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Ah, the Power of Mean Reversion.

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Frank Holmes. CEO and Chief Investment Officer. U.S. Global Investors writes:

The chatter this week has been gold. The precious metal flew up $45 an ounce on Thursday, surprising investors, the media and markets alike.

If we look back just six months ago, gold was sitting at record lows, signaling that it was in extremely oversold territory. This was the time that many investors let fear take over and dismissed the fundamental reasons for owning gold: as a portfolio diversifier and store of value.

With the price spike this week, however, some of the perpetual gold naysayers suggested the metal had shifted to overbought status. Spot gold is up nearly 3 percent for the week, while gold stocks are up around 7 percent. So is gold overbought? 

Some see gloom and doom. We see the bounce we said was coming. Based on our historical observations and the math of the markets, gold is not overbought, in our opinion, but is simply reverting to its mean. This mean reversion has shown that eventually, both gold stocks and gold bullion will move back to their historical averages.

 

Right now, as you can see from the chart below, gold stocks have seen a reversal to the long-term mean, but we are still waiting for gold bullion to do so as shown in the second chart.


click to enlarge

 


click to enlarge

Similarly, for gold bullion to reach overbought territory it would need another 20 percent move, and for gold stocks to be overbought they would need another 30 percent move.

 

There is always an emotional bias against gold, whether it is soaring high or dipping low, and that is why it’s important to manage these emotions when positioning a portfolio. At U.S. Global Investors we look objectively at the action of both gold stocks and gold bullion by monitoring these long-term data points and paying attention to buy and sell signals based on the trend of mean reversion.

 

Additionally, I remind investors that moderation is key when it comes to gold. Your exposure should be 5 percent to gold stocks, 5 percent to gold bullion, while rebalancing annually.

Another reason that gold is moving is it’s beginning its seasonal cycle, driven by cultural gold buying. The demand of gold reflected over the next several months and characterized by the purchase of the metal for cultural celebrations and religious holidays, I refer to as the Love Trade.

 

If you look at the chart below, you will see that July marks the beginning of the Love Trade with the celebration of Ramadan.


click to enlarge

The Indian Festival of Lights comes after, followed by wedding season and, of course, Christmas.

 

This seasonal pattern is one of the most powerful drivers for gold demand. Monitoring this pattern, while remaining aware of other fundamentals to gold, such as mean reversion and a prudent 10-percent portfolio weighting (5 percent in gold stocks and 5 percent in gold bullion, while rebalancing annually), are imperative to understand when investing in gold. These trends allow us to manage short-term swings, small or large, that usually cause more concern than they are truly worth in the long term.

If you’re curious to learn more about the trends in resources, I will be speaking July 22-25, at theSprott Vancouver Natural Resource Symposium. You’ll be able to take a front row seat to learn why experts in the field believe next year will be one of the most opportune times in history to invest in natural resources.

Gold Market

For the week, spot gold closed at $1,314.85, up $37.96 per ounce, or 2.97 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 7.12 percent. The Trade Weighted U.S. Dollar Index fell 0.25 percent for the week.

Date Event Survey Actual Prior
June 17 Germany ZEW Survey Expectations 35.0 29.8 33.1
June 17 U.S. May CPI 2.0% 2.1% 2.0%
June 17 U.S. May Housing Starts 1030K 1001K 1072K
June 18 U.S. Federal Reserve FOMC Rate Decision 0.25% 0.25% 0.25%
June 22 China June HSBC Manufacturing PMI Preliminary 49.7 - 49.4
June 25 U.S. May Durable Goods Orders -0.2% - 0.6%
June 25 U.S. GDP First Quarter Third Reading -1.8% - -1.0%
June 26 China May Gold Imports from Hong Kong - - -

Strengths

  • Gold rose almost 3 percent this week after Fed Chairwoman Janet Yellen stated interest rates will remain low for an extended period of time, disregarding rising inflation as noise. Surveys show investors expected the Fed to hint it would raise interest rates faster than previously anticipated. As a result, the U.S. dollar weakened to its lowest level this month, and speculators, who had pushed the number of short contracts to a five-fold rise since March, were left scrambling to unwind their trades.
  • Earlier in the week, gold naysayers were calling for the gold price to consolidate around the $1,280 range despite the escalating conflict in the Middle East that sent oil prices above $105 per barrel. Even in light of intensifying unrest in numerous places around the world, Fidelity’s head of asset allocation called for investors to sell gold and buy stocks at today’s “attractive valuations.” That strategy may work in a riskless world, but according to Mineweb contributor Lawrence Williams, the numerous conflict flashpoints around the world make this the best time to hold gold.
  • The Shanghai free-trade zone international gold trading will be a reality by year-end, according to city government officials. More details leaked out this week to give investors a better idea of the impressive capabilities of the proposed exchange. Testing for interest rate liberalization and currency usage is currently ongoing, as the exchange seeks to allow foreign investors to trade in the market using offshore Chinese yuan accounts. Jiang Shu, senior analyst at Industrial Bank in Shanghai, stated the recent advances show the Chinese authorities are serious about yuan and gold trading reform.

Weaknesses

  • A new report by SNL Metals & Mining, coming in at a modest 538 pages, concludes that the cost of building a mine has increased significantly over the last decade, from $560 per ounce of production capacity in 2004 to more than $2,300 last year. To make matters worse, SNL analysts argue that curtailment in capital spending since 2013 will take at least until 2015 to reverse the rising trend, as current forecasts show costs will rise to $2,400 per ounce this year.
  • China National Gold, the only central enterprise in the Chinese gold industry, announced it is no longer in talks with Ivanhoe Mines on its African assets after talks began last year. Similarly, in Mali, gold production is set to fall 12 percent in the next three years as mine closures outpace new production, thus curbing revenue from the country’s main export. Randgold Resources recently announced its Morila mine is in the process of being closed, while IAMGOLD suspended operations at its Yatela mine last year.
  • There was major disappointment among miners looking to mine the ocean floors as New Zealand rejected Trans Tasman Resources application for an undersea project. The country’s decision was being closely watched by other countries. The New Zealand EPA argued there were “uncertainties in the scope and significance of the potential adverse environmental effects” as reasons for rejecting the project.

Opportunities


click to enlarge

  • Headline inflation rose robustly in May for the third consecutive month, bringing the annual change above 2 percent for only the second time since the end of the recession. U.S. Personal Consumption Expenditures, the most widely monitored inflation measure by Fed officials, leaped to 1.4 percent. National Bank research argued dismissal wouldn’t be easy this time around, but that’s exactly what Janet Yellen did in her press conference. On the same note, Canaccord raised gold to overweight following the CPI readings and the belief that the Fed is “cornered.” It concludes by saying investors should buy inflation-protection hedges.
  • Bank of America recommends investors buy gold into the third quarter as the seasonality trade kicks in with Ramadan and Indian buying. Historically, the July-August period sees a demand boost from religious festivities, which Bank of America believes could push gold past $1,400 this year. In a related note, Mining Recruitment Group’s outlook suggests mining executives have turned bullish this year as a poll shows the percentage of bearish executives dropped from 64 percent to 14 percent from a year ago.
  • First Quantum announced it entered into a definitive agreement to acquire Lumina Copper for approximately $470 million. Lumina is the owner of the Taca Taca copper deposit located in Salta Province in northwest Argentina. Lumina founder Ross Beaty highlighted the sale as a win for Argentina, whose economic team is set to stabilize the nation’s currency, negotiate debt settlements with holdouts and instill confidence in foreign investors. The transaction is inevitably bullish for other copper developers in the region and the mining sector in Argentina as a whole.

Threats

  • South Africa’s platinum mining industry’s main labor union has tabled fresh new demands beyond the preliminary agreement struck with producers last week. The demands add more delay-pressure to an already long-running strike. Facts show that South Africa’s mining output has been declining in a linear pattern for the last 20 years. At this pace, argues Mineweb contributor Michael Schroeder, the last skip of gold bearing ore from the once giant Witwatersrand deposit will be hoisted in 2019, costing the country some 130,000 jobs.
  • The five-year-long positive correlation between gold and oil came apart recently as the prospects of a global economic recovery boosted energy consumption and lowered gold’s appeal. The relationship tightened over the past two weeks as the Iraqi conflict took over headlines. Analysts continue to expect oil to trade higher on fears of a Middle Eastern supply disruption, which would mean lower gold prices if the negative correlation holds.
  • A group of more than 40 Congressmen asked the U.S. Fish and Wildlife Service to delay the implementation of new rules and procedures that would be overly prohibitive for economic activity. The proposed changes to procedures could increase in millions of acres the areas designated as critical habitats, regardless of whether the protected species occupy these areas or not. These proposals have resulted from hundreds of closed-door settlements with litigious environmental groups.

June 20, 2014 (Source: U. S. Global Investors)

http://www.usfunds.com/investor-library/investor-alert/#.U6WNSfldXYg


Source: http://www.gotgoldreport.com/2014/06/ah-the-power-of-mean-reversion.html


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