Gold as an asset class was written off at the end of last year as the Federal Reserve prepared to hike its benchmark interest rates for the first time in more than a decade. With gold not finding favor among investors, it was not surprising to see gold miners struggle. However, both gold and gold mining stocks, have made a phenomenal comeback in 2016. The Market Vectors Gold Miners ETF (NYSEARCA:GDX) has gained more than 60%, year to date. The question is whether there is further upside in GDX.
Gold's Bull Run And The Crash
Gold's decade long bull run began in the 2003-2004 period. The precious metal though got a real shot in the arm post the financial crisis of 2008/2009. The crisis and the subsequent recession boosted gold's appeal as a safe haven asset. The precious metal has a reputation of doing well during times of turmoil. But it was not just gold's safe haven appeal that boosted prices. Gold also benefited from the Federal Reserve's unconventional monetary policy. In fact, it would be safe to say that gold mainly benefited from the Fed's unconventional monetary policy post the financial crisis.
The Fed first cut interest rates to near zero to support the economy. But as the U.S. economy risked falling into a depression, the central bank launched its first round of quantitative easing or QE. The Fed launched two more rounds of QE after that, with the third one being the biggest. In this period, gold prices rose to record high levels. The 10-year chart for gold below tells the whole story.
In 2011, gold touched record high levels and remained elevated until early 2013. The slide began after this as talks of the Federal Reserve winding down its QE program began. The Fed eventually ended QE in 2014 and it had been downhill for the precious metal until the end of last year.
Gold Miners Enjoy The Bull Run
Record high gold prices helped gold mining companies achieve record results. The 10-year chart below for gold mining stocks is not very different from the 10-year chart for gold itself. Mining stocks' decline though was much more significant than the decline in gold prices itself.
The decline in gold mining stocks was steeper when compared to gold because many of the mining companies loaded themselves up with debt during the boom years and when the crash began, they found their margins squeezed. To give you an idea of miners' underperformance to gold, in the two-year period (2014-2015), the SPDR Gold Trust ETF (NYSEARCA:GLD), which tracks physical gold, dropped 13.36%. In the same period, GDX dropped 35.43%. The performance was almost three times worse than physical gold. Interestingly as gold prices have bounced back this year, miners have outperformed gold prices significantly. Year to date, the GLD is up more than 16%, while GDX has gained more than 62%.
The reason for this significant outperformance is that when gold prices collapsed, miners were forced to cut costs, sell non-core mines and cut supplies. The table below shows the all-in sustaining costs for the major components of GDX.
Source: Zeal LLC
The two tables show the all-in sustaining costs for major components of GDX. The table on top shows costs from August 2015. The table just above shows costs from February 2016. As we can see, costs have come down significantly in the six-month period. Gold miners have been making adjustments in the low price environment since late 2014. And now that prices have bounced back, they are reaping the benefits.
Will GDX Continue Its Upward Trend?
The question is whether GDX has run its course or is there further upside. The answer depends upon the outlook for gold. As discussed above, mining stocks underperformed gold during the years when prices were under pressure and significantly outperformed the precious metal when prices have bounced back. Based on this relationship, it can be assumed that if gold prices remain steady, GDX will have a decent run.
There is every chance that gold prices will remain steady as the year progresses. The turmoil seen in global markets at the start of the year has eased but we are not yet out of the woods completely. Chinese economic data in recent weeks has been better but concerns about the world's second-largest economy remain. Although China has shown signs of recovery, this recovery is being driven by stimulus measures. More stimulus measures from China mean a more debt-laden economy. While this will provide a short-term boost, it makes the Chinese economy more vulnerable in the mid-to-long term. And a vulnerable Chinese economy is good news for safe haven assets like gold.
The first quarter economic data from the U.S. has not been very encouraging. Last week, a report showed that industrial production in the U.S. dropped more than expected in the month of March as manufacturing output dropped by the most in a year. A report on consumer sentiment showed that confidence has been declining among U.S. consumers. The data suggest that the U.S. economy is still fragile and the Fed might have hiked rate too soon.
In fact, since the first rate hike in December last year, the Fed has been more cautious in its stance. The turmoil in global markets has also been a factor in the Fed adopting a more cautious stance. At the end of last year, the Fed had predicted at least four rate hikes this year. This has now come down to two. And in fact, we could just end up with one rate hike given that the U.S. economy is showing some signs of weakness. The futures market indicates that we could not have a rate hike until December.
Given all these factors, gold prices could remain strong in the coming months. So the rally in GDX is probably not over. While we might not see the gains seen in the first three months of 2016, GDX could see further upside as the year progresses.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.