations in inflation and deflation. Credit is key!!! Also the last time a dip in volatility occurred it was followed by a huge spike leading the HUI from the 500 range down to the 150 range. So descending volatilty can go either way. Gold’s movement is completely related to CREDIT. Also Gold does better leading OUT of a deflationary situation NOT into a deflationary, but ONLY provided credit is assumed to expanded. (aka bailout and 0% rates led gold up). I think we can rule out interest rates going any lower than the current 0% unless the FED plans on “paying” people to take money. And what are the potentials of another massive liquidity injection? Too much political heat over that move. So where’s the credit EXPANSION going to find it’s catalyst to take gold higher?
Note how Gold followed the deflation rate down then rebounded due to the above mentioned acts by the FED. Its credit not inflation/deflation that matters the most!
http://inflationdata.com/inflation/images/charts/Annual_Inflation/annual_inflation_chart.htm
Your thesis is flawed as credit is not the only reason impacting gold.right now and I am not a gold bug but the evidence and leverage without the physical backing trumps any precious metal influence.The music is going to stop soon and there will be no chairs for the comex or lbma.All other honest discussion is pointless in this current ponzi scam.
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