SGDJ - SGDJ Could Fall Sharply If Gold Turns Bearish

2023-04-25 05:45:14 ET

Summary

• Recently, a speculative process fueled by fears of a financial crisis has seen gold close a significant portion of the gap to the August 2020 all-time high of $2,074.88/oz.
• The speculative process that led to gold's rally appears to have abated somewhat and gold may now turn bearish as prominent central bankers have hinted at additional rate hikes.
• Investors should consider selling shares of the Sprott Junior Gold Miners ETF and lock in profits by taking advantage of high prices, as shares of this fund could fall sharply.
• This fund primarily invests in publicly traded junior gold exploration and production companies. SGDJ is a non-diversified fund.
• A Sell rating for this fund carries the risk that a recession could trigger another gold bull market. However, a soft landing is not a distant possibility.

Given the possibility of bearish sentiment for gold that would drive the market price of US-listed gold stocks lower, this analysis supports a Sell rating-based thesis for Sprott Junior Gold Miners ETF ( SGDJ ) shares.

The Gold Price Outlook

Check out the Trading Economics chart below to see the recent breathtaking rally in gold prices.

Fear of a domino effect in the financial industry following the collapse of Silicon Valley Bank (SIVBQ) and Signature Bank ( OTC:SBNY ) in early March 2023 has fueled demand for gold as a safe haven asset.

The story of banks buying gold to hedge against a financial crisis went just far enough to trigger a speculative process that allowed the ounce to close a significant portion of the gap to the August 2020 all-time high of $2,074.88 a troy ounce.

Although gold is viewed as a safe haven amid the financial markets crisis, it will not offset currency panics should they occur. That's because the gold reserves that central banks hold to guarantee the value of their currencies represent only a small percentage of the money supply in circulation.

Furthermore, if banks had a financial stability problem, instead of buying gold at sky-high prices, they would seek liquidity amid the billions of dollars in deposits they lost from the crisis unleashed by US regional banks’ failure in early March.

The speculative process that led to the gold rally appears to have eased off somewhat. Over the past 5 days, the precious metal has given back some of the gains it has accumulated over the past few weeks on renewed comments from central bank governors on bank stability and ahead of the Fed's expected rate hike from next May 3 meeting.

Rate traders are reckoning with a 90% chance of a 25-basis point hike taking the fed funds rate to 5-5.25%. The rise in interest rates does not bode well for gold prices as investors are once again lured into assets that pay a steady income. Interest coupons on these assets are adjusted upwards, increasing the opportunity cost of holding the bullion, which instead generates no cash flow.

As of this writing, Gold Futures – June 2023 (GCM3) was trading at $1,993.15, a far cry from the long-term trend of the 10-year moving average of ? $1,450 an ounce.

Current price levels will face headwinds in the coming weeks from a strong chance of further than widely expected interest rate tightening, as recently hinted at by Cleveland Fed President Loretta Mester and European Central Bank [ECB] President Christine Lagarde.

“I do think that given how stubborn inflation is and given the still strong labor market, I do think that rates are going to have to move up to above that 5% level,”, Loretta Mester said in an exclusive interview last week Thursday for Yahoo Finance Live.

Instead, the ECB's rate-hike policy “still has a bit of way to go,” Christine Lagarde told students at France’s elite school Polytechnique in Paris last week Thursday, Reuters.com reported .

According to Trading Economics, analysts are forecasting a downward trend in the price of gold per ounce for the coming period.

Analysts are putting a 12-month price target at $1,779.15 an ounce, reflecting a 10.7% decline from current levels.

The Performance of Gold Junior Explorers and Producers

The rally in physical gold prices has boosted the share price of US-listed gold companies, with junior gold stocks benefiting enormously as they typically serve well as speculative vehicles to take advantage of the yellow metal's strong positive momentum.

The following chart from Investing.com describes the relationship just mentioned as an 8.14% rise in Gold Futures – June 2023 (GCM3), the gold price benchmark (dark yellow line), resulting in a 15.68% rise in VanEck Vectors Junior Gold Miners ETF ( GDXJ ), since the beginning of March.

The latter is widely used in the investment community as a benchmark to measure the performance of US-listed gold junior companies.

However, if shares of these gold junior stocks rose when gold was bullish, they should fall as analysts expect gold prices to trade lower.

In order to anticipate a possible bearish market now investors may want to take profits as gold has very high prices after the speculative process, and maybe use the money differently in the financial markets.

A Sell Rating for Sprott Junior Gold Miners ETF

Investors may want to sell some shares of the Sprott Junior Gold Miners ETF ((SGDJ)) before this fund, which invests in US-listed junior gold exploration and mining stocks, potentially suffers a significant decline if gold turns bearish as expected. The fund is up 14.46% since early March as shown in the chart above (see green line) as it benefited from a high gold beta ratio during the bullish gold market.

The Beta Gold Ratio measures the Sprott Junior Gold Miners ETF's stock price returns as a function of the precious metal's price changes.

The Beta Gold Ratio for the Sprott Junior Gold Miners ETF is ? 2.54 according to a linear model run over the past year with weekly returns, where the ETF is the output (or the dependent variable) and Gold Futures - Jun 2023 (GCM3) is the input (or the independent variable).

2.54x means that the Sprott Junior Gold Miners ETF share price, on average, returns more than double the gold price gain while losing more than double the metal price if the latter is bearish.

So let's say if gold is expected to fall 10.7% in a year as analysts are predicting, the ETF on NYSEArca could lose ? 27% over the same period.

The model used to determine the Beta Gold ratio has a coefficient of determination of 68.3%, meaning that the Beta Gold is a reliable measure of the linear relationship between the two assets and it can therefore be used to make predictions. In statistics, the coefficient of determination [R²], which ranges from a lower bound of 0 (or 0%) to an upper bound of 1 (or 100%), indicates how well a statistical model predicts an outcome. The 68.3% percentage for the R² of this analysis shows that 68.3% of the change in weekly returns on the Sprott Junior Gold Miners ETF stock can be explained by weekly changes in the Gold Futures price - June 2023 (GCM3).

About Sprott Junior Gold Miners ETF

The Sprott Junior Gold Miners Exchange Traded Fund invests at least 90% of its net assets in securities making up the underlying index known as the Solactive Junior Gold Miners Custom Factors Index (SOLJGMFT).

The Underlying Index aims to track the performance of 'junior' gold exploration and mining companies primarily domiciled in North America and Australia.

The common stocks of the underlying index, as well as the American Depositary Receipts [ADRs] and Global Depositary Receipts [GDRs] are traded on a regulated exchange in the form of shares. Foreign investors can trade these shares freely. The Sprott Junior Gold Miners Exchange Traded Fund is a non-diversified fund.

The index uses a methodology that highlights junior gold stocks, which are also small-cap stocks, with market caps ranging from $200 million to $2 billion.

Sprott Junior Gold Miners ETF states that the index tracks “junior gold producers with the strongest revenue growth and junior explorers with the strongest share price momentum.”

The Index is recompiled semi-annually in November and May as it needs to reflect the most recent factor values in its component selection and weighting process.

Fund was launched on 31 March 2015 and implies total annual operating expenses less fee waiver/refund of 0.50%. The chart below from Seeking Alpha shows that the Sprott Junior Gold Miners ETF ((SGDJ)) is not the cheapest fund compared to its peers.

Operating costs consist of an administration fee of 0.35% and other expenses of 0.26%.

The fund has 3.39 million shares outstanding and the total value of assets under management by SGDJ was $114.23 million, or ? $33.70 per share. The fund is trading at a discount of 0.09% as of this writing when the share price was $33.67.

The fund's top 10 holdings make up ? 60% of Sprott Junior Gold Miners' ETF portfolio and a full list of these 43 holdings can be viewed here .

The Diagnostics of the Managed Assets

The Sprott Junior Gold Miners' ETF portfolio has exposure to an industry whose total market capitalization as of 3/31/2023 was ? $39.954 billion.

The largest market cap in this industry was ? $2.181 billion, the smallest market cap was $158 million, and the weighted average was ? $1.169 billion.

The portfolio's investments in large caps [>$10 billion] accounted for 0%, mid-caps [$2-$10 billion] for 12.17%, and small caps [<$2 billion] for 87.05%.

In terms of industries, gold accounted for 70.69% of total portfolio investment, precious metals for 29.06% and mineral mining for 0.26%.

56.4% of the holdings are located in Canada, 38.1% in Australia and the remaining 5.5% in Peru, the United States and the United Kingdom.

Distribution and Fund Performance in Comparison to the Peer Group

The fund distributes cash flows to shareholders annually and paid $0.7094 per share on December 22, 2022, which is leading to a trailing 12-month dividend yield of 2.11% as of this writing.

Sprott Junior Gold Miners ETF reported a 21.54% decline in the dividend growth rate over the last 12 months, despite gold traded at high price levels, while all ETFs increased the distribution by 16.28%.

The distribution of the Sprott Junior Gold Miners ETF compared to its peers is shown in the screenshot below:

The performance of the Sprott Junior Gold Miners ETF compared to its peers is shown in the screenshot below:

The Stock Valuation

Shares of the Sprott Junior Gold Miners ETF ((SGDJ)) were trading well above the 200-day simple moving average of $28.46, the 100-day simple moving average of $30.94 and the 50-day simple moving average traded from $31.16, as of this writing.

The 52-week range is $21.61 to $40.34, and its middle point is $30.975, so shares are also above this median value.

As such, these levels present an opportunity for investors to sell some of their positions and take profits before gold's expected decline pushes shares of the Sprott Junior Gold Miners ETF further down than they are now.

The risk of a Sell rating for Sprott Junior Gold Miners ETF shares is represented by the possibility of an economic recession following central bank rate hikes as higher borrowing costs hamper consumption and investment.

The recession could potentially lead to a bull market for gold. Gold is considered a safe haven asset in a recessionary scenario, investors buy it to protect the value of their assets from headwinds, and the price of the metal then rises.

But investors are aware that a Sell rating carries the risk of missing the opportunity that tracking gold price action will result in shares of the Sprott Junior Gold Miners ETF trading significantly higher amid recessionary headwinds.

The risk of a recession is there, but the negative cycle is not as obvious as many might think. The Fed's measures to contain inflation are working as the consumer price index [CPI] is now rising at its slowest pace since May 2021, increasing the odds of a soft landing for the economy.

We could be in for a soft landing where the economy does not collapse despite the Fed's aggressively tightening stance on interest rates to curb elevated inflation:

“the possibility of an economic soft landing is still very much alive”, says Myles Udland, Head of News at Yahoo Finance in the Morning Brief of April 13, 2023.

Conclusion

This analysis supports a Sell rating for shares of Sprott Junior Gold Miners ETF ((SGDJ)), a fund that invests in publicly traded stocks of junior gold exploration and mining companies. The fund's shares are traded on the NYSE Arca.

Due to the high volatility of the SGDJ's shares relative to changes in the precious metal price, the fund’s share price could fall significantly from current levels if the precious metal turns bearish as expected given the current macroeconomic environment.

A recession would instead cause a bullish gold price with positive implications for SGDJ, but a soft landing of the economy despite aggressive monetary policy is also possible and should not be far off.

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