Investors often have the belief that movements in gold and gold mining stocks are caused by nominal interest rates, inflation, gold production, gold demand, the U.S. Dollar, etc. Likely, all these factors have a significant impact in gold price (at least in the short term), but in my opinion those are not the main factors affecting the price of gold in long rung. The only cause that always correlated with the gold and gold mining stocks bull markets has been a period of no value in U.S. stock markets, as we shall see below.
To start a bull market, gold mining stocks only need a period of poor stock market returns.
From 1900 to now as we see in the first chart below, gold miners have had three bull markets (identified by green ovals) and if we compare with next chart of U.S. stock market (Dow Jones Industrial Index) we can see clearly how each bull market of gold miners coincided with period when U.S. stock markets gave a poor return (identified by red box). More specifically between 1900 to 1935 gold miners (we have based the calculation on return of Homestake Mining Company Stock who was the biggest gold mining company in the United States in the period) gave a accumulated return over 700% while Dow Jones Industrial gave only around 40%. Between 1965 to 1983 Gold Mining Index (BGMI Index) gave a accumulated return over 1000% while Dow Jones Industrial gave only nearly 0%. Curiously 1900-1935 was a deflationary period and 1965-1983 was an inflationary period, in both periods gold miners were one the best assets class, so, what it's more important for gold miners performance in the long term, inflation/deflation or U.S. Stock valuations? The last gold miners bull market began between 2000 to 2011 when the Dot-com Bubble burst, then Gold Mining Index (BGMI Index) gave a accumulated return nearly 500% while Dow Jones Industrial gave a accumulated return around 4%.
Source: Global Financial Data
Source: Measuring Worth
On a CAPE Ratio basis, the U.S. stock market is at the third most expensive level it has ever been.
almost all advanced investors know the cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or P/E 10 ratio, it is a valuation measure applied to the S&P 500. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. Well, this generalized valuation measure of stock market tells us that from 1880 the price of S&P 500 Index was more expensive than today just twice (1929 and 1999). Having said that, we know that always this ratio have been over 24, U.S. stock indexes fell sharply while gold mining stocks rallied heavily.
Source: Home Page of Robert Shiller
Gold is money denominated in dollars, therefore gold and gold mining stocks should revalue themselves from a similar way to increase of the base money in dollars in the long run.
It is mostly assumed that the S&P 500 index represents the U.S. nominal GDP and therefore long-term appreciation of the index should be similar to U.S. nominal GDP growth. Following this reasoning if gold is considered money denominated in dollars and U.S. monetary base is money created in United States it would seems logical to think that the price of gold and thus the value of gold mining stocks in the long run should vary depending on the increase in United States monetary base (M0).
U.S. monetary base is the sum of currency (including coin) in circulation outside Federal Reserve Banks and the U.S. Treasury, plus deposits held by depository institutions at Federal Reserve Banks.
Source: Federal Reserve Bank of St. Louis
We can see in the chart below (normalized return of the U.S. Monetary Base and Gold Miners "Composite") as the value of gold miners historically moves around the monetary base. Usually when the CAPE is in average levels, gold miners performance is flat (underestimation) and when the CAPE reaches its peak and begins a period of contraction it cause a sharp rally in gold mining stocks (overvaluation). Now gold mining stocks would have to rise by over 400% to match the historical increase in the U.S. monetary base.
I have tried to show in this article that the major factor affecting the price of gold and gold mining stocks in the long-term is the U.S. stock market valuation and not interest rates, inflation, gold production etc. Having said that, I think now is a good time to invest (for the long term investors) in gold mining stocks and ETFs, such as the Market Vectors Gold Miners ETF (NYSEARCA:GDX) and the Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ), mainly for two reasons:
- The CAPE ratio shows U.S. stock market valuations are too expensive now, and soon CAPE could reach its cycle peak. That's good for gold mining stocks.
- Gold mining stocks prices are far from their main driver, the U.S. monetary base historical increase (in fact, the most away in the history).
I think that gold mining stocks upside will be more than 500% in the next 5 to 10 years.
Disclosure: I am/we are long GDXJ, GDX.
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.