In my January update on the VanEck Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) I argued that the poor performance of the ETF was at odds with the elevated price of gold and the positive outlook for the metal, which made small and mid-cap gold miners highly attractive. After a 38% rally off the January lows fueled by rising gold prices, the GDXJ has since given back all of its gains as gold prices have come under pressure from rising U.S. real yields. After taking some profit on the GDXJ on strength last month, I am not using the recent weakness to add to my positions as valuations and real yields do not support such a move.
The 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%. The GDXJ charges an expense fee of 0.53% and has a current dividend yield of 0.93%.
Many gold mining bulls point to the poor performance of the GDXJ relative to the price of gold as a reason to expect significant upside in the ETF. As the chart below shows, when gold first traded at current levels in 2011, the GDXJ traded over three times higher than it does now.
However, this is an apples-to-oranges comparison. The reason being that the GDXJ price does not take into account the dramatic increase in the market capitalization of the underlying index over this period. A surge in share issuance among the stocks in the index has seen the market capitalization of the MVIS Global Junior Gold Miners Index rise significantly over this period.
As a result, while one might expect the low price of the GDXJ relative to gold to result in extremely cheap per share valuations, this has not been the case. Even as gold prices have risen 70% since their 2018 lows, sales per share on the MVIS Global Junior Gold Miners Index have gone nowhere. As a result, the price-to-sales ratio, at 2.5x, is still above its 10-year average. While profit margins have managed to rise slightly over the past few years, the trailing price-to-earnings ratio is still by no means cheap at 22.0x.
While I still believe that real interest rates will remain deeply negative over the long term as the Fed prioritizes growth and asset prices over inflation, the rise in real bond yields cannot be ignored and is a major headwind to gold prices. After yesterday's sharp rise in bond yields and decline in inflation expectations, 10-year inflation-linked bond yields crossed back over into positive territory for the first time since March 2020, and imply a much weaker gold price than current levels. If gold were to follow the path of real bond yields, we could easily see the metal head back down to USD1500 over the coming months.
Despite the headwinds facing the GDXJ, I still think the ETF will outperform U.S. stocks over the coming years as loose monetary and fiscal policy keep inflation elevated and drive up gold prices. The GDXJ is still undervalued relative to the S&P500 on most valuation metrics, particularly the ones that strip out the latter's unsustainably high-profit margins. However, I see little benefit to holding the GDXJ over gold itself. While it is true that a recovery in gold prices would likely cause the GDXJ to rally even more aggressively as has been the case in the past, this volatility works both ways. With the history of share dilution and the high expense ratio on the GDXJ, investors may be better served investing in the metal itself in risk-adjusted terms.
The GDXJ has given back most of the gains made from the February-April rally, underperforming gold significantly over the past few weeks. Despite this underperformance, the GDXJ is by no means cheap as sales and earnings have been diluted by persistent share issuance in the underlying stocks. With real U.S. bond yields continue to rise, now back into positive territory, gold prices look likely to come under further downward pressure, which suggests further weakness for the GDXJ. While I continue to expect outperformance relative to U.S. stocks over the long term, investors may be better served investing in gold itself.
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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.