ABX:CC - GDX: Timing The Market And The $2000 Floor For Gold

2023-09-05 04:08:14 ET

Summary

• The need for monetary and fiscal intervention into the markets creates a long-term bull market for the price of gold.
• Although a more direct exposure to the precious metal makes sense for long-term investors, gold miners appear attractive right now.
• The market is pricing a too pessimistic scenario for margins of high quality gold miners which reduces downside risk.

Holding gold and precious metals as part of an equity portfolio has fallen out of favour over the past decade as supportive monetary and fiscal policies created the illusion that risk is non-existent.

In recent years, however, the case for holding gold has strengthened significantly due to the ever mounting risks for the existing monetary system.

Although I have always been in favour of having a direct exposure to precious metals, as of late the attractiveness of the gold mining sector is hard to resist. Business fundamentals have been improving, while at the same time share prices of major gold miners have come under significant pressure.

The VanEck Gold Miners ETF ( GDX ), for example, is among the most popular choices for anyone looking to get exposure to the sector, without having to take the additional risk of picking individual gold mining stocks.

Having said that, we should not forget that over longer periods of time, a direct exposure to gold still delivers superior results and buying the GDX requires a degree of market timing as it was in early 2016 and 2019.

Why Timing The Market?

Timing the market is usually a futile exercise and is something that goes against the nature of long-term investors.

Nonetheless, at present the downside risk for high quality gold miners has been reduced significantly. On one hand, investors have shunned the sector and with that valuations of high quality miners have come down to multi-year lows.

On the other hand, margins are now at record high levels even as costs are rising. The graph below perfectly illustrates all that for one of the largest publicly traded gold miners and the fourth largest holding of the GDX - Agnico Eagle Mines ( AEM ). The gap between the company's operating margin and its sales multiple is at its wides point since the 2011-12 period when the price of gold peaked.

However, the situation at GDX two largest holdings - Newmont Corp. (NYSE: NEM ) and Barrick Gold Corp. (NYSE: GOLD ) is a bit different. While AEM's margins benefited from recent capital allocation decisions, NEM and GOLD have seen a notable drop in profitability in recent years.

As expected, the chief culprit has been the skyrocketing costs of energy and raw materials.

In the third quarter of 2022, as a result of these challenging market conditions, record inflation rates, the rising prices for commodities and raw materials , prolonged supply chain disruptions, competitive labor markets and consideration of capital allocation, the Company announced the delay of the full-funds investment decision for the Yanacocha Sulfides project in Peru.

Source: Newmont Corporation 2022 10-K SEC Filing

But unless we see a worsening dynamic between the price of gold and input costs for gold miners, this is already reflected within the price of both NEM and GOLD.

Dividend yields of GDX main holdings are also at their highest levels since 2013 - the year when we saw a major drop in the price of gold that ultimately led to dividend cuts across the board.

Not surprisingly, these generous dividend payouts have come under scrutiny over the past year as costs remain elevated and the price of gold is still range bound.

The $2,000 Floor For The Price Of Gold

The risk of a prolonged margin squeeze for gold miners appears to be the major risk that GDX investors face in the short-term. As inflationary pressures persist, speculation that the price of gold could fall materially have not gone away.

In my view, however, it is highly likely that the $2,000 mark could become a floor for the spot price of gold from here on. The reason being twofold:

• Firstly, the negative relationship between the price of gold and real interest rates has disappeared.

This relationship has been the key pillar in the bearish narrative for gold for many years and that's why called it a major misconception back in 2021.

• Secondly, a potential future recession would only exacerbate the current risks for the monetary system which in turn provides a major tailwind for the price of gold.

In addition to the yield curve inversion, the Conference Board Leading Economic Index® ((LEI)) is also signalling an upcoming economic slowdown.

The index continues falling in July and its annual change is now recession territory.

The Conference Board Leading Economic Index® ((LEI)) for the U.S. declined by 0.4 percent in July 2023 to 105.8 (2016=100), following a decline of 0.7 percent in June. The LEI is down 4.0 percent over the six-month period between January and July 2023—a slight deterioration from its 3.7 percent contraction over the previous six months (July 2022 to January 2023).

Source: conference-board.org

On one hand, lower economic activity could keep commodity and energy prices in check in the short run which would be an important tailwind for gold miners' profitability. More importantly, however, a more severe recession would require yet another unconventional monetary or fiscal response, which in turn would highlight the inability of the current system to cope with such events without intervention. I covered this topic in further detail a few years ago, but such interventions only strengthen the case for holding gold.

A major economic slowdown would also have negative consequences for the federal deficit which is an event that usually occurs post a recession and is not preceding it. In combination with the record high interest payments on government debt, this could easily turn into a disaster and spur a flight to safety.

Navigating the record high money supply and the risk of a sharp increase in money velocity is yet another risk that could undermine the stability of the monetary regime.

All that creates a favourable environment for the price of gold and provided that energy and commodity prices remain stable for the time being, it could easily result in a major tailwind for gold mining companies too.

Conclusion

Having a direct exposure to the price of gold as an addition to an equity portfolio is beneficial over the long run. Over shorter time horizons, however, GDX could offer superior returns, provided that the market timing is right. Given the current dynamic between the price of gold and cost inputs, it appears that the market is pricing a too pessimistic scenario for gold miners which in my view makes a strong case that GDX could outperform the SPDR® Gold Shares ETF ( GLD ) over the short-term.

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