Liking How It's Looking
There are two reasons to like how things are currently looking.
For one, gold stocks have carved out an undeniable 6-month uptrend. The uptrend established despite gold itself only moving sideways, despite US markets continuing to inch up, and despite the feeling that gold stock disinterest remains widespread. And the upswing has pushed up through some long-term trends.
There are reasons that has happened – but first, the second reason I like how things look.
Gold is quietly proving its case as a steady hand in this strange market. From bond yields to exchange rates and economic indicators to stock market performance, the global economy is doing weird things. As the weirdness continues, people are remembering gold's unique ability to offer both security if things weaken and exposure if things strengthen.
There is much to say about all of that. Let's dive in.
Gold Stocks Are Gaining
Since bottoming at a six-year low in November gold stocks have been ascending.
The early-year hump somewhat conceals the trend, but it is there – whatever gold does. In April, for example, gold surged then declined to end the month flat but gold miners as portrayed by the GDX rose 10%.
And now the trend is pushing past some important barriers.
As this chart shows, the GDXJ has broken above a long-term trend line that has kept prices capped since early 2011. It has all the markers of a real bottom formation.
Why is this happening?
The usual reasons continue to strengthen. Metal prices seem to have bottomed – gold is steady, copper is up 16% after its big slide, zinc has gained 18% in two months, and nickel rose more than 20% in April. Mining and exploration stocks have been so unloved for so long that these positive signs have contrarian investors moving in, taking advantage of extreme undervaluations in this reliably cyclical sector.
Then there's the macro scene, which is finally starting to lend support.
US markets continue to reward those already invested but they are pretty expensive to anyone looking to establish new positions. At the end of April the average trailing price-to-earnings (P/E) ratio of the elites of the S&P 500 was 26 times.
There is much debate about whether those valuations are too high. Whether they are high or too high, for investors seeking value the fact remains that the best mining stocks are available at about half that: the end of Q1 saw Newmont with a P/E of 13.8, BHP Billiton generated a P/E of 16.2, Rio Tinto's P/E is currently 13. Gold miners are even cheaper, especially mid-tier producers.
Of course, cheap is only a good deal if a stock looks set to move up – but that is precisely the situation for gold stocks.
Gold itself cannot go significantly lower. Mines quickly turn uneconomic when gold approaches $1,100 per oz. and new projects are unthinkable. That is a self-limiting situation: for any commodity, if demand exists then the price is supported at least just above the average cost of production.
But there's good reason to believe support for gold is considerably stronger than that.
Gold is Bigger than Interest Rates
The most common arguments against gold are interest rates and the US dollar. Neither of those worry me, because things are more complicated and more global than that.
Today's macroeconomic environment is marked by unprecedented monetary policies, low rates, expensive stock valuations, and deflation concerns. In addition, emerging markets are gaining influence and other currencies are competing with the dollar for international use.
Amidst all that, US interest rates and the US dollar are less important to gold than many would assume.
For example, on the physical side emerging market demand for gold now accounts for 70% of global demand; the US accounts for less than 10%.
Then there's the fact that non-dollar gold demand is not overly sensitive to dollar movements. China and India account for half of global gold demand and both markets are as likely to rise as fall when the dollar strengthens, as they respond more to the price of gold in local currencies and to cultural factors.
This stuff matters because the rise of Asia as a gold trading hub means more and more gold transactions will be settled in non-dollar currencies going forward. Examples of this include the launch of the international board of the Shanghai Gold Exchange; the introduction of the Kilobar Gold Contract on the Singapore Gold Exchange; the announcement of a new kilobar gold futures contract in Hong Kong; and the Thailand Stock Exchange's plan to launch a physical gold exchange.
OK, that all makes sense from a big picture point of view, but won't gold still get hammered when the Fed does finally raise rates?
No. Rate hikes are often good for gold.
Sure, higher interest rates increase the opportunity cost of holding gold. However, stock market performance declines as rates rise, which encourages investors to look elsewhere for gains. Inflation is also usually rising, another plus for gold.
On the demand side, jewelry and technology make up 60% of annual physical gold demand. Higher interest rates typically coincide with higher economic growth and consumer spending, which boost these kinds of sales.
Finally, central banks don't really care about interest rates – they are gathering gold as a long-term hedge against all kinds of uncertainty and will continue to buy regardless of rates. Central banks have been net buyers of gold for 14 straight quarters.
Between pro-cyclical jewelry and technology demand, significant emerging market demand that is mostly insensitive to US rate changes, increased interest in gold as investors flee sliding stock markets, and sustained demand from central banks, a US rate hike is far from a doomsday signal for gold.
History supports this stance. For example, between mid-2004 and mid-2006 the Fed boosted rates from 1% to 5.25%. Gold responded by gaining 50%.
It all ties together. US markets have been the obvious place to park money for several years now. The result is a market that many consider lofty and overextended. There are more reasons the rise should cease than reasons it should continue.
Wages and exchange rates and other pressures keep making it more expensive to operate a US business; weak retail and housing demand keep cutting into revenues. Unemployment is stubborn; wages are pressured; consumers don't have money to spend. Low oil and natural gas prices are hurting those important US sectors.
All of this prevailing economic weakness is preventing the Fed from raising rates, which cuts into investor confidence.
Confidence matters. Confidence in the Fed's process driven US markets – speculative capital crowded into the dollar and into the US in general largely based on an expectation that is was the strong economy, a premise that a rates raise would prove.
If rates aren't raised, the premise falls apart. If the gains of the last five years begin to turn to losses, concerns will pile up.
Confidence is a thin foundation for a major currency or market run. And confidence in this rally is waning. If it breaks, the equity bubble bursts.
Moreover, the bubble-bursting prick could come from outside. A crisis in the Eurozone, weakening in China to the point that Beijing has to let the renminbi slide and commodity prices fall further, or increasing global currency wars that push the US dollar up again and stifle American businesses – any of these could also tip US markets into a slide.
Once the downturn happens, once the obvious investment arena evaporates, investors will look elsewhere. That search will return metals at the best bet sector. Commodity prices were hammered down but are now recovering; equities are similarly undervalued and prospective.
Gold will lead the change. Gold demand will shoot up in any kind of stock selloff. Once gold starts to gain, producers provide leverage.
It's a matter of cost of production versus the value of the product. Producers have wrestled their costs as low as they can. It now costs most miners something like $1050 to produce an ounce of gold. When gold is worth $1200, each ounce generates $150 in profit.
If gold inches up 20% to $1450, that same miner is suddenly making $300 profit on each ounce – twice as much. That's great leverage.
Leverage is usually a double-edged sword, because of course miners' losses are also leveraged to the price of gold. But right now that downside risk is almost zero because gold cannot fall much farther. The only way forward is up.
When precisely it will all unfold I do not know. I like how things are looking right now. And importantly I see very little downside risk, which is why the time to position is today.
As a recent subscriber to your newsletter, I wanted to say thank you for all the amazing information and detailed analysis regarding the many companies you're invested in. I cannot begin to imagine how much time you put into your work. I am very new to investing in the mining sector and did quite a bit of research before selecting your newsletter over the many others available. I was nervous about signing up to anyone's newsletter as there is so much negativity on the internet about newsletter writers (e.g. pump and dumpers). Anyways, I'm feeling good about being aligned with you.
Thank you so much for this excellent Maven letter. Your market analysis and logic is again exceptional. Your insights, knowledge and feel have given me a wonderful couple of hours. I am now planning my activity. I look forward to seeing you tonight on the Virtual Metals forum, I am pleased that you start first as I am a morning not a night person.
I hope you and your family stay well.