Why Gold Isn’t Overvalued At $1400?

MAKE MONEY BLOG$;Standard & Poor’s chief investment strategist Sam Stovall is out with a note pondering whether gold is overvalued at its present levels – just below $1,435 an ounce Monday afternoon – as reflected in its price versus the stock market.

On that basis, Stovall writes, the answer is no. Over the 40-year span from January 1971 through March 31 of this year, the median relative price of stocks (represented by the level of the S&P 500) to an ounce of gold was 1.05, meaning the latter has been worth 5% more than the price of gold. The edge went to gold from 1973 to 1991, rising to nearly six times the value of the S&P in 1980, but the fall of the Berlin Wall and the beginnings of the tech bubble reversed that trend  in the 1990s leading stocks to a peak of 5.5 times the value of gold in August 2000.

What has followed has been a “massive reversion to the mean” Stovall writes, bringing the value of stocks versus gold to its present level of 0.92, which implies that gold “is only 13 basis points more expensive that its average to stocks over the past 40 years.”  With gold over $1,400 an ounce the natural question is whether stocks themselves are overvalued, a concern Stovall addresses by noting that the price-to-earnings ratio for the S&P is 13.7 times full-year 2011 estimates, very reasonable relative to historical averages.

While Stovall concludes that gold is not overvalued relative to stocks, he is quick to caution that price fluctuations or consolidations to moving averages or support levels are hardly out of the question. He notes that Standard & Poor’s investment policy committee discussed the possibility that the gold trade is “tired and crowded.”

According to S&P’s short-term technical strategist Chris Burba, the trend of consolidation preceding “forceful moves higher once resistance is violated and buy stops are triggered” is likely to remain intact provided the March 15 low of $1,380.70 holds.

S&P’s conclusion is that although there may be elements of fatigue in the near term, there are as many if not more signs that the long-term move is higher. For one thing, S&P anticipates further weakness in the dollar, which could only sustain a short-lived advance Friday after a solid March jobs report, and notes that gold’s correlation to the greenback is stronger than its connection to other inflation harbingers like the consumer price index and oil prices.

The Federal Reserve is helping keep gold in the catbird seat. Although some central bankers are making noise about raising benchmark interest rates, the current near-zero level of the federal funds rate is helping reduce the opportunity cost of holding gold, an investment that offers no yield. Volatility in global currencies and concerns over sovereign debt, particularly in the euro zone periphery, are also supportive for the bullish gold story.

Stovall also notes that seasonality is in favor of gold. Because of high demand during wedding season in India the third quarter is historically the best of the year for gold, with an average 3.4% gain since 1971, although gains are seen only 56% of the time.

While gold prices may still be reasonable relative to the stock market, gold miners face a set of challenges that higher prices alone cannot surmount. In a March 14 note, RBC Capital Markets addressed value creation when production growth slows.

According to RBC analysts, gold companies appear to hit a threshold when they near 5 million ounces of annual production: “organic growth begins to stall and corporate acquisition[s] become the dominant growth strategy.”

A value trap occurs when shares look inexpensive, but the stock falls and multiples contract. The trap can be avoided with value-creating methods including raising dividends. As RBC analysts Stephen Walker and Michael Curran pointed out in their March note, record gold prices are helping producers book robust earnings and cash flow, allowing for more capital to make its way back to shareholders through dividends. But in order to return the 2-3% “required to attract income-oriented investors,” margins would need to stay at current levels, a challenge given rising operating, capital and acquisition costs.

That brings up the possibility of divestitures or spin-outs, and althoughBarrick Gold is aiming to remain the world’s largest gold producer, RBC notes that its 2010 spin out of African Barrick Gold in a Londong IPO could be informative for future strategy. The analysts spotlight the miner’s Australia Pacific assets – 8 mines that produce nearly 2 million ounces – as a candidate for a similar maneuver.

RBC does not expect divestitures from Newmont Mining, but believes North America’s two other major gold producers, Kinross and Goldcorp, could spin off assets or even break themselves up to create value. Kinross has a West African asset that could be used as to roll up other producers in the region and combine with Russian assets to form a formidable geographic asset. Goldcorp, RBC says, could be split into a pure gold and poly-metallic gold producer. Goldcorp and Barrick were RBC’ s preferred plays among the large-cap producers as of the March 14 note.

source: forbes.com

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