Get Prepared for Massive Launch

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. . .only a few weeks left before we see lift off.

We have been looking at global trends and the debt markets very carefully this year so as to remain prudent about our views on the direction of gold and the Australian gold sector. This may seem like a long bow to draw however the thigh bone is connected to the knee bone when it comes to global markets and capital flows.

We specialize on coverage of gold and the Aussie gold stocks that make up the Australian gold sector, which is one of the important gold share markets due to our high level of gold production (and another key reason I will get to shortly). Another important part of our work is on the currencies due to the importance of the AUD to our gold sector and also for our international clients. We have even taken on a leading Fx broker as an advertiser due to the importance of Fx for international capital flows at this point in history.

Our thesis for this year has been one that includes continued trends on global markets on the back of stimulus capital along with increasing sovereign debt trouble and contagion, which will (and has) produce fear. We have seen this as a positive environment for gold along with extreme volatility and distortions in the currencies and see no reason to change that view at this stage.

Gold is breaking out in all currencies and I forecasted a rise to the US$1,180 area a week or so back. It has not quite made that target and may not—perhaps it will overshoot. After hitting record highs in Euro terms the gold price consolidation of the past 4.5 months in USD terms appears to be drawing to an end with only a few weeks left before we see lift off. I am expecting one last dip in the USD price of gold (POG), which will be short lived and reasonably shallow. The US$1,100 level is not out of the question on this hypothesized pullback.

Australian Gold Emerging Producers Index

Investors that watch shared behavior Down Under lately would have noticed accumulation patterns along with strong activity on many of the stocks and some important take-over activity. This is exactly the sort of behavior that precedes a strong rally. As you can see above there is major scope for upside just to recover pre-2008 crash levels. In fact we could see a broad doubling of the Emerging Producers Index shown above.

Again I thank Nick Laird at Sharelynx for this index and chart of which we have three at GoldOz. We can easily double from the current level of 91 if we are merely to get back to the highs of 2006 when gold hit US$730 per ounce and that index probed the 200 level. Remember that costs soared after that peak affecting the profitability of all gold producers, which goes some way to explain this anomaly. On my count, however, we could see US$1,500 this year; and, depending on the AUD movements, these stocks can easily expect to be experiencing margins This consolidation activity can and has lasted for months at times as seen ahead of strong rallies over the past several years. Reporting season is in full swing here so I am increasingly focused on scanning through and condensing these quarterly reports for my membership base. I will release a series of articles more devoted to gold stocks in the near future when this process is complete. This process will also enable me to finally select the educational report companies for release ahead of any potential upside.

The past few days has seen some sharp liquidation ahead of a possible Au correction and perhaps due to some unwinding of the AUD carry trade, which is mostly in cash and treasuries here in Australia. This intensifies the opportunity Down Under as the gold stocks are already excellent value. Some evidence is shown in the AUD down days and topping pattern on the chart below.

AUD-USD Fx

The daily chart of the AUD: USD ratio shows a long, high consolidation period and some divergent patterns. Over on the left, I have marked the sell signal that preceded a fall from 94c to 87.5c late last year. On the right I have marked a similar pattern, not quite as strong, however the sharp down days and rapidly falling RSI smack of more pressure on selling activity than buying in my opinion. The risks of losing profits from carry trade activity on the Fx move are increasing.

Sovereign Debt, the Carry Trade and Gold

My thanks go to Sprott Asset Management this week for their excellent article on Greece and the impact of this crisis on the Greek banks. It illustrates what I have been saying for months that the problem is all about debt and is not a quick fix scenario. An important quote from their article: "We envision Greek depositors asking themselves how a government that can't raise enough money to stay solvent can then turn around and guarantee their bank deposits? It's a fair question to ask." They also had this to say:
"While there were some similarities in our rankings (for example, our model ascribed AAA ratings to the local currency debt of Australia, Canada, Finland, Sweden, New Zealand which matched the ratings given by S&P), we found some glaring inconsistencies in the rating results for less fiscally prudent countries that left us scratching our heads."
I want to draw your attention to Australia from this comment because Sprott AM have concluded that Australia is low risk due to low levels of sovereign debt. Capital flows will increasingly favour countries with lower sovereign risk as the global sovereign debt crisis gradually deepens. More attention will have to be paid to this risk.

This is the second reason mentioned above for believing that Australia will become an important gold market. Capital flows to area of less risk particularly when risk weighting increases in importance. This is important for the Australian gold sector moving forward. When you combine this fact with the growing globalization and standardization of financial markets, the web and ease of participating in the emerging markets (and Australia) we will see standardization of gold stock values. Another long bow to draw I don't think so but form your own opinion.

When gold stocks become the flavour or the month (or year) due to rising gold prices then guess what?? A proportion of these risk adverse capital flows will head towards the Aussie gold stock sector. This is not an unrealistic assumption based on our current modelling.

Australia will remain an attractive place to live and invest as time and the new world investment climate develops further. In the short term a fall in the AUD and correction in the Aussie Gold Sector would present as an excellent opportunity for foreign buyers to get set in the Aussie gold sector if they are not invested already.

The low lying fruit in the carry trade is now gone as the differential between Central Bank interest rates have not kept pace with currency movements. Therefore, short term the unwinding of the carry trade is highly likely and would cause a fall in the AUD giving new capital in ideal entry point for deployment in Australia. The AUD is a comparatively small market so when capital flows do reverse the move can be swift and dramatic.

Longer term we revert to the new risk weightings away from high sovereign debt towards emerging economies and the commodity supply countries like Canada and Australia. On the unwinding of the carry trade we will get the prime investment climate for Australian gold stocks of the entire bull market to date. This is an exciting event as the fundamentals are tipping this way.

Perhaps this is why Sprott and other large funds have been accumulating here? The upside potential for our gold sector is excellent as they merely complete the catch up process after the battering they received in the 2008 crash. There may be one important issue holding up some capital now so let's take a look at the Ken Henry tax report for a minute.

Henry Tax Review

Now to the threat of the new resources tax (Dr. Ken Henry Report) to be revealed on May 2nd. Firstly, the federal government will have to issue a response to the report and may or may not adopt the recommendations. There are over 100 taxes here in Australia; however, only 10 of them reap 90% of the revenue, so the government is quite sensibly trying to simplify the system. If only the world was simple though there are some issues.

Please do not get me wrong and suggest that I support anything but assistance for an industry that is performing well and has potential to provide more jobs for Australians. The federal budget is released on May 11th and may include some of the recommendations; however, it is likely that the bulk of them would be implemented slowly to avoid shock to the industry. The last major tax review in Australia saw some items take up to 20 years to deliver.

The consensus is that the form the tax would take would be for it to kick in only after project capital is recovered and "excessive profits" are being earned. This tax is meant to replace the state government taxes and this would make sense and be a benefit to companies as it would allow for less profitable and start up operations to see some relief from tax.

The great difficulty is that the plan requires the cooperation of WA and Queensland governments, which preside over the very mines that produce over 70% of the nation's mineral wealth. The states have just been locked into historic negotiations over GST share and our health system so feathers are already ruffled a little. WA is known to be strongly opposed to giving up its own tax revenue and therefore opposes the Henry plan before it is even tabled.

If the federal government goes ahead we will see confrontation; and, if they decide to leave the current taxes in place and impose a small tax on top for these "super profits," then the goal of simplification will fail. There is no doubt the mining companies will complain loudly but will it make any difference really?

There are significant benefits derived from operating in a politically stable country like Australia with its many advantages over less-developed countries. Infrastructure, educated workforce, climate, sound banking system, low sovereign debt and proximity to the world's growth engine (Asia) offset any potential difficulties provided the government get the structure and implementation of this new proposed reform reasonably fair. So we not only have to understand the Henry Report is a set of recommendations, we also have to see how it all pans out.

Neil Charnock
[email protected]
www.goldoz.com.au

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