Gold Thesis: Gold Wins When Bonds Break

Mar. 16, 2020 6:15 PM ETGDX, GDXJ, AEM, AUY, AEM:CA, YRI:CA34 Comments25 Likes
Don Durrett profile picture
Don Durrett
4.66K Followers

Summary

  • Exter's Pyramid implies a potential run to gold.
  • The Coronavirus seems to have lit a fuse in the financial markets.
  • A few cracks in the bond market is all that is needed for gold to move higher.
  • Ultimately, the gold miners could benefit in a big way.

It's March 13th, the S&P 500 is down about 25% from its recent ATH (all-time high), and the Coronavirus is still spreading. The odds are good that volatility in the markets will continue in the near term. The S&P 500 rallied today and is back above the critical 200 WMA (week moving average) support level, but I think this level will be retested soon.

Is this sell-off event the follow-up financial crisis that many have been waiting for since 2008? Is the Coronavirus the pin that will pop the "everything" bubble? So far this market sell-off has not brought on another financial crisis. No banks or financial institutions have failed like what occurred in 2008. So far all we have had is a large sell-off.

Is there going to be a second phase to this sell-off that brings on another financial crisis? No one knows for sure, but if the Coronavirus continues to spread in Europe and the USA, then the odds certainly increase for that outcome.

Exter's Pyramid

The question arises: how well prepared is the global financial system for the next crisis? As a gold investor you need to be aware of Exter's Pyramid. This is the pyramid of risk and gold sits at the bottom, as the ultimate safe-haven asset. Right above gold is cash, followed by short-term bonds (see below).

Exter

As long as cash and short-term bonds are considered safe assets, then gold is not needed as a hedge. This is why most investors do not hold any gold in their portfolio. However, if the bond market begins to crack, the only place to go for safety is cash, and then gold. Moreover, if governments print money like a banshee, then even cash becomes suspect due to inflation and debt concerns.

We have not had inflation fears in the US since the 1980s, although other countries have. Plus, we have not had global bond fears since 2008 to 2010. The reason why gold increased in value from 2009 until 2011 (in my opinion) was from bond and currency fears, as investors moved down the pyramid to acquire more asset safety. I call this the gold fear-trade, which could easily return if bonds begin to crack.

Gold is the ultimate asset according to the Exter risk Pyramid. However, this asset is ONLY needed when the rest of the Pyramid fails, or partially fails. If the levels above gold hold their value (especially bonds), then gold is not needed and has little demand. Such is the situation we are experiencing at this moment. When I say little demand, I am referring to the fact that only about 1% of investors hold any gold in their investment portfolio, and most investment advisors consider gold something that only central banks own.

Gold Mining Stocks

During recent market crashes of 2001, 2008, and again this week, investors sold gold to raise cash. Gold was considered an expendable asset and was mostly sold instead of bought. Because gold miners are dependent on gold prices for their share price, they are not hedged very well during a market crash. In fact, gold mining stocks are considered a risk-on asset, and thus are usually sold during market crashes. That happened this week.

So, during a market crash, we usually see gold sold off and gold mining stocks as well. The ugly truth about investing in gold mining stocks is their risk is atrocious. Not only is it difficult to make money investing in gold miners, but they crash hard during market sell-offs -- which are inevitable.

Why even buy gold mining stocks if the risk is so high? Because if the financial system breaks and the bond market partially fails, the move to gold will be significant. The best corollary investment that will benefit in a huge way from global bond defaults will be gold mining stocks. I am expecting a breakdown in the bond market in the near term and that's why I am overweight gold miners.

My Gold Investment Thesis

I'm a big believer that the debt bubble is really a bond bubble. This bond bubble is across the globe and is valued at around $100 trillion. As a gold investor, all I need is 1% of the bond market to default. That is all that is needed for investors to make a move into gold as a hedge against bonds and fiat currencies.

Currently, the most common investment allocation is 60% equities and 40% bonds. Those bonds are held for safety. But what happens if bonds begin to fail? Suddenly, the ultimate safe haven (GOLD) becomes attractive. I realize that my thesis is a stretch looking at history, because since 1945, there has never been a global bond breakdown that pushed investors into gold in a big way.

This unusual thesis of focusing on global bond defaults for higher gold prices is the reason why I consider this a once in a lifetime investment. I plan to sit tight in my gold mining stocks and wait for the bond market to pop. If I'm right, then the wait will have been worth it, and then I can get out. I plan to never to look at gold again as an investment, or perhaps hold on to a little bit of physical gold. But no more miners! Why? The risk is too high.

Let's presume I am right and the bond market is getting ready to pop. What's going to happen? Well, with that outcome, gold is easily going to a new high above $1,935. I say easily, because that is nowhere near the likely top. So, we are talking about $2,500, $3,000, even higher. At those levels, what do you think the gold miner valuations will be?

Big Potential Returns

I've been a gold mining stock investor since 2004, so I have thought quite a bit about future valuations. The first thing to consider is free cash flow. The average gold miner is worth about 5x free cash flow. Quality gold miners are valued around 10x free cash flow, and the elite gold miners can be valued above 20x free cash flow. If my thesis is right and gold breaks out in a big way, then the quality gold miners will be valued somewhere between 10x and 20x free cash flow.

Do the math for a few Canadian gold producers and see what kind of upside potential is possible if my thesis holds. Here are some steps that can be used to easily calculate an estimated future market cap. This can be compared to their current market cap to calculate an upside potential.

1) Go to Sedar.com and you can easily find their last quarter financial statement. Find their net income for the last quarter and multiply it by 4 to get an estimated free cash flow for the next year.

2) Go to their website and find out how many ounces they will produce in 2020 from their company presentation.

3) Divide the total number of ounces of expected 2020 production (step 2) by the estimated free cash flow (step 1). This will give you the free cash flow per oz. of production.

4) Calculate their estimated future annual free cash flow per oz. by adding $500 per oz. to their current amount of free cash flow per oz. (step 3).

5) Calculate their future market cap as follows: Number of ounces of expected production x future cash flow per oz (step 4) x 10 (conservative multiplier).

6) Compare their current market cap to their potential future market cap (step 5).

You will find that most Canadian producers have the potential to be valued at multiples of their current market cap if my thesis holds.

The HUI (gold miners index for large-cap miners) is currently at 163. In 2011, when gold hit its high of $1,935 the HUI was at 635. Do the math. If we go back to a new high, the large-cap gold miners will rise in value around 300%, and that is the average return. What happens if gold reaches $2,500? The returns could be stunning. And this doesn't even include returns for mid-tier producers and juniors, which will be higher.

Easiest Way to Play

The two big gold miner ETFs (GDX and GDXJ) are the easiest ways to take a position in gold mining stocks. They won't outperform many of the mid-tier producers and juniors, but they will reduce your risk exposure. The yearly fees for these ETFs are quite low considering you are getting a professionally managed fund.

If you don't like ETFs, then my favorite large-cap gold producers are Kirkland Lake Gold (KL), Yamana Gold (AUY), and Agnico Eagle Mines (AEM).

Catching a Falling Knife

I doubt that we are at the bottom, considering the volatility in the markets that we are currently experiencing. The HUI is currently at 163 and the low was 100 in 2015. So, conceivably could retrace back to 100. I would say good entry points are 150 and 125. I consider 150 to be the distressed level. Anything sub 150 is a buy signal in my mind.

Conclusion

This is a once in a lifetime investment. You don't get those returns in a sector more than once, unless perhaps you are in it for a lifetime. But for most of us, this is it. This is our opportunity to have massive returns in a short period of time. Of course, you don't have the possibility to have those large returns without extremely high risk. Waiting for the bond market to crack requires exposure to extreme market volatility. Welcome to the gold miners.

I often think that I know how Michael Burry felt during the housing bubble, when he shorted the housing market from 2005 to 2008. His experience was chronicled in the Big Short. He had a thesis that the housing market would crash, but it required patience and waiting. He thought he was right, but he wasn't certain it would pay-off. I feel the same way. I'm confident the bond market is going crack, but I'm not certain. Plus, even it if does crack, there is no guarantee that my thesis of gold rising will occur.

This article was written by

Don Durrett profile picture
4.66K Followers
Author of How to Invest in Gold & Silver: A Complete Guide with a Focus on Mining Stocks. Expert on gold and silver mining stocks. Website: https://www.goldstockdata.com.Twitter: https://twitter.com/DonDurrettYoutube: https://t.co/TKA05E3Gsr?amp=1Instagram: https://www.instagram.com/dondurrett/Website: https://www.dondurrett.com
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Disclosure: I am/we are long GDXJ; KL; AUY. 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.

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