GDXJ: Weakness Is An Overreaction To Fed Hike Fears

Summary

• The rise in real bond yields over the past few weeks has kicked the legs from under the gold price recovery in place since March last year.
• The VanEck Vectors Junior Gold Miners ETF (GDXJ) is now down 45% from its August 2020 peak, and back below pre-Covid levels.
• Such weakness has come despite gold rising over this period, which has left the GDXJ trading at deeply depressed valuation levels.
• The recent rise in real government bond yields is likely to prove temporary as equity market concerns force the Fed to keep policy loose despite elevated inflation.
• This should allow the long-term gold bull market to continue, which should result in strong returns for the GDXJ given its long-term trend of outperformance during periods of gold upside.

scyther5/iStock via Getty Images

The rise in real bond yields over the past few weeks has kicked the legs from under the gold price recovery in place since March last year. Gold mining stocks have been hit particularly hard, with the VanEck Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) down 45% from its August 2020 peak, and back below pre-Covid levels. Such weakness has come despite gold rising over this period, which has left the GDXJ trading at deeply depressed valuation levels. While a further rise in real yields would likely keep the ETF depressed, at these levels the risk-reward outlook is particularly favourable.

GDXJ tracks the performance of the MVIS Global Junior Gold Miners Index, a market-cap-weighted index of global gold- and silver-mining firms, focusing on small and mid-caps. The index covers global precious-metals-mining firms that generate at least 50% of their revenues from gold and silver. To ensure diversification, single stocks are capped at 8%. A sector-weighting cap factor is employed to ensure that 80% are determined as gold stocks, and silver stocks are limited to not go above 20%.

GDXJ Vs Gold Price

Bloomberg

While the 0.53% expense ratio the fund charges is on the high side, it is likely to be a negligible contributor to long-term performance given the high level of volatility in the sector. This higher volatility manifests in outperformance during times of gold price strength and underperformance during periods of gold price weakness. As can be seen on the chart above, despite gold being up since its March 2021 low, the GDXJ is actually down significantly.

Valuation Discount Is Substantial

This price weakness has resulted from declining valuations, with the GDXJ's underlying MVIS Global Junior Gold Miners Index now trading at deeply discounted levels as the chart below shows. On a forward Enterprise Value/EBITDA basis, the index trades at 5.3x, while the forward Price/Earnings ratio is 14.6x.

GDXJ Forward EV/EBITDA and P/E

Bloomberg

The degree of undervaluation is even more significant when compared relative to the broader stock market. Even after the recent market weakness, the MSCI World trades at a forward EV/EBITDA of 12.1x and a forward P/E of 18.1x. The GDXJ's discount to the market contrasts greatly with the historical premium that gold mining investors have paid and strongly suggests long-term outperformance.

Real Yield Outlook Is Key

The key question, though, is whether we are in for more upside in real yields as the Fed's priority shifts towards inflation fighting. As the chart below shows, gold prices are inextricably linked to real bond yields, and continued upside in real yields would likely spell trouble for the mining sector, justifying its current valuation discount.

Gold Price Vs 10-Year Inflation-Linked Bond Yield (Inverted)

Bloomberg

I believe the long-term trend of lower real bond yields has further to go. As I argued in 'GDX: Assessing The Damage From The Fed Minutes', the Fed will ultimately be forced to keep monetary conditions extremely loose due to two factors: its desire to support the stock market, and its need to keep government borrowing costs low.

Regarding the first point, the past few weeks of equity market weakness has seen bond yields across the middle and long end of the curve decline despite a rise in short-term rate hike expectations. As rising short-term rates have pressured equities, bond investors have begun to pare back their long-term rate expectations. Any further equity weakness would likely drive down long-term yields as investors price in an about-turn by the Fed.

Regarding the second point, the Fed is also constrained by the actions of Congress, with continued large fiscal deficits necessitating continued bond buying and driving up inflation. The rise in government debt over the past two years is the primary cause of the multi-year high inflation prints we currently see. In theory, the Fed could hike interest rates and reduce debt monetization to force Congress to cut spending or raise taxes to prevent a surge in interest rates and bond yields. However, doing so would be highly unpopular and potentially usher in a recession. A much more likely scenario is for the Fed to continue encouraging fiscal largess and driving a further wedge between inflation expectations and interest rate expectations.

Summary

The GDXJ has declined by almost half since its 2020 peak despite gold prices remaining relatively stable, resulting in deeply discounted valuations. The recent rise in real government bond yields is likely to prove temporary as equity market concerns force the Fed to keep policy loose despite elevated inflation. This should allow the long-term gold bull market to continue which should result in strong returns for the GDXJ given its long-term trend of outperformance during periods of gold upside.

Disclosure: I/we have a beneficial long position in the shares of GDXJ either through stock ownership, options, or other derivatives. 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.