The gold price, the S&P/TSX Gold sub-sector, and the Philly XAU index of 30 gold/silver equities (Charts 1-3 below) suggest that the gold sector is turning a corner: gold bullion has broken upwards through its 200-day moving average, and both the S&P/TSX Gold sub-sector and the XAU have broken up through their 52-week moving averages. Technical analysts tell us these are good signs!

In our econometric work on the monthly valuation of equity sub-sectors we have determined that the S&P/TSX Gold sub-sector is seriously undervalued. The ratio of the Gold sub-sector to the S&P/TSX Index is near a new low and the ratio of the Gold sub-sector to the S&P/TSX Index less the Materials sector (the Gold sub-sector is an important component of the Materials sector) is at a new low, see Chart 4.

An econometric model of the latter ratio, which includes variables such as the gold price, interest rates and energy prices (as energy prices rise the Energy sector will rise and affect the relative value of the Gold sub-sector), indicates furthermore that the Gold sub-sector is now seriously undervalued in terms of the S&P/TSX Index less the Materials sector – see Chart 5. (The econometric analysis is a relative analysis, meant to encourage/discourage an overweight/underweight position in a specific sector.) In short, the econometric analysis currently recommends, all else equal, an overweight position in the Gold sub-sector.

A similar recommendation emerges when the S&P/TSX Gold sub-sector and the XAU index are compared with only the gold price. This less sophisticated analysis of the gold equity to gold bullion ratio – see Charts 6-9 – indicates that the gold equity to gold bullion ratios are currently well below long-term and short-term trends, and in one case more than two standard deviations below trend.

Neither the econometric analysis nor the equity/bullion ratio analysis include firm-specific variables; the investor must therefore establish whether there is indeed any value at all in the gold equity sector. This will require consultation with financial advisors and gold equity analysts – the latter concentrate on firm-specific variables.

My objective here however is to point out that the stage may be set for a recovery in the gold sector this year and next. The gold sector has been savaged in recent years on account of tumbling gold prices and unattractive firm-specific variables. But the outlook for gold prices has improved in recent weeks; many heretofore bearish observers have revised their near-term forecasts upwards and the “speculators” on COMEX have begun to build their net-long positions once again.

With respect to gold prices specifically, our view is that demand and supply will be the important issues in 2014 and 2015. Normally we’d be suggesting that international liquidity, inflation (or the lack thereof), Fed tapering, real interest rates, the trend of the US dollar, etc. are the key factors on which to focus. And indeed these will still be very important factors in 2014 and 2015. But last year, 2013, saw a dramatic decline in ETF gold holdings – 881 tonnes according to the latest data from the World Gold Council. (And “speculators” on COMEX reduced their net-long positions by over 195 thousand contracts between October 2012 and August 2013, which is the equivalent of 607 tonnes of gold.) In short, 2013 saw a phenomenal, never before recorded, investment and speculative move against gold.

One can think of the 881 tonnes of ETF gold sales as a reduction in investment demand (see Chart 10 overleaf where ETF sales are commingled with bar and coin demand), or as outright ETF supply (see Chart 11). Either way, the 881 tonnes of ETF sales had to be absorbed in the market – by way of more jewelry demand, more bar and coin demand, more official demand, more unrecorded offtake in India (i.e., smuggling), or by way of other forms of identifiable/unidentifiable demand.

(The collapse of speculative long positions in 2013 on COMEX does not have an easily identifiable equivalent tonnage of outright physical sales, but it wouldn’t surprise me if there were 50-100 tonnes of physical supply generated in one form or another as a result of the closing out of net long positions in 2013.)

The key question for 2014 is: will there be a repeat of ETF selling amounting to 881 tonnes in 2014? If the answer is no, and we think that is the right answer, then all other things constant the price of gold will have to rise in order to choke back demand to the available supply.

Not all else will be constant, of course. But 881 tonnes (and an unknown COMEX-related tonnage) add up to a lot of tonnes of gold. If central banks do not buy gold in 2014 for example, that would only remove an estimated 369 tonnes of demand from the market – less than half the ETF sales in 2013. I think there may be no net selling at all from the ETF sector in 2014; if I am right then 881 tonnes of ETF supply need to be made up from elsewhere or, assuming Asian demand parameters do not change dramatically, the price of gold must rise.

In short, developments in the gold sector are starting to look very interesting again; equities are “depressed” by our measures and the gold price is likely – though nothing is certain – to bottom out this year. Given that our long-term outlook for gold bullion has not changed appreciably we think the reader might wish to have a closer look at the gold sector once again.

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