Keep Your Eye on the Ball – August 25, 2023

Keep Your Eye on the Ball – August 25, 2023
Morgan Lewis Posted on August 26, 2023

Keep Your Eye on the Ball

This week’s highlights feature both weak and weaker-than-expected economic data in the US and around the globe. Consumer sentiment dropped, mortgage rates jumped to their highest level since 2001, and another credit ratings agency (S&P Global) followed Moody’s lead and slapped downgrades on a slew of US banks. One way or another and to varying degrees, all of the above are related to the Federal Reserve’s ongoing interest rate hiking cycle. It’s fitting then that the most anticipated event in markets this week by far was Jay Powell’s highly anticipated annual Jackson Hole Symposium speech. 

Ultimately, however, the hype wasn’t justified. Chairman Powell neglected to say much of anything new. The Fed-head just reiterated the same old message that, depending on incoming data, the Fed may opt to either further increase interest rates or not, but until inflation looks sustainably headed to the Fed’s 2% target, the higher-rates-for-longer regime will remain in place.

Next week’s HAI will detail some of the more notable data from this week and provide additional commentary on Powell’s speech. This week, HAI is dedicated to the topic of gold and the industry of gold-related companies.

Since peaking in late spring, gold has suffered a relatively mild, slow, and grinding correction. There has been no crash, but rather consolidation of the previous substantial up-move that started in late 2022. A corrective consolidation is normal, healthy, and to be expected for an asset that powerfully ran up from the low $1,600s in the autumn of 2022 to all-time-high overhead resistance during the late spring of 2023.

HAI firmly believes gold has an agenda, complete with plans for a significant breakout into new all-time high territory in its future. The move off the 2022 lows was a significant start, but much like a long-distance road trip, each completed leg of the journey necessitates a pit stop to recharge the driver and gas-up the tank. Gold’s correction since the spring has so far been absolutely consistent with just such a refuel phase.

In 2022 and so far in 2023, gold has displayed historically uncharacteristic relative strength in the context of a strong dollar, a meaningful increase in real yields, and a Fed tightening cycle that among other objectives sees Fed chairman Jay Powell intent upon restoring Fed institutional credibility. Gold could easily have suffered a steep decline in the face of that three-headed monster. So far, however, it hasn’t happened. Despite the ongoing corrective phase, gold has held up well. The current correction in the gold price has given back, from peak to recent trough, only $185 of the preceding $467 rally. In the midst of this mild, corrective, sideways grind under all-time highs, however, gold’s refueling process, so vital to the remainder of the trip, has been ongoing and constructive.

Technical and sentiment indicators at the highs of last spring were overbought and overcooked. They needed to cool, and have already largely reset to lower levels from which the gold market can initiated another rally leg. In addition, gold market positioning in the futures market has reset from excessively over-bullish levels last spring toward the initial stages of a capitulatory over-bearish position. Such a bearish posture in the futures market is a contrarian indicator. It is the necessary kindling for another rally leg. Over recent weeks, we have seen positioning in some of the most important segments of the futures market swing back toward levels that are typically consistent with late-stage declines and early-stage rallies.

In particular, we have seen the “hot money” in the space, mostly momentum trading hedge funds, unwind their speculative long positions and add fairly aggressively to their short exposure (again, a contrarian indicator that is cleansing and ultimately very bullish for the market going forward). The newly emerging and developing bullish positioning signature in the futures market is, at the same time, significantly strengthened by the fact that strong-handed institutions (pension funds, insurance companies, and family offices)—the group that represents “the investor class” in the gold sector—have moved back to building their long positions. The distinction is: Those that merely trade gold as a financial instrument (without a fundamental adherence to gold’s greater investment thesis) aim to catch price momentum, be it up or down. Those that invest capital into gold according to a belief in the long-term gold thesis buy dips in anticipation of a longer-term move higher. 

This investor class has started to step into the gold market again. They are now buying the dip. All of these developments—in market technicals, sentiment, and positioning—are vital pieces in the process of correction and refueling. They can best be described as necessary preconditions for the market to initiate the next rally leg higher in metals prices. In short, by these measures, gold has largely reloaded the revolver, re-cocked the hammer, and now appears close to firing another shot higher.

To place gold’s current position in context, it’s also important to note that, despite the correction, gold futures contracts have managed a record streak of 23 consecutive weekly closes above $1,900. The significance of the streak is in suggesting a change in market behavior. Rather than recoil sharply and quickly from what were previously seen as historically high prices anytime the market raced over $1,900, gold’s price now tends to act as though $1,900 is a floor. Importantly, it’s a floor at which investment class buyers are again engaging the market.

While the refueling process has largely achieved the necessary preconditions for the next rally, the ultimate breakout to new all-time-high territory will likely require a trigger to catalyze the rally. And though it’s not the only potential trigger, the most likely catalyst remains a Federal Reserve that first stops hiking interest rates and then eventually begins an easing cycle of varying degrees of intensity. That development is almost certain to be a question not of if, but when. 

So, the gold market has made substantial healthy progress, it is largely refueled and recharged, and the preconditions for a rally are in place. In the meantime, we await a catalyst for the expected breakout to new highs.

Despite the resilience in the price of physical gold, however, the overall sector has slipped into a classic precious metals risk-off mode. The risk-off signature in the precious metals market consists of gold and then silver holding up best, the mining stocks underperforming both physical gold and silver, and then the more speculative junior miners and development plays performing worst of all. This is exactly what we’ve seen since late spring. Broadly speaking, as long as metals prices remain range-bound and capped below the overhead resistance and eventual breakout zone, this risk-off in the mining stocks may continue—for a time.

The weakness in precious metals mining stocks relative to gold has taken place despite what HAI estimates to be a sector-wide increase in all-in sustaining-cost profit margins from $510/oz gold in Q1, to $570/oz of gold produced in Q2. Despite the poor recent performance of the precious metals stocks amid this ongoing risk-off sector dynamic, current margins for sector producers are strong for this industry relative to history. If gold continues to correct lower while the recent uptick in energy prices maintains a trajectory higher, producer margins could compress again. Nevertheless, we are far from a weak margin environment for best-in-class producers.

This sector, and in particular the highest quality names, is far healthier and better run than at any time in relevant history. The gold price is strong, and while higher costs have kept margins lower than they might have otherwise been, cash flows are still strong. And importantly, with the gold price remaining higher for longer, the miners’ strong margins are becoming increasingly consistent.

Consistency is a new development in this sector. Its importance is impossible to overstate. Strong and consistent margins power every aspect of these businesses, and such margins ultimately result in more valuable companies. Strong and consistent margins lead to strong and consistent cash flow streams, earnings growth, and increasing cash piles on company balance sheets. That cash then gets redeployed for sustaining reinvestment, investment in M&A, exploration, and development. Eventually, that growing cash pile also manifests in increased share buybacks and expanded dividend payouts to shareholders. More valuable companies with reduced share counts and growing dividend streams is a formula that translates, over time, to higher share prices—full stop.

Despite a sector that’s pushing toward previously unseen levels of financial health, however, precious metals companies across the spectrum—from the royalty streamers to major producers to juniors and developers—are being largely overlooked and heavily discounted. For a financially healthy sector, especially one in which the future looks brighter than ever, we appear to have a stark mispricing on our hands.

In HAI’s view, however, this weakness in the mining stocks looks to be temporary. If one has patience and can stomach the possibility of further short-term drawdowns, there is very likely a golden mining stock opportunity beyond the near-term mispricing.

Helping the sector while it awaits a breakout higher in the gold price will be the fact that, across the industry, most producers have heavily back end-weighted production schedules for the remainder of the year. Sector-wide results should, therefore, improve materially with much stronger second-half 2023 production numbers. Increased production will also help to subdue unit costs due to economies of scale. If gold prices continue to hold up and average closer to $1,900/oz or higher for the remainder of the year, then that higher production, as economies of scale help keep costs in check, will translate to further improved margins. Again, strong financial results and strong overall financial health driven by strong and consistent margins will be increasingly difficult for the market to ignore. If the gold price breaks out higher, difficult to ignore quickly turns into impossible to ignore.

When the current risk-off trading dynamic in the precious metals sector eventually abates, the weakness in the miners is very likely to give way to a large catch-up move higher. Going forward, if gold prices hold up before eventually breaking out, the present near-record-low price-to-net-asset-value (P/NAV) multiples for mining stocks may be akin to trying to hold a beach ball under water. The mining sector could springboard violently higher and should vastly outperform physical gold.

We’ve seen this before. We saw a similar dynamic develop in late 2015. Late that year, at the end of the multi-year bear market for metals, mining stocks made all-time lows relative to gold. But when the sector rallied off the bottom, gold’s 32% rally paled in comparison to the mining stocks that, on aggregate as measured by the HUI gold mining index, rallied 188% in just seven explosive months. HAI believes the current set-up for a dramatic move higher in the mining sector is quickly building toward what may be as good as, if not even better than, that set-up in late 2015. All we need is the catalyst—a turn toward a sustained breakout higher in the gold price.

Again, HAI expects that breakout higher when market anticipation turns to conviction that a Fed policy shift from tightening to easing is imminent. As noted above, HAI firmly believes gold has an agenda complete with plans for a significant breakout higher into new all-time high territory in its future. But how high might that yellow brick road climb?

There are many different ways to think about an answer to that question. One way to analyze gold’s potential was discussed this week by commodity research firm Goehring & Rozencwajg. According to their work, a strong historical relationship exists between the Federal Reserve’s monetary base (their balance sheet), and the amount of gold held by the U.S. Treasury. When the Fed’s monetary base greatly exceeds the value of gold held at the Treasury, gold is undervalued, when the value of gold held at the Treasury surpasses the Fed’s monetary base, gold is overvalued. According to this metric, gold had three distinct periods of undervaluation and two periods of overvaluation during the past 100 years. Periods of overvaluation proved great selling opportunities; periods of undervaluation proved excellent gold buying opportunities. In fact, after each period of maximum undervaluation, gold was the best-performing asset class in the decade that followed. The periods of gold’s extreme overvaluation were the late 1930s and then again in 1980. Conversely, periods of radical undervaluation were in the late 1960s, the late 1990s, and again now.

Even though the price of gold has risen dramatically since the last period of extreme undervaluation in 1999, the Federal Reserve’s monetary base has increased by even more. By this measure (the size of the Fed’s monetary base vs. the value of gold held by Treasury), gold is currently 30% more undervalued than the extreme in 1969, and slightly more undervalued than in the 1999 extreme.

If history repeats and this gold bull market continues until gold reaches a state of overvaluation, that would imply that the value of gold held by the Treasury would have to exceed the Fed’s monetary base by at least 1.5 times. Based on current gold held at the Treasury and the Fed’s monetary base (even if you very conservatively strip away all $3.2 trillion of “excess reserves” on the Fed’s balance sheet), gold would still have to reach $14,000/oz to reach the historical overvaluation bull-market terminus. If you don’t remove the excess reserves, that number truly skyrockets.

As Goehring & Rozencwajg conclude, “In our view, gold will emerge as the asset class with the most potential this decade, no matter the financial or geopolitical backdrop. Under the most extreme scenarios (a repeat of the deflationary implosion that produced the Great Depression or a period of inflation that verges on hyperinflation), gold will be the winning asset class.” To translate into recent HAI parlance, regardless of whether we face the crack-up boom-like scenario of “inflationary fire,” or the deflationary scenario of “recessionary ice,” the current set-up for gold offers the most potential under the widest swath of possible macroeconomic outcomes in comparison to any other asset class—period.

What’s truly amazing is that the return potential imbedded within the extreme undervaluation of gold outlined by G&R is only further compounded by the fact that gold mining stocks are at their own extreme state of undervaluation relative to gold. If gold moves higher and mining stocks merely return to their historical average value relative to physical gold, the return potential is, for lack of a better word, special.

This potential for special returns in the precious metals sector is one of the most exciting balls currently in play within the investment universe. HAI will continue to keep an eye squarely fixed upon that ball at all times. That said, until we discern an unmistakable green light on this yellow brick road, keep helmets on and seat belts securely fastened. It’s likely to continue to be a bumpy ride.

Weekly performance: The S&P 500 gained 0.82%. Gold was up 1.22%, silver jumped 6.60%, platinum added 3.63%, and palladium was down 2.45%. The HUI gold miners index rallied by 3.13%. The IFRA iShares US Infrastructure ETF was down 0.31%. Energy commodities were volatile and mixed on the week. WTI crude oil was off 1.03%, while natural gas gained by 4.16%. The CRB Commodity Index was up 0.99%. Copper was higher by 1.35%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 1.21%. The Vanguard Utilities ETF was nearly flat, up 0.17%. The dollar index gained 0.71% to close the week at 104.01. The yield on the 10-yr Treasury was down a tick, off 1 bp, to end the week at 4.25%.

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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