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Have gold and silver peaked?

With precious metals prices falling through key support levels, and trouble brewing for gold and silver miners, we say what companies to buy, sell and hold in the sector.
February 26, 2013

Gold and silver prices crashed through key support levels last week and could be on their way down to their respective major support levels $1,525 (£1,000) an ounce and $27 an ounce. Should prices plunge further than that, all bets are off. Indeed, if the last bear market for precious metals is anything to go by, prices could go into hibernation for as long as 20 years.

Even habitually bullish commentators on gold are starting to openly ask whether precious metals prices actually reached their zenith back in 2011 and are now in long-term decline. Most actually don’t think so. Technical analysis suggests this is merely a short downturn within an ongoing bull market for precious metals that has been running strong for 12 years.

Time to retreat

We’re not convinced of either case just yet, but for now the risks seem skewed to the downside. As a result we’re downgrading several of our recommendations on precious metals miners and advising investors to reduce their exposure to gold and silver-related equities. Below, we set out new recommendations on over a dozen precious metals equities, separated into ‘sell’, ‘hold’, and ‘buy’ sections.

So why have prices suddenly dropped? As we explained last week, there are two main reasons for the abrupt sell-off. The first is entirely technical. Gold has been trading within a range of $1,800 to $1,525 an ounce for the past year and half. Twice gold has failed to break through $1,800 and subsequently drifted back to $1,650 and then $1,525. When gold rose for a third time in October following a third round of quantitative easing by central banks, but then failed to break through $1,800, it created what technical analysts call a ‘triple-top’ formation. Prices once again fell back to support levels – first $1,650, and likely $1,525 shortly.

The second reason is that the ‘fear trade’ is temporarily off. The key drivers of gold these past few years have been fears of inflation, a eurozone breaking up, a US dollar collapsing and the ‘fiscal cliff’. These fears have waned over the past few months. Gold bears from Citigroup now argue “the world has passed its worst point of systemic risk to the global financial system and that the ‘insurance metals’ (gold and silver) have had their day in the sun”. That's because the global economy is seeing early signs of a return to growth - albeit very minor growth at this stage, admits Citigroup - while bond purchases by the European Central Bank have curtailed the worst of the eurozone debt contagion. Likewise, the US dollar is being underpinned by cheap energy supplies from fracking for shale oil and gas, so the long-term bearish argument on the dollar has reversed.

Stay worried

But have the structural problems within the US and the eurozone disapeared. The issues of excessive government debt as well as the proliferation of paper money, have not remotely gone away. In fact, there is talk of yet more quantitative easing needed in the UK and elsewhere, while the deadline for the next US debt ceiling negotiation is fast approaching. What's more, mixed election results in Italy have just brought the economies of the eurozone periphery back into focus.

We don’t believe the world has seen the full extent of the fallout from the 2008 financial crisis yet, but the problems have been successfully papered over by governments and central banks so as to keep equity markets rising. How long they can artificially keep their economies pumping is anyone’s guess, but it could foreseeably last a while, potentially even several more years (remember, it has been five years already!).

All of which leaves us with a dilemma. By selling out now, would we simply be following the herd and miss the bull market when it resumes its upward trend? Or would we be avoiding further carnage in precious metals equities as gold drops to new, unforeseen depths? Investors must make up their own minds here, but we’ve decided to err on the side of caution for now with our our changes in the share recommendations below.

 

 

SELL

Fresnillo(FRES): We are downgrading Mexican silver miner Fresnillo from hold to sell because of its premium valuation. The shares trade on 23 times consensus forward earnings for 2013, compared with an average of 10.4 times consensus earnings for the large-cap diversified miners. With the prospect of a resumption of a silver bull market diminishing, we expect that premium to come under pressure as the market adjusts to a lower base-case silver price.

Polymetal(POLY); Polyus (PGIL); Petropavlovsk (POG); Highland Gold (HGM): We’re downgrading all four of the big Russian gold miners to sell as we feel investors will only want to keep top-quality miners in their portfolios during a bearish phase for gold. Operating costs in Russia are rising across the board as a result of higher labour, diesel and power costs, as well as deteriorating ore grades, and political risk is a constant. While their valuations aren’t particularly demanding – the group trades on an average consensus rating of nine times forward earnings – we see few immediate catalysts that would generate a strong rerating other than a gold bull market.

African Barrick Gold(ABG): The Tanzania-focused gold miner had a tough year in 2012, with gold production of 626,000 ounces down 9 per cent on 2011. Worse, African Barrick recently announced that it expects 2013 production of between 540,000 to 600,000 ounces. With an operational turnaround at least 12 months away, and sentiment for the sector falling, we downgrade the shares from hold to sell.

HOLD

With one eye fixed on locking in whatever gains are left from gold’s resurgence last autumn, we are closing out several of our gold-related buy tips, including Pan African Resources (PAF), Mwana Africa (MWA) and Kefi Minerals (KEFI) after respective gains of 16 per cent, 32 per cent and 16 per cent. Their shares now warrant a hold rather than a sell because of their ambitious future growth plans, which should shelter them slightly from a further drop in the gold price. Mwana is also diversified as it produces nickel as well as gold, and explores for copper and diamonds.

Nevertheless, we feel obligated to close out our heavily-underwater buy tips, Amara Mining (AMA) (formerly known as Cluff Gold) and Aureus Mining (AUE) after 58 per cent and 43 per cent losses, respectively. Amara’s share price has retreated to a three-year low of 43p and while we’re tempted to continue sticking with it through the tough times ahead, it’s probably time to cut our losses. With new production from the promising Baomahun project not expected for some years to come, and the company’s Kalsaka mine nearing the end of its life, Amara’s shares could struggle to rerate unless gold is rising.

Aureus Mining listed when the gold price peaked in 2011 and has had a difficult time gaining traction ever since, even though it has advanced its flagship project in Liberia to a construction-ready state. We still like its future prospects, but it’s tough to see the near-term catalysts that will drive the shares back up to where we first recommended them before production starts.

In a similar vein, we downgrade ancient buy tip Bezant Resources (BZT) to a hold after the company missed a payment by agreeing a one-year extension to its option agreement with Gold Fields.

As for the more trouble-prone gold miners – Centamin (CEY) and Avocet Mining (AVM) – we have kept their shares on hold as their share prices have fallen so far in recent months that they are now in ‘deep value’ territory. But investor sentiment remains against them, and we see limited potential for significant upward movement in the short term.

London’s top gold miner, Randgold (RRS), also warrants a hold rating in spite of its premium valuation. The shares currently trade on 14 times consensus earnings for 2013. That premium valuation could be excused in the past on the basis that $1,600 to $1,900 per ounce of gold was the new normal. Not only would a further fall in the gold price threaten earnings forecasts, but the market would be less willing to grant the company its superior valuation going forward. Nevertheless, Randgold consistently outperforms its peers and has very high-quality assets, albeit in very dangerous jurisdictions. The company also has near-term production growth through its huge Kibali mine, where first gold is expected in the fourth quarter of this year.

BUY

We keep recent buy tips Archipelago Resources (AR) and Newmont Mining (NEM) on buy recommendations. That’s because they have very low cash operating costs and their share prices at the time of our tips already reflected a challenging market for gold mining equities. We also reiterate our buy advice for Liberia-focused gold explorer Hummingbird Resources (HUM), as it has a treasury bursting with cash and an active drill program planned for 2013. Hummingbird is also expected to release a scoping study for its flagship Dugbe F project later this quarter.