A Gold Rally Resembling 2016

Summary

• Gold has gained over +20% in three months.
• The narrative beyond gold's recent rally is about as convincing as that during the 2016 gold rally.
• Don't overstay your welcome in gold or the miners this time around.

Gold: Fear Trade Or Something More?

If there was an "asset class of the summer", it would have to be the gold complex. The price of physical gold has jumped +20% since May.

The weekly chart of gold looks attractive for chartists. A three-year basing pattern then clean break above 2016 and 2018 highs. Technicals alone, as we discuss below, won't bring the gold price back to 2011 highs, however.

As asked in our sub-title, is gold surging on fear of recession? Or trade war uncertainties. Or perhaps gold just goes through cycles, like any asset, and it so happens that gold price rises every few years.

The first question our readers have been asking is, "is gold reacting to the yield curve inversion". As shown below, in the four prior instances of a 10-2 yield curve inversion (all followed by U.S. recessions), gold has had major moves in three cases. During the shallow 1991 recession, gold traded sideways, then down. So, our response would be that the gold price does react to impending recessions. Although we note that the yield curve all but inverted in December 2018 (when everyone knew the economy was entering recession) and gold prices were falling. Either the gold market knew December 2018 was not the real recession warning or there is something else this time that sparked the gold rally in the past three months.

Is that "something else" sparking the gold price inflation in the economy? Not likely CPI and PCE inflation measures remain below the 2% inflation target. Even the University of Michigan Inflation Expectations are tame.

Gold, priced in dollars, also tends to rise when the greenback weakens. So, the recent dollar strength belies a strong gold rally.

In sum, we are lacking fundamental reasons to explain a continuation of the gold rally to 2011 highs. Unless, of course, the gold market is right, unlike in 2016, and the economy and financial markets are heading for disaster. The more likely scenario is, as soon as the trade wars are over and recession fears pass, money will come out of bonds and gold and go back into productive assets.

Gold Miners Are Finding Friends Among Mainstream Investors

Turning to the Gold Miners (GDX), these stocks have been an even better 2019 investment than physical gold. Probably a lot of short-covering in this chart.

However, the weekly chart of the gold miners is bumping up against 2016 highs, which should bring back bad memories for gold investors. We don't like it when talking heads on CNBC are recommending a 5% weight in gold miners for the Average Joe's retirement portfolio.

The peak-to-trough rally for the GDX in 2016 was +140%. For readers hoping for a repeat performance for GDX in 2019, we point out that the 2016 rally came from a low base. That said, the GDX probably will extend gains, at least testing the $32 level.

Moreover, looking at the biggest GDX holdings, valuation will soon become a headwind.

Newmont Goldcorp (NEM) (10.8% of GDX), like all the gold miners, are enjoying strong positive EPS revisions. Nevertheless, for the moment, earnings are not being revised up as fast as the stock price is rising. Of course, the market may be right and EPS for next year needs to be revised much higher. But with a P/E using the most up-to-date forward earnings at 25.3x, Newmont's stock price will probably come off current levels if the gold price just "plateaus" at $1,500. We like Newmont for growth, but we have a Sell based on our value criteria.

Barrick Gold Corp. (GOLD) (10.3% of GDX) is even more pricey at 37.2x forward earnings. Our valuation score (Enterprise Value/EBITDA) for Barrick is ranked 210 out of the 287 Materials companies we track. Not reassuring for a long-term hold.

Newcrest Mining (OTCPK:NCMGF) (6.8% of GDX) is the cheapest of the big gold miners on a P/E basis, but other valuation metrics leave us dubious. We have a sell on Newcrest as a value stock also.

We are not negative on gold miners here. But we are very prudent after the lightning-fast 2016 run-up in the GDX, in similar conditions. We are not against owning growth stocks with poor relative valuation scores in our methodology. However, this means greater attention must be paid to EPS and Revenue Revisions. If the analyst consensus no longer sees earnings accelerating, we'd get out of the miners… even if the price meltdown is underway.

One solution open to resource investors is to continue playing the gold miners during this rally, but proactively take profits into price strength. Money taken out of gold miners can be used to accumulate Energy stocks at bargain prices. We recommend targeting high-dividend paying Energy companies with strong balance sheets, as discussed in last week's Commentary, "Want Yield? Fuel Up On Energy".

Analyst’s 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.

Comments

[goldstd69]

what IS different this time is the debt burdens are even worse than 2016...the paper currencies are getting clobbered in terms of gold...europe is falling apart with deutsch bank but one symptom...Russian, China and other nations are buying gold like it was on sale month after month...major banks buying gold...change occurs at the margins and next will be the US dollar...what will gold do then???? who knows

[Robert 7809591]

"The more likely scenario is, as soon as the trade wars are over and recession fears pass, money will come out of bonds and gold and go back into productive assets."

Isnt that like saying once the rains stop people will put their umbrellas away and come out into the sunshine??

[thor11]

yes, it is. doesn't mean people won't have or buy umbrellas anymore. just that the price for umbrellas won't be the same as during the rain.

[Jeremy Robson]

I don't think that buying energy stocks when the economy is slowing down (after a ten year expansion) is good risk management.

[Tubsy]

Every author has an agenda. Clearly this one wants to sell Energy stocks.

The coming crash will be a once in a lifetime event. For holders of US energy stocks its a shame it will be in their lifetime.

[WMA, LLC]

not at all. We have 1 Energy holding. If you read carefully our article (seekingalpha.com/...), we are watching several high dividend-paying quality (no bankruptcy risk) Energy companies for an investment. We did not say it is time to pull the trigger, but as investors, doesn't it seem like a good idea, as Buffet often says, to BUY when there is blood in the streets?

[Tubsy]

My own blood has been running in the streets for the past 2 years waiting for the beginnings of a run in the precious metals complex. Do you honestly think I am going to sacrifice potentially ten bagging my investment for a 5% "bankruptcy free" yield?

Understand your audience:)

[WMA, LLC]

yes, interesting point here. The inveterate gold investors that have suffered sitting in this non-productive GLD for years have a different mind set than the Johnny-Come-Latlies who have only seen a positive return on their GLD lines.

[bdcortright]

This rally in gold is not just because of the trade war.... Look at the bond market, the negative yielding debt all around the world, look at money supply...

[WMA, LLC]

we have had negative yielding sovereigns in Europe for several years. Why is gold reacting now? The 10-2 US yield curve almost inverted in December, but gold did not really start taking off until this June....

gold is a pure sentiment trade, and for reasons X,Y, & Z people have decided that now is time to act on their latent fears.

[Ultrabase]

The author wrote: "we have had negative yielding sovereigns in Europe for several years. Why is gold reacting now?"

The reason gold is reacting now is because the yuan was devalued. Since March 2019, the yuan has been going down, and gold, silver, and platinum have been going up. It's a fact.

Could it be that certain people are eager to get their savings out of yuan, and so are buying gold, silver, and platinum instead?

[Palace]

The Fed hadn't capitulated several years ago. Only recently has it become clear that they can never normalize and that real rates are becoming more and more negative

[coloradan]

With all the uncertainty about financial markets (Trump irrationality, Chinese trade war, Boris Johnson and Brexit, stock buyouts petering out, negative interest rates, etc), a 5% diversification into gold and silver is just plain smart. Gold is characterized by long down periods and then sharp spikes. Everything is setting up for a sharp spike. The market is relatively small so even a 5% allocation by investors will sharply increase demand.

WMA, LLC: You can have your energy stocks, I'll bet on precious metal stocks. Let's compare results in 12 months.

I've been actively investing in precious metals for 3 years, and have done very well. There are still a lot of good individual gold stock plays, but it takes time and effort to do the research. When you get it right, it can be very lucrative. (My best investment, Great Bear Resources is a 13x+ since I bought in early '18. That offsets a lot of losers.)

Or just play it simple, invest in gold (GLD), GDX or GDXJ. My preference is the latter as these companies rise the most in rising gold price markets. And, if the price of gold continues to rise, there will be increasing takeover action for many of these companies.

As an aside, I find it amazing that so many company 401Ks, etc, don't offer any investments in this class. Really stupid, in my view.

[wizard98]

What a stupid article. We are in the 2nd inning of this massive move in Gold and Silver . The 2nd inning folks ! 0.5% of total investments is in gold and PM . That number should be 2% easy ( 4x more ) with 16 trillion in negative rate bonds . Yes - Interest rates are a BIG factor in this gold move unlike what the author says . Watch were gold is in 24 months from today .

[WMA, LLC]

what a stupid comment. What year/month did you buy your gold? Can you confirm that as of today (from your date of purchase) that your total return on gold (including dividends) is greater than the S&P 500 or the bond index total returns ?

[Gunne]

A few key differences with 2016.

-In 2016, there was no trade war between the US and China, today things are more sour.

-In 2016, the market knew that it didn't had to take Brexit in consideration for some time to come, now it could come rather quick.

-In 2016, gold didn't make a new high in major currencies, today it does in most major currencies.
pbs.twimg.com/...
source : goldchartsrus.com / Dan Popescu.

-In 2016, negative yielding debt topped below 12 trillion, and retreated. Nowadays, we're at 17 trillion and counting. Back then, there was virtually no corporate debt issued at a negative rate, now we passed the 1 trillion mark.
pbs.twimg.com/...
source : Biancoresearch, Bloomberg.

-In 2016, global bond yields were consolidating and started moving up, now we're at 120 year lows.
ei.marketwatch.com/...

In 2016, most major economies, didn't have an inverted yield curve, some very briefly. Nowadays, the charts looks different.
confoundedinterestnet.files.wordpress.com/...

In 2016, the US was still 100 basis points away from an inverted yield curve, nowadays we're about there.
fred.stlouisfed.org/...

[Nick007]

+ another -- gold rising as the dollar rises is a different beast

a decline in the strength of the dollar, a stated aim of the US president and one which he is willing to go to war with his own Fed to achieve, is another potential catalyst for gold

[Smarty_Pants]

I'd be interested to see how you calculate valuations. Here's my quick, back of the envelope, estimate for NEM:

2018H2 EPS = $0.73 Average gold price = $1,225
2019H1 EPS = $0.45 Average gold price = $1,300
TTM: $0.73 + $0.45 = $1.18
Price on 7/25/2019 = $37.28 (after EPS announcement) TTM P/E = 31.6

Average gold price 2019 H2 = $1,450 (or higher if prices hold above $1,500)

2019H2 + 2020H1 Revenues should increase by 10% to 15% over the next year just from increased price of gold. That's an extra $200+ to $300+ million (10% to 15% of TTM revenue) going straight to the bottom line, or about $0.25 to $0.37/share.

TTM + $0.25 = $1.43/share x P/E of 31.6 => $45.19/share
TTM + $0.37 = $1.55/share x P/E of 31.6 => $48.98/share
(Analysts average EPS for Dec2020 is $1.87)

That's not including any potential multiple expansion, added production, or higher gold prices. Even conservatively the current price of $40.39 is at least "fair value" (likely a bit below that) for a year from now.

A 31.6 P/E on $1.87 gives a valuation of $59.

You can argue that you believe a P/E of 25.3 is deserved, but Mr. Market thinks a P/E of 31.6 is what NEM deserved for TTM results after the last earnings announcement, so that's what I used for estimating future valuation. If the price of gold stays above $1,500, or increases more, then Mr. Market will begin 'normalizing' the higher P/E ratios.

[WMA, LLC]

It is a difficult exercise to forecast EPS on the miners, unless you have a crystal ball to tell you each gold price inflection point.
We used 2020 consensus forecast earnings to get the 25.3 PE on Newmont. Maybe the industry expert analysts are mistaken. In any case, earnings = gold price. We own three miners in our Top Picks portfolio and its not EPS that were are watching. seekingalpha.com/...

[Smarty_Pants]

"It is a difficult exercise to forecast EPS on the miners, unless you have a crystal ball to tell you each gold price inflection point." - WMA, LLC

And yet analysts get paid to make those forecasts, and you use them as a basis for your own valuations and as inputs into your buy/sell decisions.

Forward P/E ratios for NEM, GOLD, and FNV all exceeded 30 during the 2016 gold rally. Yet you value NEM as a "Sell" at a forward P/E of 25.3?

What reason do you have for believing forward P/Es won't go over 30 now? I can identify recent historic data under similar circumstances (rising gold prices) which supports my assumption. What drives your assumption that a forward P/E of 25.3 is "too high" for the current conditions in the gold market?

Your valuation multiple of 25.3 on forward earnings being too high doesn't make much sense to me, but I respect your right to have an opinion which differs from mine on the matter.

[WMA, LLC]

?? We said that NEM is a sell on our Value criteria. The company is expensive within the Materials sector. Yet we have an overall Buy because the Growth element currently outweighs the valuation headwind. And, as WMA Trade Book subscribers can attest, we have been LONG Newmont since May 29, 2019 and the line is at +27.9% for our Top Picks portfolio

[RenoGuy]

Meant to say “it’s now clear”

[RenoGuy]

Gold is rallying because it’s not clear that “temporary” extreme measures taken by central banks are in fact permanent measures. Incredibly low rates and quantitative easing make a nice backdrop for precious metals. The dollar is strong vs other fiat currencies, many of which are being printed by the second. But the supply of precious metals is relatively fixed which is why investors are flocking to it as a store of value.

[FarmerJan]

Gold is better than buying negative yielding bonds worldwide. The europeans, japanese and others understand this. Also pushing down U.S. bonds.

[Markjc63]

This rally has nothing to with 2016. People are starting to wake up and smell the coffee. It smells good. However something else stinks , US Government Debt. Trade war , that China will win in the end.

A total loss of confidence in the USD. Gold price moving higher = USD price being manipulated as it remains high.

The average American is knee deep in debt , more than at any other point in time. 1929 will NOT be The Great Recession , this one will top it. Nailed on that the whole house of cards crashes before Trump seeks a second term.

[Exit Strategy]

Yep, there’s a groundswell of deep unease across multiple domains of concern.

[gold_seeker]

I wouldn't touch energy stocks with a 10ft pole right now. Energy along with industrials are continuously performing terribly in this volatile market. Why would you give such a terrible recommendation to the average Joe? If you really cared about the average Joe just tell him to sit on cash, that way he can never lose any money.

[WMA, LLC]

Really? You would advise again buying high-quality Energy dividend payers today? What is your horizon 1-3 months? But you'll buy dividend-less gold miners after a once-in-5-years price spike!

[gold_seeker]

I wouldn't advise buying Gold miners to the average Joe. I would advise it to the folks who are willing to stomach the risk. I would, however, strongly advise to have 5 - 10% Gold to your portfolio. The market is heading towards a significant slow down and energy stocks will go through a significant down trend.

[WMA, LLC]

Gold is also a non-yielding asset. We don't understand why people jump on the "5% gold in your portfolio" bandwagon.
Uh, if Energy stocks are not *already* in a significant downtrend, I'd hate to see what you are referring to come true!