Gold is on the cusp of breaking out to all-time highs in U.S. dollars and has already done so in virtually every other currency. Gold mining stocks continue to lag the metal and represent a compelling investment opportunity at this moment. The COVID-19 pandemic panic was merely the black swan that punctured a financial market asset bubble that took almost a decade to inflate.
Think of the pandemic as the pin that punctured the credit balloon. In a few months, the pandemic will ease (hopefully) with the formulation of a COVID-19 vaccine, widespread testing and other responses that will surely come from the healthcare industry. However, the fiscal and monetary policy damage committed by all governments to save the world has created a debt hangover that will linger for years. Economic growth will rebound but only to subpar levels once extreme health-related restrictions are lifted and “stimulus” kicks in.
The requisites for robust economic growth most likely to misfire are investor confidence and bank lending. Both have been severely compromised. Whether this landscape evolves into a long stretch of deflation or combusts into untamed inflation remains to be seen. What seems quite apparent is that traditional Keynesian stimulus measures are in their endgame. They will most likely deliver only steadily diminishing returns. Starkly opposite economic outcomes are possible from this policy morass; both would be positive for gold but negative for real returns on fixed income or equities.
As of this writing, gold is trading about 10 percent less than its all-time high of $1,900 attained nine years ago (September 2011). In effect, it has gone nowhere for a decade despite a tectonic shift in the investment and economic outlook. A lengthy correction lasting until 2016 and subsequent churning resulted in the establishment of a powerful multi-year basing structure. From this base and with strong macroeconomic tailwinds, we believe new highs well above $1,900 can be achieved over the next four years.
Despite enthusiastic advocacy and much chatter from investment luminaries, including Ray Dalio, Jeff Gundlach, Seth Klarman and others, gold remains severely and inappropriately underrepresented in the portfolios of fiduciaries, endowments and family offices. Flows into channels such as gold-backed ETFs have been strong relative to previous low levels, but must still be considered a trickle in terms of what could still come.
We forecasted this past year that 2020 would mark a pivotal, secular turning point for all major asset classes including equities, bonds, gold and currencies. A return to the pre-2020 financial market normalcy and investment complacency is unlikely. Consensus hopes remain high that the credit smash is only a temporary repercussion of the health scare. We disagree and suggest the effects will be long lasting.
Despite the solid price gains achieved by gold in the past two years, there is much more upside to come as investors gradually give up on repeated equity market bottom fishing and the hope of a return to financial market normalcy. A full reversal to the previous complacency cannot take place following a brief crash. The mood change will more likely become pervasive after grueling stretches of disappointing returns from previously successful investment strategies.
The decade preceding 2020 was characterized by the systematic stifling of price discovery for interest rates and the appropriate dependent valuations for financial assets. Such distortion was made possible only by unprecedented central bank balance sheet expansion that encouraged, abetted and rewarded risk taking in the form of ever greater leverage.
The prolonged somnolence of gold was among the most egregious price distortions of the previous decade, and this suppressed interest in the metal as a risk mitigator and portfolio diversifier. Disinterest was fed in large part by the nearly universal expectation that the past would always be prologue and that highly leveraged financial and economic structures would perpetually result in outsized returns. The greatest change stemming from the credit bust will be a mood shift or paradigm change in the opposite direction.
At gold’s previous peak in 2011, the combined balance sheets of the U.S. Federal Reserve and the European Central Bank totaled about $5.5 trillion. Today, that number is more than $11.4 trillion and rapidly moving higher. The USD gold price is still lower than nine years ago. Gold price is still well below where it should be and will likely trade higher in the new macro landscape.
If gold is not correctly priced for what has transpired and what lies ahead, gold mining stocks are even more inappropriately priced. Based on current metal prices, most companies are generating positive earnings and cash flow and, in many cases, free cash flow that can be applied to higher dividend payouts. Compared to other sectors of the economy, the gold mining industry stands almost alone in looking forward to strong 2020 earnings and a positive outlook for 2021.
2020 free cashflow yields for large-cap producers range from 3 percent to 7 percent and 6 percent to 25 percent for intermediate producers based on conventional sell-side research. The stats are similar or better for 2021 based on spot gold prices. Mining stocks are inexpensive in absolute terms and have never been cheap relative to the gold price.
Since 2008, the relative valuation of gold equities to gold bullion has fallen 75 percent from the prior 25-year average. The ratio of the XAU Index to spot gold averaged 0.2497x for a quarter century through 2008. As of March 31, 2020, the ratio was 0.0501x.
It is undoubtedly true that the industry will suffer health-related mine shutdowns and other shortfalls this year. Much of the disruption potential has already been broadcast and priced into the market. Some downside news may still have yet to surface. However, most miners are not financially levered and should be able to survive a few quarters of lower or no production. Unlike the airline, leisure, retail and manufacturing sectors, gold not produced today should grow in value and be produced at higher prices and lower costs next year and those beyond. It is not the same story for many other sectors of the economy. Based on fundamentals, gold stocks are inexpensive. By contrast, several other sectors of the economy could face long stretches of poor earnings, bad news flow and financial woes.
The gold mining sector registered a decline of about 20 percent during the first quarter as shares got battered by indiscriminate liquidations during March. However, as of this writing, most shares trade near to where they stood at the beginning of the year, and have certainly registered outstanding performance in relative terms.
Gold mining shares continue to be viewed by investors with deep skepticism as reflected by valuation and flows, but it appears to us the sector is on the verge of an upside breakout from a multi-year base should our assessment of the macroeconomic environment prove correct.
Gold is extremely underowned, underrepresented and poorly thought of in the circles of conventional investment thinking. It is still considered to be a fringe asset. Just ask Goldman Sachs, which recently advised its clients on April 5: “We concluded then (2010) that gold does not have a role as a strategic asset class in clients’ already well-diversified portfolios. We have updated the research and the evidence is even more compelling today than it was then.”
We remind the reader that Goldman is the same firm that in December 2019 declared the U.S. economy to be “recession proof” and then in March 2020 cautioned that stocks had substantial further downside. Goldman’s commentary is, in our opinion, a reasonable proxy for conventional wisdom. One could easily find other embarrassing examples of mainstream thinking ignorant of the best-performing asset class — by far — versus equities and bonds since 2000.
The secular gold bull that began in 2000 and corrected for a few years has returned to life with renewed vigor. The setup for gold and gold mining shares ticks every box for highly rewarding investment returns.
John Hathaway is a senior portfolio manager at Sprott.