The internet/tech bubble back in 1998 to early 2000 was an irrational time in the stock market - and that's an understatement. This is when I cut my teeth in the market, so I remember quite well all of the euphoria and hype that permeated investors' minds at the time.
Then I look at a long-term chart of the Nasdaq, and what took place almost 20 years ago doesn't seem so out of the ordinary. Once again, we have a near vertical ascent in stocks, and valuations are swiftly rising.
I look at Nvidia, a company that is now worth just over $100 billion, and can't help but be reminded of valuations circa 1999.
Just to put things in perspective, Intel's market cap is at $172 billion. The difference in annual operating cash flow should put NVDA's valuation (or over-valuation) in perspective. Shades of 1999 indeed.
I'm not here trying to top-call the market, I don't know when general equities will cool down. All I will say, is that what's taking place is ultimately exceedingly bullish for gold.
Stocks are rising because rates remain low, Trump is talking about pumping up growth, and the global economy is recovering (growth is broad based and accelerating).
Bubbles are forming, and nobody is doing much to stop it all. This is the perfect breeding ground for inflation.
While recent PCE readings and other inflation data have remained stubbornly low over the last few months, inflation will not remain at these levels. Not in this environment - where asset prices are increasing everyday. And as a side note, M2 growth is inflation. Increases in the money supply simply haven't shown up in the data yet.
Gold (GLD) typically does well when general equities are in a bear market, and vice versa. However, there was one scenario that could take place where everything moves higher in value. In hyperinflationary economies, you will see both a rising stock market and rising gold price (priced in that economy's currency). We aren't in that type of environment now, and I don't believe that's where we are exactly going, but we could be heading for something much worse than the 1970's. That was the ultimate objective anyway, as I have always stated that significant monetary inflation is the only way to fix the debt crisis. That's a fact. There is simply no other resolution.
Gold is reacting, it is recovering from the bear market lows. Since the beginning of 2016 (which was roughly the bottom in the sector), the HUI is far outperforming the Nasdaq. Gold only started trailing behind the major U.S. indices a few months ago.
But gold actually bottomed in late 2015, and if you take its performance since then, it's gained more than the S&P 500.
However, the gains that have taken place so far in the precious metals and mining stocks are minuscule compared to what's to come. Gold is going to have the mother of all resets in price soon, it has to. This is because of simple supply/demand fundamentals. The more stocks and other assets rise in value, the stronger the fundamentals for gold become.
That's why I'm so focused on this sector.
Why A Reset Must Occur
For some reason, those negative on gold still believe that the precious metal is going into the triple digits in the short-term and will stay there for the long-term. But as I argued in 2015, you can't have gold under $1,000 for any extended period of time, it's just not going to happen. The fundamentals simply won't allow it.
Those bearish on the metal need to ask why gold didn't decline to $800-$900 back in 2015? Because if it was going to happen, then that certainly would have been the ideal time. And why isn't it there now?
The reason, is that supply/demand are going to continue to support gold at current prices, and will force much higher prices over the long-term.
The graph below is from the Q2 2017 Gold Demand Trends that was published by the WGC. It highlights the amount of cost-cutting by the gold producers and developers over the last 4-5 years. Spending on non-sustaining capex (new development projects) has completely dried up, and sustaining capex (spending on existing mines) is significantly less than it was in 2011-2013. Gold miners have gone into self-preservation mode in order to protect margins and repair balance sheets.
And it's worked, as AISC across the industry have declined and balance sheets are on the mend. However, this has come at the expense of current and (more importantly) future production.
Below are the 2016 output figures for the top gold mining companies. Most of the big names saw declines in production year over year. Even the smaller companies saw flat production levels on average.
The situation isn't going to improve, in fact, it's going to get worse. Newton's Third Law: For every action, there is an equal and opposite reaction. You can't have this drastic of a decline in spending without severe consequences to production.
Take Newmont (NEM)for example. Even if they get their mid to long-term projects online over the next few years, they are still going to experience flat to declining production.
It's the same situation for Barrick Gold (ABX), AngloGold Ashanti (AU), Gold Fields (GFI) (unless they get South Deep at full production), and other big miners. Goldcorp (GG) has some growth planned, as does Agnico-Eagle (AEM) and Kinross (KGC), but increased output from these companies is being more than offset by production declines at the other mining outfits.
This chart from the World Gold Council shows just how dire the situation is right now. The WGC compiled data for "for 700 mines and projects, collectively accounting for around 60-65% of global mine supply between 2010 and 2016. Unidentified and informal/artisanal gold production is excluded." Even if you factor high-probability projects (i.e. those highly likely to reach commercial production), there is going to be a steep drop-off in global gold production over the next 3-5 years.
The WGC concludes with the following:
Having plateaued in recent years, mine production will soon enter a period of decline....This is largely a consequence of sharp cuts in capital expenditure over recent years (total capex for companies in the HUI Index declined 65% between 2012 and 2016 ), as well as a lack of significant discoveries. We have seen this before: lower prices in the late 1990s and early 2000s also negatively impacted production and exploration in the years that followed. And while there are signs of renewed interest in brownfield development and extending the life of existing mines, these are not yet sufficient to offset the steep cuts in project development spending of recent years. Inevitably, the supply pipeline will be squeezed.
The speed at which production will fall is uncertain. As existing reserves are depleted, the current project pipeline will be unable to replace them fully. Over the long-term, the global production profile will depend on the trajectory of the gold price and potential exploration upside, particularly the speed with which brownfield exploration can be brought into production.
This sentence is key: Over the long-term, the global production profile will depend on the trajectory of the gold price.
Gold prices at $1,250 keep the sector breathing, but this isn't a healthy price level yet. It's certainly not enough to boost mine production over the next 3-4 years.
The only way to correct this problem is with higher gold prices. We also aren't talking $100-$200 increases either. $1,350 gold isn't going to move the needle enough for these companies and get them to really spend on exploration and development.
Also of note, while new gold projects have come online over the last three years, they are making smaller contributions compared to prior years. The graph below shows that the new mines built in 2014-2016 aren't mega projects that are substantial contributors to global gold production. You simply don't have any elephant sized deposits being brought online. There are big deposits out there, but they are mostly low grade and will cost billions of dollars to construct. You can't maintain a healthy industry with piecemeal projects like these. This graph shows that the project pipeline remains weak and the industry is just limping along - adding production bit by bit. Producers are trying to replenish large mines that are exhausted, and they aren't doing a good job of it.
Current gold prices are also causing reduced amounts of recycled gold, which is a key part of the supply chain. Total mine supply of gold was down 8% in Q2 2017 compared to the prior year quarter, almost entirely because of a drop in the amount of recycled gold. Mine production was down a fraction as well.
The low price environment is starting to impact the global supply of the precious metal. The more prices stay in the range, the greater the impact will be in the future. It will still take a while for all of this to affect the market, but it will definitely result in reduced volumes of gold production annually. Throw even lower prices of gold into the equation, and the timeline for reductions in output speeds up.
Again, gold investors are concerned about the precious metal declining down to $1,000 (or less). I don't believe we will see it drop to those levels, but I will admit, it always remains a possibility. I could never take that completely off the table because investors can act highly irrational.
But if it does, let's just go over what would take place.
For starters, the "cutting of spending to the bone" by the miners over the last few years has allowed them to significantly reduce AISC compared to 2012-2013 levels. AISC in 2016 were $954 per ounce on average, which resulted in healthy margin expansion. One thing I want to point out from this graph, is the industry has always maintained some type of positive margin every year. In other words, the price of gold has never fallen below the average cost of production. Miners have the ability to rein in spending, so that helps in those lean years. But they have already cut back this time around, and aggressively as well. There isn't any way to drive down costs further, other than shutting down high cost (low margin) production. That's only going to exacerbate the problem.
(Source: TD Securities)
If gold prices decline to say $950, then the industry is underwater (which has never happened). If it happens this time, then production gets shutdown, and the supply situation gets worse.
There is another variable to this as well. If you look at the graph above, you will see that in 2004, the AISC for the industry was just $331 per ounce. Even today, with the extreme cost cutting, the median AISC is almost 3x higher. This is simply because of inflationary pressures in the mining sector, which are continuous. Inflation occurs in everything, including the cost of mining. Labor costs rise, the cost of mining equipment increases, etc. Inflation in the mining sector is incessant. It's just like every other industry (at least non-tech). 20 years from now, the average AISC will probably be multiples higher than it is today. That's why gold continually rises over time. It's not because of sentiment, it's because the cost to produce continually increases.
If gold moves down to $950, then these mining companies are not only going to be fighting to preserve margins, they are also going to be battling inflationary pressures in their cost structures as well (which is a battle that never ends). AISC are much lower now than they were a few years ago, but the mining companies won't be able to maintain these costs over the next 2-5 years. AISC will start adjusting higher as inflationary pressures will rise.
The only way this industry can get around this cost of production issue (and the resulting drop in supply) is if there was a surge in output. Back in the 1980's and 1990's, you had significant quantities of big gold discoveries, which is why worldwide gold production doubled over the span of 10-15 years. That increase in production is also one reason why gold prices remained low for so long. Anytime you double the supply of anything, prices are going to be under pressure - unless there is enough demand to counterbalance the increase.
Now we are in the opposite situation, as global gold production is expected to remain flat at best over the next 5 years, but will most likely start to decline if the price environment doesn't improve.
The bottom line, is there is a significant structural issue that most market participants seem to be unaware of.
If we could speed up time and watch this play out, then I'm confident it would go almost exactly as I just described. The only thing that could alter this course for gold would be if there were: 1. some major high-grade discoveries, and/or 2. implementation/advances of technology in the mining sector that made these mines much more productive. It's doubtful that the former is going to occur. The latter could, but its impact would depend on how significant of an advance occurred. Considering that the sector is still using antiquated mining techniques, and the mining industry advances at a snails pace, I'm not counting on technology solving the problem. It seems a little like trying to push a square peg through a round hole.
Bringing this all-together: you have a rising stock market where p/e's are excessive and global economic growth is now accelerating, you have inflation "data" (and I use that term loosely) that is low but the Fed is hellbent on getting it higher (above even their preferred target), you have almost every asset class rising enormously in value over the last several years and it's not stopping or even slowing, then you have the gold price just starting to rebound from the depths of the bear market but not enough to positively impact the supply (which is on the verge of contracting and will do just that if prices stay at these levels or move lower).
That's the predicament. Assets are rising in value, which means more money in the system, which in turn is trying to chase a flat - to soon to be dwindling - amount of gold supply. If global M2 doubled overnight, imagine the impact that would have on the gold market. You would have twice the amount of money in the system that is trying to buy that same amount of gold. While M2 isn't going to move up 2x in 24 hours, the point is, over time it will. With the way the stock market is advancing and considering interest rates are ultra low, it's going to happen sooner rather than later.
The only way to correct this future imbalance is for a major reset in the price of gold. One which results in a doubling or tripling of the current value. If the gold sector sees annual supply shrink, then it will be absolutely necessary for this type of upward adjustment in price.
There are some who try and make the argument that there are still signifiant quantities of above ground stock of gold, so the industry wouldn't face a supply shortage. This is a very illogical argument to try and make. You can't look at the supply of gold in a vacuum. You have to take into consideration money supply growth, population increases, and other factors that impact demand.
So you have to ask, if the downside for gold is ~20-25% to reach $950-$1,000, but the upside is 2-3x what gold is trading at today, then why are investors fighting this market so aggressively and why are so many so worried about falling prices? More importantly, what exactly do the bears think the outcome is going to be here? Gold at $500? That's not going to happen.
This is why I will remain focused on the gold sector for the foreseeable future and not general equities. Why concentrate on the stock market, which hasn't outperformed gold or the HUI since the late 2015/early 2016 bear market lows and has an inferior risk/reward? The upside in gold remains far greater than the stock market. Trying to move Apple, Amazon, Facebook, etc. up 2x is like trying to move a mountain. Moving gold up 2x will be like flicking a gnat.
The Gold Edge
If you would like to read more of my thoughts, ideas, and research on the gold sector, including which companies I believe are best positioned for outsized returns in this bull market, you can subscribe to The Gold Edge, my premium service here on Seeking Alpha. There is currently a free, two-week trial.
Disclosure: I am/we are long KGC,GG,AU,GFI.
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.