Gold Shows Signs of Overheating - Market Analysis

The recent rally in gold is nothing new. Gold is the only asset class that has moved higher every year for the past 7 years. But in November, the gold bulls took the rally to a new level as gold went on an amazing streak which saw the yellow metal move lower in only 3 sessions in the entire month. At one stretch, it was up 13 straight sessions and was hitting new record highs nearly every day.

Gold finished November up 13%, its best month in 10 years. For the year, the metal is up 33%.

The November move has little to do with actual gold demand. India, which is the world's largest consumer of gold, imported only 18 tonnes compared to 34 tonnes in November 2008. While the wedding season lasts until the end of December, and gold jewelry sales are normally strong in that period, there has been weakness even in that market as prices hit new highs.

Indian consumers are also selling jewelry and other gold scraps into the rally, instead of hoarding it, as prices have become just too juicy to resist. According to Virtual Metals, a precious metal consultant, recycled scrap gold in India rose to 227 tonnes, the highest level in the world, and is now over 50% higher than in previous years.

Similarly, other Asian countries are seeing similar patterns of higher recycled scrap gold levels and plunging demand.

What Is Driving Gold Prices Higher?

Obviously, gold has decoupled from demand fundamentals and is being driven by other criteria including inflation fears. Additionally, some investors are viewing it as an alternative to the dollar and other paper currencies.

You can also never underestimate the greed factor. Hedge fund managers are discovering that there's money to be made in the yellow metal. Last year, the flavor of choice for the speculators was oil. This year, apparently, it's gold.

Recent data from the Commodity Futures Trading Commission showed that hedge funds, private equity funds and other large money managers increased their net long positions in gold to twice the 5-year average. It's now at the highest level since 1993.

Although gold is very hot right now, with everyone in on the trade, odds are that a big pullback is in the offing. Nothing goes straight up forever.

During the last 7 years, gold has had substantial pullbacks. In just the last 18 months, gold has declined by double digits 3 times: in March 2008 by 15.5%, in July 2008 by 24.8% and in February 2009 by 11.7%.

Metal Exposure in Our Portfolios

In our portfolios, we have held some gold miners in the past, including Barrick Gold (ABX), but the gold miners have had difficulties meeting analysts' estimates. Those miners that do have solid fundamentals and rising estimates are a little too expensive in even just a price-to-earnings criteria for our blood. When there is a pullback, we'll revisit it.

We currently own Freeport McMoran (FCX) which operates one of the largest gold mines in the world but is also a big copper producer. Like gold, copper has also climbed in 2009 and is at 14-month highs. We like the combination of owning both the precious and the industrial metals.

We added Freeport McMoran to the Focus List in September and are up 25% on it through December 1. The company is a Zacks #2 Rank (buy) stock.

Portfolio Updates

Additions

Donaldson Co Inc. (DCI) came into the focus list fresh off the heels of strong Q1 results that lifted its share price to a new 52-week high just above $45. The engine filtration and purification systems maker produced earnings of 45 cents per share, 11 cents better than the Zacks Consensus Estimate.

The company has beat in each of the last four quarters by an average of 9 cents, or 27%. We also saw a nice jump in estimates on the good quarter, with the current year adding 29 cents and moving to $1.81. The next-year estimate is pegged at $2.10, a 16% growth projection.

Crane Co. (CR) manufactures highly engineered industrial products for aerospace, electronics, chemical and transportation markets. We like this company for several reasons, including the fact that there is nothing like it in the Growth & Income portfolio so it adds diversification.

The Zacks #2 Rank (Buy) company boasts an industry-leading yield of 2.7% and posted solid third-quarter earnings of 60 cents per share, which surpassed the Zacks Consensus Estimate by 25%. Crane hiked the lower end of its earnings outlook, and analysts followed suit. The full-year Zacks Consensus Estimate of $2.05 per share climbed 8% over the past month.

[In full disclosure, the author of this article owns shares of Freeport McMoran.]

Tracey Ryniec is the Value Stock Strategist for Zacks.com. She is also the Editor in charge of the market-beating Zacks Value Trader service.

Zacks Investment Research