2023-06-29 01:07:56 ET
Summary
- The VanEck Gold Miners ETF has lost 18% since May, with downside momentum building in gold since it failed to maintain the $2,000 level. Free cash flows from their 2021 peak, indicating a potential further crash in the GDX.
- The GDX ETF tracks the NYSE Arca Gold Mining Index. The ETF's already low yield of 1.6% is at risk of declining as free cash flows across the sector continue to dry up.
- The gold mining sector's balance sheet is healthier than in 2015, but the prospect of negative free cash flows, falling dividends per share, and a rise in equity issuance could lead to a crash in the GDX.
The VanEck Gold Miners ETF ( GDX ) has lost 18% since its May peak, more than double the loss seen in gold prices over this time. Downside momentum appears to be building in gold since its failure to hold on to the $2,000 level, and the GDX likely has significant further downside. As I argued last month , even a small drop in gold prices could cause the gold mining index to suffer from negative free cash flows. Since then, free cash flows have tumbled further and are now down 86% from their 2021 peak, with a contraction now looking highly likely, which could create another crash in the GDX as we saw in 2015.
The GDX ETF
The VanEck Gold Miners ETF tracks the performance of the NYSE Arca Gold Mining Index. Newmont ( NEM ) has the largest weighting on the index at 10.3%, followed by Barrick Gold ( GOLD ) which has an 8.9% weighting. These two stocks remain responsible for the bulk of the GDX's dividend payments, allowing the ETF to pay a yield of 1.6%, but even this low yield is at risk of declining as free cash flows across the sector continue to dry up. The GDX charges an expense ratio of 0.51%, which also acts as a meaningful drag on long-term returns. While the ETF has historically been slightly less volatile than the VanEck Vectors Junior Gold Miners ETF ( GDXJ ), it still has extremely beta to the price of gold, making it highly susceptible to gold bear markets.
Gold Price Decline Gaining Momentum
The extreme divergence between gold prices and their fair value based on inflation-linked bond yields has begun to normalize as gold has moved lower, but even as gold has lost value, its fair value has continued to decline thanks to continued upside pressure on real yields. The chart below shows 10-year inflation-linked bond yields vs gold prices.
Gold's overvaluation is even greater when we compare it with the yield on shorter-term inflation-linked bonds as short-term real yields are now considerably higher than long-term yields. 1-year real yields are now extremely high at 3.6% as short-term rates continue to climb even as inflation 1-year expectations have fallen back below 2%. Should we start investors pare back their expectations of rate cuts over the coming years, long-term real yields may spike further to the detriment of gold's fair value, and most likely gold prices.
A Cash Crunch Is Coming
Even at current gold prices gold miners are barely generating any free cash flows. In dollar terms, total free cash flows for the NYSE Arca Gold Mining Index stand at just $2.7bn, putting the price to free cash flow ratio at a staggering 100x.
Assuming no change in capex, it would take just a 10% decline in operating cash flows to tip free cash flows into negative territory, and at current operating margins this would require just a 3% decline in sales per share. As we saw in the last gold bear market that ended in 2015, gold mining costs tend to decline with a lag, so it is now highly likely that we see negative cash earnings over the coming months as the effect of the recent decline in gold prices shows up in earnings data.
While the gold mining sector's balance sheet is in better shape than it was in 2015, the prospect of negative free cash flows, falling dividends per share, and a rise in equity issuance could lead to a crash in the GDX. Note that at the valuation lows in 2015, the GDX traded at less than half of current valuations in terms of its price-to-book and price-to-sales ratios, which hit lows of 0.7x and 1.3x, respectively. Note also that this crash low occurred when nominal and real borrowing costs were far lower than they are today.
Fed Reversal Unlikely Before Further Losses
A reversal in monetary policy combined with rock bottom valuations for the gold mining sector allowed for a strong recovery in the GDX following its 2015 lows, and a reversal in policy by the Fed would certainly improve the outlook for the ETF. However, such a policy reversal would likely require some sort of deflationary credit stress to shock policymakers into action as we saw in 2015 and before that in 2008. The problem for GDX investors is that these events tend to be particularly negative for gold mining stocks due to their low free cash flow margins.
For further details see:
GDX: Crash Risks Rising As Cash Crunch Intensifies