Ivan Martchev

The Great Gold/Silver Divergence Continues

The price of "poor man's gold," aka silver, traded at multi-year lows last week, dipping below $14/oz. marginally and barely closing above that key level at the end of the week. Do you know where the price of gold was the last time silver hovered around $14 in late 2015 and early 2016? Below $1,050/oz.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I do not believe that silver will "hold" $14, as they say in the trading business, and will go much lower, as we have rising interest rates in the U.S., combined with late-cycle fiscal stimulus. Such an environment is ripe for a continued dollar rally, which is being helped by the Trump administration's aggressive attempts to rebalance the U.S. trade deficit. The Broad Trade-Weighted U.S. Dollar Index is up sharply this year, and the precious metals tend to trade in an inverse ratio to the dollar. As the dollar rises, gold tends to fall.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

As I have mentioned here previously, President Trump does not have to completely eliminate the trade deficit for the broad trade-weighted dollar to reach an all-time high. As we are in the middle of the trade battle to rebalance the biggest problem in the U.S. trade deficit - namely, the situation with China - it is worthwhile to point out, again, that the trade picture is not nearly as bad as it was during the years of the George H.W. Bush administration, when the trade deficit reached 6% of GDP.

At 2.4% of GDP, the U.S. trade deficit is exactly where it was 30 years ago, while the U.S. economy has grown more than four-fold. I realize that the absolute numbers seem horrific - like the $375 billion imbalance with China - but the situation is not nearly as bad as Mr. Trump portrays it to be. That said, the U.S. trade policy was badly in need of an overhaul, and his aggressive actions are addressing that issue.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

That said, some of the moves in the emerging markets currency space are horrific. It is not only the Argentine peso and Turkish lira that are under pressure. All emerging markets' free-floating currencies - including the ones with "dirty pegs" - are under pressure, which has caused a rather disconcerting dive in the JPMorgan Emerging Markets Currency Index, which at last count is at an all-time low.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Could it be that such profound weakness in the EM currency space is causing safe haven buying of gold bullion, and hence we have this divergence between a really weak silver price and a less-weak gold bullion price? Yes, that could be, but based on historical correlations, if the non-trade-weighted U.S. Dollar Index rallies meaningfully past 100, it would be surprising to see such gold strength continue.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

What Mining Stocks Are Telling Us

Just like silver bullion tends to be weaker than gold bullion during tough times for the precious metals, and vice versa (silver is stronger when investor interest is high), the same is true for the mining stocks relative to the metals. This is because of the operational leverage in mining stocks where, in theory, if they are not hedged, a 10% rise in the price of gold tends to produce a bigger boost in EPS growth to the tune of 20-30%, depending on the cost structure, in mining shares. At least this is what theory says.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In practice, all gold mining companies are different. Cost structures vary wildly, where strip mining tends to be the cheapest, while deep mining tends to be the most expensive. Then, we have to get into the grade of the deposits. Still, if one views the gold mining space via broad ETFs like the VanEck Vectors Gold Miners ETF (NYSEARCA:GDX) and the VanEck Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ), one would see that they have both taken out the lows they saw in late 2016, when gold traded down to $1120/oz.

It is worth pointing out that smaller-capitalization mining stocks tend to be more leveraged to the price of gold, as they are also a lot more speculative. You know the precious metals market is hot when a mining company with no production and no clear plans to start mining - which, in effect, is a call option on its mineral rights - sees its stock price flying. Those are the types of stocks that also experience spectacular crashes when the precious metals market is weak, as is the case at the moment.

This is where they say, the plot thickens. Based on the outlook for the U.S. economy, Fed policy, and trade policy, I expect the dollar rally to continue well past the end of 2018. Whether the gold price will take out $1000/oz. by year end is unknowable at the moment, but secondary indicators for precious metals prices surely say that the precious metals market is a lot weaker than the present level of gold prices suggests.

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