Financial Advisor

Weekly Update: 9 Days Away from a Crisis

Global financial markets were on pins and needles Sunday night as investors contemplated the possibility of a default by the United States government. President Obama and House Republicans have yet to agree on a deal to raise the $14.3 trillion debt ceiling. The August 2 deadline is looming and the fallout if an agreement is not reached has the potential to be severe.

Ratings agencies such as Standard and Poor's and Moody's would likely slash the nation's triple A rating, leading to a plunge in the value of the U.S. dollar as well as lower stock and bond prices. S&P noted that the dollar could fall 10% if America defaulted. If the credit quality of the U.S. deteriorated, rates would likely rise and debt service costs would soar. Gold prices could spike to $2,000 per ounce under such a scenario. David Bianco, chief equity strategist at BofA Merrill Lynch, warned a rating cut could drive the S&P 500 down to 1250, 7% lower than its current price.

Equity markets should face selling pressure Monday morning unless there is a late Sunday/early Monday announcement that a deal is close. Looking out over the balance of the week, a last minute compromise remains the most likely scenario despite the current acrimony on Capitol Hill. However, the longer the impasse goes on, the greater the possibility is that a deal does not get done - a scenario that could send the price of gold soaring. It seems unlikely that the President and Congress would inflict irreversible damage to the credit quality of the U.S., but we are now just nine days way from the deadline.

The U.S. dollar serves as the reserve currency of the world, backed by nothing but confidence since President Nixon severed the gold link in 1971. U.S. politicians are playing a dangerous game of chicken. Gold should act as a barometer of the debt ceiling talks with the yellow metal poised to hit fresh record highs early in the week.  

While a deal would likely send gold prices lower, the lack of a meaningful deficit reduction plan should keep the yellow metal from falling below its 50-day moving average of $1,537 per ounce.

Sentiment Outlook

From a sentiment perspective, the outlook for gold has deteriorated somewhat. Speculative net long positions on the COMEX for gold are currently sitting near their 2011 highs and the Market Vane bullish consensus figure for the yellow metal is sitting at 83%. Additionally, the most recent reading of the Hulbert Gold Newsletter Sentiment Index (HGNSI) stood at 67% bulls - on the cusp of reaching the multi-year high of 73.7% posted in late April.

While sentiment does not drive prices on its own, it does present a slightly less bullish backdrop. Rising bullishness reveals that a growing number of investors and traders are already long the sector.

KEY UPCOMING CATALYSTS FOR GOLD

Earnings season for the gold mining sector kicks off this week with the Big Three - Goldcorp (Wednesday), Barrick Gold (Thursday) and Newmont Mining (Friday) - all set to release second quarter reports this week. 

The share prices of gold mining producers have lagged the performance of the spot gold price severely this year. While gold has gained 12.6% thus far in 2011, the Market Vectors Gold Miners ETF (GDX) - a benchmark for the gold mining sector - has dropped 1.2%. Valuation multiples have contracted for the large-cap gold producers, partially as a result of skepticism over the sustainability of $1,600 gold. Rising cost structures and production misses have also plagued the sector.

Gold mining companies must demonstrate to investors they offer earnings leverage to the gold price or gold bullion exchange traded funds will continue to attract the majority of the fund flows. This week they have the opportunity to demonstrate this leverage. Watch for management teams to increasingly focus on dividends as a way to differentiate from the gold bullion ETFs.    

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