Should You Steer Clear of Gold Stocks?

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Demand for gold will remain strong in the years to come given the demand for jewelry, bars and coins as well as its safe-haven appeal. Yet, the gold mining industry has a number of headwinds lurking. Below, we have discussed some of the key challenges and what investors in the sector can look forward to in the coming months and years.

China Woes

China's stock market has been shaken by the slowdown in the country's economy. China's economy grew at an annual rate of 6.7% in the third quarter of 2016, flat with the prior two quarters, marking its slowest in seven years. For 2016, the government anticipates the growth rate to remain in the same range.

In China, policymakers continue to shift the economy away from its reliance on investment and industry toward consumption and services. This is expected to slow growth in the short term while building the foundations for a more sustainable long-term expansion.

The continued general economic slowdown has had a negative impact on customer sentiment. Jewelry demand in China 2016 slumped 17% due to higher gold prices . Demand in China will remain constrained in the short term.

Production to Flatten on Lack of New Projects

Total mined production totalled 3,236 tons in 2016, flat year over year. While output is slowing down from older mines, particularly in South Africa and the U.S., the incremental impact on production from new mines coming on stream is gradually on the ebb. Previously, incremental production from newer mines led to continued growth in overall gold production. However, newer mines are now at or near their full potential, leading to slowing down in the growth rates. This has made further production gains increasingly difficult.

After a period of implementing cuts to spending on capital and administration, much of the recent cost reduction has come from lower oil prices and favorable exchange rate moves. Reduced spending on exploration and development has already taken its toll on the production pipeline and will further squeeze production in the coming quarters.

Some gold companies, including Barrick Gold Corp. (ABX), Goldcorp, Inc. (GG) and Newmont Mining Corp. (NEM) are currently high-grading at certain mines. The high-grade portion of a mine is mined first as this increases the grade of the mined ore and lowers cost per unit.

However, it has its pitfalls as it depletes reserves very quickly, thus affecting long-term supply. Gold miners, grappling with low gold prices and cost pressure, have not been in a position to invest in new projects in recent years. Companies including AngloGold Ashanti Ltd (AU) and Agnico Eagle Mines Limited (AEM) have slashed capital and exploration spending. Given the lack of new projects, mine production will eventually reach a plateau in the next couple of years.

Gold Substitutes in Technology

Demand for gold in technological applications is affected by sluggish economic conditions in key markets and substitutes found for the metal. Despite inferior durability, copper and palladium-coated copper have made vast inroads into the share of gold in the bonding wire sector. The decade-long decline in the dental sector shows no sign of abatement as gold continues to lose ground to ceramic alternatives, which have improved steadily in quality, strength and durability.

Impact of a Stronger Greenback, Rate Hike

There is an inverse relationship between the trade-weighted U.S. dollar and the price of gold . If the dollar gains strength against major currencies on the back of positive macroeconomic data, like an improving job market and growing industrial activity, it will again put gold prices under pressure.

In Dec 2016, the Fed raised interest rates by a quarter percentage point, bringing the target range for the federal funds rate to between 0.5% and 0.75%. Further, the Fed signaled a faster pace of increases in 2017. Higher U.S. rates raise the opportunity cost of holding non-yielding bullion and normally weigh on gold.

Inherent Risks

Gold exploration and mining are time consuming and expensive tasks. Given its scarcity and remote location of deposits, exploration for new gold deposits is difficult. Once an economically viable deposit is identified, bringing a mine on line can take a decade or more, and it requires substantial capital investment.

Moreover, the mining industry is subject to several risks such as political conflicts, environmental hazards, industrial accidents, unexpected geological conditions, labor force disruptions, unavailability of materials and equipment, weather conditions, pit wall failures, rock bursts, cave-ins, flooding, seismic activity and water conditions. However, once a mine is successfully developed, its returns can be enormously high. This will more than mitigate the risks inherent in development and the capital invested for the project.

Gold Stocks to Avoid for the Time Being

We presently recommend investors to stay away from the following gold stocks as they presently have an unfavorable Zacks Rank. The other metrics also indicate that they are not profitable investment options at present.

Goldcorp Inc. (GG) currently has a Zacks Rank #5 (Strong Sell). The average negative surprise for the last four quarters is 152.08%. The 2016 earnings estimates have gone down by 29% in the last 90 days and for 2017 have decreased 40%.

Randgold Resources Ltd. (GOLD), another Zacks Rank #5 stock, has witnessed a 13% drop in its 2016 and 2017 estimates. The company has a negative average earnings surprise of 16.24% in the past four quarters.

Golden Star Resources Ltd. (GSS) carries a Zacks Rank #4 (Sell). The Zacks Consensus Estimate for 2016 is at loss of 13 cents per share. The estimates for 2017 have gone down 42% in the last 90 days.

Bottom Line

Dwindling production, lack of new projects and the constant threat of a stronger greenback are some of the sector's worst detractors. But what about investing in the space right now; are there opportunities for short-term investors overriding the headwinds?

Check out our latest Gold Mining Outlook for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.

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Newmont Mining Corporation (NEM): Free Stock Analysis Report

Golden Star Resources, Ltd (GSS): Free Stock Analysis Report

Randgold Resources Limited (GOLD): Free Stock Analysis Report

Goldcorp Inc. (GG): Free Stock Analysis Report

AngloGold Ashanti Limited (AU): Free Stock Analysis Report

Agnico Eagle Mines Limited (AEM): Free Stock Analysis Report

Barrick Gold Corporation (ABX): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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