The US stock markets enjoyed an extraordinary surge in 2017, shattering all kinds of records.  This was fueled by hopes for big tax cuts soon since Republicans regained control of the US government.  But such relentless rallying has catapulted complacency, euphoria, and valuations to dangerous bull-slaying extremes.  This has left today’s beloved and lofty stock markets hyper-risky, with serious selloffs looming large.

History proves that stock markets are forever cyclical, no trend lasts forever.  Great bulls and bears alike eventually run their courses and give up their ghosts.  Sooner or later every secular trend yields to extreme sentiment peaking, then the markets inevitably reverse. Popular greed late in bulls, and fear late in bears, ultimately hits unsustainable climaxes. All near-term buyers or sellers are sucked in, killing the trend.

This mighty stock bull born way back in March 2009 has proven exceptional in countless ways.  As of mid-December, the flagship S&P 500 broad-market stock index (SPX) has powered 297.6% higher over 8.8 years!  Investors take this for granted, but it’s far from normal.  That makes this bull the third-largest and second-longest in US stock-market history.  And the superior bull specimens vividly highlight market cyclicality.

The SPX’s biggest and longest bull on record soared 417% higher between October 1990 and March 2000.  After it peaked in epic bubble-grade euphoria, the SPX soon yielded to a brutal 49% bear market over the next 2.6 years.  The SPX wouldn’t decisively power above those bull-topping levels until 12.9 years later in early 2013, thanks to the Fed’s unprecedented QE3 campaign!  The greatest bull ended in tears.

The second-largest bull was a 325% monster between July 1932 to March 1937.  But that illuminated the inexorable cyclicality of stock markets too, as it arose from the ashes of a soul-crushing 89% bear in the aftermath of 1929’s infamous stock-market crash.  Seeing today’s central-bank-inflated bull balloon to such monstrous proportions rivaling the greatest stock bulls on record highlights how extreme it has become.

All throughout stock-market history, this binary bull-bear cycle has persisted.  Though some bulls grow bigger and last longer than others, all eventually give way to subsequent bears to rebalance sentiment and valuations.  So stock investing late in any bull market, which is when investors complacently assume it will last indefinitely, is hyper-risky.  Bear markets start at serious 20% SPX losses, and often approach 50%!

Popular psychology in peaking bull markets is well-studied and predictable.  Investors universally believe “this time is different”, that some new factor leaves their bull impregnable and able to keep on powering higher indefinitely.  This new-era mindset fuels extreme euphoria and complacency, with memories of big selloffs fading.  Investors’ hubris swells, as they forget markets are cyclical and ridicule any who dare warn.

To any serious student of stock-market history, there’s little doubt today’s stock-market situation feels exactly like a major bull-market topping.  All the necessary ingredients are in place, ranging from extreme greed-drenched sentiment to extreme bubble valuations literally.  If this bull was merely normal, the risks of an imminent countertrend bear erupting to eradicate these late-bull excesses would absolutely be stellar.

But the downside risks in the wake of this exceptional bull are far greater than usual. That’s because much of this bull is artificial, essentially a Fed-conjured illusion.  And that was even before the incredible 2017 taxphoria surge in the wake of Trump’s surprise victory!  Back in early 2013 as the SPX was finally regaining its previous bull’s peak, the Fed unleashed its wildly-unprecedented open-ended QE3 campaign.

Understanding the Fed’s role in fomenting this anomalous stock bull is more important than ever.  Not only is the Fed deep into its 12th rate-hike cycle of the past half-century or so, it has begun quantitative tightening for the first time ever.  This QT is starting to unwind the trillions of dollars of QE that levitated the stock markets for years.  While QT started small in Q4’17, it’s ramping to a $50b-per-month pace in Q4’18!

The Fed’s QE giveth, so the Fed’s QT taketh away.  Literally trillions of dollars of capital evoked out of nothing by the Fed to monetize bonds directly and indirectly bid stock markets higher.  The Fed’s deep intertwinement in this stock bull’s fortunes is easiest to understand with a chart.  Here the SPX in blue is superimposed over its implied-volatility index, the famous VIX that acts as a proxy for popular greed and fear.

This anomalous stock bull was again birthed in March 2009 in the wake of the first true stock panic since 1907.  After that epic maelstrom of fear fueled such an extreme plummet to climax a 57% bear market, a new bull was indeed overdue despite rampant bearishness and pessimism.  The very trading day before the SPX bottomed, I wrote a hardcore contrarian essay explaining why a major new bull market was imminent.

Back in early 2009 stock-market valuations were so low after the panic that a new bull was fully justified fundamentally.  And its first four years or so played out perfectly normally.  Between early 2009 to late 2012, this bull market’s trajectory was typical.  It rocketed higher initially out of deep bear lows, but those gains moderated as this bull matured.  And its upside progress was punctuated by healthy major corrections.

Stock-market selloffs are generally defined in set ranges.  Anything under 4% isn’t worth classifying, it is just normal market noise.  Then from 4% to 10%, selloffs become pullbacks.  Beyond that in the 10%-to-20% range are corrections.  Selloffs greater than 20% are formally considered bear markets.  In both 2010 and 2011 the SPX suffered major corrections in the upper teens, which are essential to rebalance sentiment.

As bull markets power higher, greed naturally grows among investors and speculators. They start to get very complacent and expect higher stocks indefinitely.  Eventually this metastasizes into euphoria and even hubris.  Major corrections, big and sharp mid-bull selloffs, rekindle fear to offset excessive greed and keep bulls healthy.  Interestingly even in 2010 and 2011 the Fed played a key role in stock-market timing.

Those early bull years’ major corrections coincided exactly with the ends of the Fed’s first and second quantitative-easing campaigns.  QE is an extreme monetary-policy measure central banks can use after they force interest rates, their normal tool, down to zero.  The Fed’s zero-interest-rate policy went live in mid-December 2008 in response to that first stock panic in a century, and QE1 then QE2 soon followed.

Quantitative easing involves creating new money out of thin air to buy up bonds, effectively monetizing debt.  While QE1 and QE2 certainly caused market distortions, both campaigns had predetermined sizes and durations.  When traders knew a particular QE campaign was nearing its end, they started selling stocks which drove the major corrections.  So the Fed decided to change tactics when it launched QE3.

As the SPX approached 1450 in late 2012, that normal stock-market bull was topping due to expensive valuations.  After peaking in April, stock markets started rolling over heading into that year’s presidential election.  Stock-market fortunes in the final several months leading into elections can greatly sway their outcomes.  So in mid-September 2012 less than 8 weeks before the election, a very-political Fed hatched QE3.

QE3 was radically different from QE1 and QE2 in that it was totally open-ended.  Unlike its predecessors, QE3 had no predetermined size or duration!  So stock traders couldn’t anticipate when QE3 would end or how big it would get.  Stock markets surged on QE3’s announcement and subsequent expansion a few months later.  Fed officials started to deftly use QE3’s inherent ambiguity to herd stock traders’ psychology.

Whenever the stock markets started to sell off, Fed officials would rush to their soapboxes to reassure traders that QE3 could be expanded anytime if necessary.  Those implicit promises of central-bank intervention quickly truncated all nascent selloffs before they could reach correction territory.  Traders realized that the Fed was effectively backstopping the stock markets!  So greed flourished unchecked by corrections.

This stock bull went from normal between 2009 to 2012 to literally central-bank conjured from 2013 on!  The Fed’s QE3-expansion promises so enthralled traders that the SPX went an astounding 3.6 years without a correction between late 2011 to mid-2015, one of the longest-such spans ever.  With the Fed jawboning negating healthy sentiment-rebalancing corrections, sentiment grew ever more greedy and complacent.

QE3 was finally wound down in late 2014, leading to this Fed-goosed stock bull stalling out.  Without central-bank money printing behind it, the stock-market levitation between 2013 to 2015 never would’ve happened!  One of the most-damning charts of recent years shows the SPX perfectly tracking the growth in the Fed’s balance sheet as its monetized bonds accumulated there.  This great stock bull is largely fake.

Without the Fed’s QE firehose blasting new money into the system, stock-market corrections resumed in mid-2015 and early 2016.  After topping in May 2015 not much higher than QE3-ending levels, the SPX drifted sideways to lower for fully 13.7 months.  That too should’ve proven this artificially-extended bull’s top, giving way to the overdue subsequent bear.  But it was miraculously short-circuited by the Brexit vote.

Heading into late June 2016, Wall Street was forecasting a sharp global stock-market selloff if British people actually voted to leave the EU.  What was seen as a low-probability outcome promised to unleash all kinds of uncertainty and chaos.  And indeed when that Brexit vote surprised and passed, the SPX plunged for a couple trading days.  Then meddling central banks stepped in assuring they were ready to intervene.

So this tired old bull again started surging to new record highs in July and August 2016, although they weren’t much better than May 2015’s.  After that euphoric surge on hopes for post-Brexit-vote central-bank easings, the SPX started to roll over again heading into the US presidential election.  Wall Street warned just like Brexit that a Trump win would ignite a major stock-market selloff, and again proved dead wrong.

The shocking post-election stock surge has been called Trumphoria or taxphoria.  Capital flooded into stocks for a variety of reasons.  In addition to hopes for far-superior government policies boosting corporate profits, funds rushed to buy to chase good year-end gains to report to their investors.  And the resulting stock-market record highs, and fevered anticipation for big tax cuts, started seducing investors back.

This exuberant psychology greatly intensified in 2017, with the SPX periodically surging to series of new record highs on political news fanning investors’ optimism.  Since Trump won the election, nearly all of the SPX’s significant daily rallies ignited on news implying big tax cuts were indeed coming soon as widely hoped.  The wealth effect from that stock elation unleashed big spending, which really boosted corporate profits.

But this Fed-goosed stock bull was already very long in the tooth, and stock valuations were already near formal bubble territory, even before Trump was elected.  The resulting Trumphoria surge on hopes for big tax cuts soon really exacerbated serious pre-election risks.  That included extending the span since the end of the last SPX correction to 1.9 years.  Normal healthy bull markets see correction-grade selloffs annually.

Between the SPX’s original top in May 2015 soon after QE3 ended and Election Day 2016, at best stock markets simply ground sideways.  At worst they were rolling over into what should’ve grown into a major new bear.  Trumphoria short-circuited all that, sending stocks sharply higher and delaying the inevitable cyclical reckoning.  By mid-December 2017 the SPX had rocketed a crazy 25.7% higher since Election Day alone!

An ominous side effect of that anomalous late-bull surge was extremely-low volatility, with all kinds of low-volatility records set.  The VIX S&P 500 implied-volatility index on this chart reflects that, slumping to multi-decade lows throughout 2017!  Low volatility reflects low fear and high complacency, the exact herd sentiment ubiquitous at major bull-market toppings.  Just like stock markets, volatility is forever cyclical too.

Volatility often skyrockets off exceptional lows, as the great sentiment pendulum must swing back to fear after peaking deep in the greed side of its arc.  And the only thing that generates fear late in stock bulls is sharp selloffs.  No matter how bad news is, euphoric investors happily ignore it if it doesn’t drive stocks lower.  But eventually some catalyst always arrives, usually unforeseen, that finally stakes the geriatric bull.

When the last stock bulls peaked in March 2000 and October 2007, there was no specific news that killed them.  Lofty euphoric stock markets simply started gradually rolling over, mostly through relatively-minor down days which generated little fear.  These modest grinds lower kept most investors unaware of the waking bears, boiling them slowly like the proverbial frog in the pot.  But even little losses eventually add up.

Since nearly all the amazing stock-market gains between late 2012 to mid-2015 were directly fueled by the Fed’s QE3 money printing, fears of the coming quantitative tightening may prove the bull-slaying catalyst.  The Fed conjured money out of thin air to buy bonds in QE, and it will destroy that very money by effectively selling bonds in QT.  QT’s capital outflows should prove as bearish for stocks as QE’s inflows were bullish!

The FOMC actually started discussing QT at its early-May meeting, and formally announced it at its late-September meeting.  QT actually got underway in Q4’17 at a modest $10b-per-month pace.  But it’s on autopilot to grow by $10b per month each quarter until it reaches terminal speed at a $50b-per-month pace in Q4’18.  That will make for $600b per year of QE-injected capital removed from markets and destroyed.

QT is utterly unprecedented in history, and its acceleration in 2018 has profoundly-bearish implications for these QE-inflated record stock markets.  As QT started late in 2017 at low levels, it only totaled $30b this year.  But in 2018 alone that will explode 14x higher to a total of $420b of QT!  Prudent investors will sell in anticipation of QT hitting full steam, as unwinding the Fed’s huge QE-bloated balance sheet is a grave threat.

Back in the first 8 months of 2008 before that stock panic, the Fed’s balance sheet averaged $849b.  By February 2015, it had ballooned to a freakish $4474b.  That’s up a staggering 427% or $3625b over 6.5 years of QE!  QE levitated the stock markets in two primary ways.  That Fed bond buying bullied yields to artificial lows, forcing bond investors starving for yields to buy far-riskier stocks that were paying dividends.

More importantly, those unnatural contrived extremely-low yields courtesy of QE fueled a boom in stock buybacks by corporations unlike anything ever witnessed.  American companies took advantage of the crazy-low interest rates to literally borrow trillions of dollars to buy back their own stocks!  Between QE3’s launch and Trump’s victory, corporate stock buybacks were the dominant source of stock-market capital inflows.

QT along with the Fed’s current rate-hike cycle will allow bond yields to rise again, eventually greatly retarding corporations’ desire and ability to borrow vast sums of money to use to manipulate their own stock prices higher.  In late December, the Fed’s balance sheet was still way up at $4408b.  These QE-inflated stock markets have never experienced QT, and it ain’t gonna be pretty no matter how slowly QT is implemented.

While this easy Fed is far too cowardly to fully reverse $3.6t worth of QE since late 2008, even a trillion or two of QT over the coming years is going to wreak havoc on these QE-levitated stock markets!  That’s a serious problem for today’s extreme Fed-goosed bull with a rotten fundamental foundation.  Underlying corporate earnings never supported such extreme record stock prices, and the coming reckoning is unavoidable.

Regardless of the Fed’s balance sheet, quantitative tightening, or valuations, the near-record-low VIX slumping into the 9s since back in May shows these stock markets are ripe for a major selloff anyway.  At absolute minimum, it needs to be a serious correction approaching 20%.  But with this stock bull so big, so old, and so fake thanks to the Fed, that selloff is almost certain to snowball into the long-overdue next bear.

And investors aren’t taking the threat of a new bear seriously.  Crossing the bear threshold just requires a 20% retreat.  Even such a baby bear would erase all SPX gains since mid-2016.  A normal bear market at this stage in the Long Valuation Waves is actually 50%, cutting stock prices in half!  That would wipe out the great majority of this entire mighty stock bull, dragging the SPX all the way back down to mid-2011 levels.

Even more ominously, bear markets naturally following bulls tend to be proportional. That makes sense since bears’ job is to rebalance sentiment and work off overvalued conditions.  So there’s a high chance the coming bear after such an anomalous Fed-goosed bull won’t stop at 50%!  The downside risks from here are incredibly dire after such a huge bull driven by extreme central-bank easing instead of corporate profits.

And that finally brings us to valuations, this old stock bull’s core problem.  This final chart looks at the SPX superimposed over a couple key valuation metrics.  Both are derived from averaging the trailing-twelve-month price-to-earnings ratios of all 500 elite SPX companies.  The light-blue line is their simple average, while the dark-blue one is weighted by market capitalization.  Today’s valuations ought to terrify investors.

Unfortunately today corporate earnings are intentionally obscured by Wall Street to mask the dangerous overvaluation that is rampant.  Analysts make up blatant fictions including forward earnings, which are literally guesses about what companies will earn in the coming year!  These almost always prove wildly optimistic.  Analysts also look at adjusted earnings, another Pollyannaish farce where companies ignore expenses.

Wall Street also plays a deceptive estimate game to make quarterly-earnings results look way better than they really are.  Instead of comparing actual hard quarterly profits with the same quarter a year earlier, they intentionally lowball estimates so companies beat regardless of their actual earnings trends.  Investors are being bamboozled, with the only honest way of measuring corporate profits buried and forgotten.

That is based on generally-accepted accounting principles which are required when companies actually report to regulators.  The only righteous way to measure price-to-earnings ratios is using the last four quarters of GAAP profits, or trailing twelve months. Those numbers are hard, established in the real world based on real sales and real expenses.  They are not mere estimates like totally-bogus forward earnings.

Every month at Zeal we look at the TTM P/Es of all 500 SPX companies.  At the end of November, the simple average of all SPX companies actually earning profits so they can have P/Es was an astounding 30.5x!  That’s literally in bubble territory, just as Trump had warned about during his campaign.  14x earnings is the historical fair value over a century and a quarter, and double that at 28x is where bubble levels start.

If you study the history of the stock markets, stock prices never do well for long starting from bubble valuations.  Such extreme stock prices relative to underlying corporate earnings streams actually herald the births of major new bear markets.  Again these usually cut stock prices in half.  So buying stocks here, late in a huge old bull market artificially levitated by the Fed, is the height of folly.  Massive losses are inevitable.

Remember stock markets perpetually meander through alternating bull-bear cycles.  Back in late 2012 before the Fed stepped in to try and brazenly short-circuit these valuation-driven cycles, valuations were actually in a secular-bear downtrend.  After secular bulls drive valuations to bubble extremes, with greed forcing stock prices far beyond underlying corporate earnings, secular bears emerge to reverse those excesses.

During secular bears, stock prices grind sideways on balance for long enough for earnings to catch up with lofty stock prices.  Before QE3 temporarily broke stock-market cycles, that process had been happening as normal between 2000 to 2012.  Secular bears don’t end until valuations get to half fair value, 7x earnings.  So instead of being into bubble levels, valuations would normally be between 7x to 10x today.

That’s the massive downside risk stocks face due to their Fed-conjured bubble valuations! While the red line above shows the actual SPX, the white line shows where it would be trading at 14x fair value.  Even that is way down around 1235 today, less than half current levels!  But mean reversions from extremes nearly always overshoot in the opposite direction, so the potential SPX bear-market bottom is much lower.

Sadly Wall Street will never bother telling investors that valuations matter.  Stock-market history proves beyond all doubt that buying stocks high in valuation terms nearly always leads to considerable-to-huge losses.  All the financial industry cares about is keeping people fully invested no matter what, since that maximizes their fees derived from percentages of assets under management.  Talk about a conflict of interest!

The more expensive stocks are in valuation terms when they are purchased, the worse the subsequent returns will be.  And no matter how awesome Trump’s policies may ultimately prove, they aren’t going to rescue corporate profits anytime soon.  Republicans’ corporate-tax cuts have long been way more than fully priced in to stock prices.  Wall Street analysts love to claim 2017’s extraordinary rally was earnings-driven.

But valuations prove otherwise.  By late November the SPX had soared 24.2% since Trump won the US presidency.  But during nearly that same span the SPX’s simple-average TTM P/E surged 15.9%.  That implies only about a third of the entire Trumphoria rally was driven by higher corporate profits!  And even that is suspect, since the wealth effect from this year’s record stock markets fueled exceptionally-high spending.

The stock markets’ lofty valuations before Trumphoria and the bubble valuations since are a very serious problem that can only be resolved by an overdue major bear market!  Only that will drag stock prices low enough for existing and future corporate earnings to support reasonable valuations again.  Investors sure don’t believe a new bear market is possible, but they never do when bull markets are topping in extreme euphoria.

It’s not just the Fed’s QT that’s coming in 2018 and 2019, but the European Central Bank is also slashing its own QE campaign.  That ran at a blistering €60b-per-month pace in 2017, totaling €720b.  But it will be cut in half to just €30b a month starting in January.  The combination of Fed QT and ECB QE tapering is going to strangle this stock bull!  A QE-conjured stock bull can’t persist when QE is reversed and slashed.

Together these leading global central banks so critical to stock-market fortunes are effectively tightening massively in 2018 and 2019 compared to 2017.  Next year alone will see the equivalent of $950b more Fed QT and less ECB QE than this year.  Can bubble-valued stocks survive nearly a trillion dollars less central-bank liquidity in 2018?  And two years from now that will swell to another $1450b less than this year!

Investors really need to lighten up on their stock-heavy portfolios, or put stop losses in place, to protect themselves from the coming central-bank-tightening-triggered valuation mean reversion in the form of a major new stock bear.  Cash is king in bear markets, as its buying power grows.  Investors who hold cash during a 50% bear market can double their stock holdings at the bottom by buying back their stocks at half price!

Put options on the leading SPY S&P 500 ETF can also be used to hedge downside risks.  They are cheap now with euphoria rampant, but their prices will surge quickly when stocks start selling off materially.  Even better than cash and SPY puts is gold, the anti-stock trade.  Gold is a rare asset that tends to move counter to stock markets, leading to soaring investment demand for portfolio diversification when stocks fall.

Gold surged nearly 30% higher in the first half of 2016 in a new bull run that was initially sparked by the last major correction in stock markets early that year.  If the stock markets indeed roll over into a new bear in 2018, gold’s coming gains should be much greater.  And they will be dwarfed by those of the best gold miners’ stocks, whose profits leverage gold’s gains.  Gold stocks rocketed 182% higher in 2016’s first half!

Absolutely essential in bear markets is cultivating excellent contrarian intelligence sources.  That’s our specialty at Zeal.  After decades studying the markets and trading, we really walk the contrarian walk.  We buy low when few others will, so we can later sell high when few others can.  While Wall Street will deny the coming stock-market bear all the way down, we will help you both understand it and prosper during it.

We’ve long published acclaimed weekly and monthly newsletters for speculators and investors.  They draw on my vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks.  As of the end of Q3, all 967 stock trades recommended in real-time to our newsletter subscribers since 2001 averaged stellar annualized realized gains of +19.9%!  For only $12 per issue, you can learn to think, trade, and thrive like contrarians.  Subscribe today!

The bottom line is today’s euphoric record stock markets are hyper-risky.  They are trading up at bubble valuations thanks to 2017’s stunning post-election rally.  Such lofty stock prices are risky any time, but exceedingly dangerous late in an enormous bull market artificially extended by the Fed.  A major new bear market is long overdue that will at least cut stock prices in half.  Don’t be fooled by the extreme complacency!

Prudent investors have to overcome this groupthink herd euphoria and protect themselves from what’s coming.  That means lightening up on overvalued stocks, building cash, and buying gold.  Central banks have a long history of trying and failing to eliminate stock-market cycles.  The longer they are artificially suppressed, the worse the inevitable reckoning as these inexorable market cycles resume with a vengeance.

Adam Hamilton, CPA

December 29, 2017

Copyright 2000 – 2017 Zeal LLC (www.ZealLLC.com)

 

The gold miners’ stocks largely ground sideways in 2017, lagging gold’s solid rally.  Being trapped in this vexing consolidation has decimated sentiment, leaving a bearish wasteland bereft of hope.  But contrary to perceptions, this deeply-out-of-favor sector is actually a coiled spring today.  Gold stocks are ready to surge dramatically higher as psychology inevitably shifts, pointing to much higher prices coming in 2018.

The main appeal of gold-mining stocks is their underlying profits’ leverage to gold.  The gold miners are much riskier than gold itself, facing many operational, geological, and geopolitical challenges that the metal doesn’t share.  Thus investors and speculators alike must be compensated for these large added risks with superior returns to gold.  That didn’t happen in 2017, which is why gold stocks are so widely despised.

All year long, the extreme stock-market rally driven by hopes for big tax cuts soon stole the limelight from gold.  The flagship S&P 500 stock index has blasted 19.7% higher year-to-date, stoking incredible levels of euphoria.  That sucked all the oxygen out of the investment world, overshadowing everything else.  So investors have largely shunned gold this year, since it is normally the anti-stock trade moving counter to stocks.

Usually soaring stock markets crush gold, like back in 2013.  That year the Fed’s new third quantitative-easing campaign conjured $1020b out of thin air to monetize bonds.  The resulting artificially-low interest rates fueled a stock-buyback boom, catapulting the S&P 500 29.6% higher.  So investors felt no need to prudently diversify their stock-heavy portfolios with gold, thus this metal plummeted 27.9% lower that year!

Considering gold is often hostage to stock-market fortunes, it performed remarkably well in 2017 despite the endless record highs in major stock indexes.  Gold was up 10.0% YTD as of the middle of this week, very impressive considering the circumstances.  Gold miners’ inherent profits leverage usually enables their stock prices to amplify underlying gold rallies by 2x to 3x, so they should be up 20% to 30% this year.

The dominant gold-stock index is the HUI NYSE Arca Gold BUGS Index, which is closely mirrored by the leading GDX VanEck Vectors Gold Miners ETF.  Unfortunately its performance this year has been utterly dismal compared to gold, with the HUI up just 1.8% YTD!  That makes for horrendous leverage of 0.2x, wildly unacceptable considering gold miners’ big additional risks compared to the metal they bring to market.

There have been exceptions, with some miners far outperforming their languishing peers. This Tuesday in our weekly newsletter, we just realized 184% gains on a year-old trade in a leading mid-tier gold miner!  The gold stocks have been tradable this year, seeing sizable rallies within their consolidation grind.  But overall they’ve been drifting listlessly on balance, naturally wreaking great damage on sector sentiment.

Gold stocks are underperforming so massively this year due to sentiment.  Because this small contrarian sector is languishing, traders want nothing to do with it.  And because they are widely avoided, the gold stocks are trapped in consolidation hell.  The only thing able to start shifting sentiment back to bullish is a meaningful gold rally igniting material gold-stock buying.  The resulting gains would win back capital inflows.

Sentiment and technicals are inexorably intertwined.  No matter what else is going on, when stocks are high traders get excited and bullish.  That’s obviously happened in the stock markets this year, despite the Fed and the ECB on the verge of radical tightenings that will strangle this stock bull.  The parabolic bitcoin mania is another wild case in point. But when stocks are down, traders naturally wax sullen and bearish.

As at all sentiment extremes, traders assume gold stocks are doomed to suffer this frustrating weakness indefinitely.  But that’s a bad bet, as sentiment perpetually meanders back and forth between excessive greed and fear.  The longer psychology remains on one side of that arc, and the more extreme it gets, the greater the odds for an imminent mean-reversion swing back the other way.  Those tend to overshoot proportionally.

The last time gold stocks were this out of favor drifting near lows was the second half of 2015.  The gold miners were left for dead, with nearly everyone predicting they would spiral lower forever.  Yet sentiment shifted out of that bearish echo chamber, and the gold stocks skyrocketed like North Korean ICBMs.  In merely 6.5 months, the HUI soared 182.2% higher!  That amplified gold’s concurrent 25.2% rally by a big 7.2x.

2017’s painful consolidation is the perfect breeding ground for another monster gold-stock upleg in 2018.  After spending a year basing at deeply-undervalued prices relative to today’s gold levels, it shouldn’t take much of a sentiment shift to catapult gold stocks way higher.  From a contrarian standpoint this unloved sector’s technicals are actually quite bullish today, with the gold miners’ stocks wound up like a coiled spring.

Last year’s colossal gold-stock upleg that has already been forgotten is crystal-clear here. Contrarians willing to fight the herd and buy low in late 2015 when gold stocks were shunned made out like bandits.  They nearly tripled their capital in a half-year!  Once this sector starts moving, the resulting uplegs tend to be massive.  The key is bucking popular bearish sentiment to get invested early before the crowd rushes back in.

That enormous upleg birthing a mighty new gold-stock bull last year was followed by a huge drop driven by gold.  Since prevailing gold prices directly drive miners’ profits, gold stocks follow and amplify moves in the metal they mine.  In the second half of 2016, gold plunged sharply thanks to a highly-improbable series of events.  That was super-anomalous, thus gold bounced back this year despite the record stock markets.

First gold was hit by gold-futures stop losses being run, then slammed by the Trumphoria stock-market surge in the wake of November 2016’s surprise election results, and finally by the Fed’s second rate hike of this cycle.  Seeing an isolated event-driven selloff isn’t unusual, but suffering three in a row back-to-back is unheard of!  I explained each anomaly in depth in an April essay if you’re interested in getting up to speed.

Gold dropped 17.3% in 5.3 months, certainly a massive correction but shy of new-bear-market territory at -20%.  Gold stocks as measured by the HUI amplified gold’s downside by 2.5x, smack in the middle of that historical 2x-to-3x-leverage range.  So the huge gold-stock selloff in the second half of 2016 wasn’t outsized at all compared to the anomalous carnage in gold.  That’s the way this sector has always worked.

Once again gold miners’ profits leverage to gold explains their price action.  Consider an example, a gold miner producing gold at all-in sustaining costs of $1000 per ounce.  At $1250 gold, that yields earnings of $250 per ounce.  If gold rallies or falls 10% to $1375 or $1125, this miner’s profits literally soar or plunge 50% to $375 or $125 per ounce!  The higher any miner’s costs, the greater its profits leverage to gold prices.

In Q3’17, the major gold miners of GDX reported average all-in sustaining costs of just $868 per ounce.  At this week’s $1265 gold levels, that yields major-gold-miner earnings of $397 per ounce.  This makes for hefty operating margins of 31%, levels most industries would kill for.  Yet the markets are pricing gold stocks today as if they were running catastrophic losses.  At the middle of this week, the HUI was near 185.6.

The first time this leading gold-stock index hit these levels in August 2003, gold was only trading in the $360s.  Now it is 3.5x higher, the gold miners are far more profitable, yet their stocks are still ludicrously languishing at 14.3-year-old levels!  This makes zero sense fundamentally, revealing the gold miners’ radical undervaluations today.  Such extremes can only be driven by sentiment, and never last for very long.

The catalyst that will shatter this bearish-sentiment curse is gold rallying.  At the GDX major gold miners’ latest average AISC of $868 in the third quarter, a mere 10% gold advance would boost mining earnings by 32% to $524 per ounce.  That will rapidly shift psychology back to bullish.  Just like in the first half of 2016, these ridiculously-low gold stocks will take off like rockets once gold starts decisively moving higher again.

And that’s likely very soon thanks to major central banks.  This quarter the Fed just started quantitative tightening for the first time ever, to begin unwinding the trillions of dollars evoked into existence during its long years of QE.  While QT only ran $10b per month in Q4’17, it will gradually ramp up next year to its terminal $50b-per-month pace in Q4’18!  QT is exceedingly bearish for these surreal QE-inflated stock markets.

On top of that the European Central Bank will slash in half its own massive QE campaign from €60b per month to €30b monthly starting in January 2018.  Between the Fed’s new QT and the ECB’s new QE tapering, 2018 is going to see the equivalent of $950b less central-bank capital injections than enjoyed in 2017!  And in 2019 that will keep growing to another $1450b of central-bank tightening compared to this year.

With the Fed and ECB strangling this anomalous QE-levitated stock bull, gold will really shine again.  As stock markets grind lower, investors will remember the wisdom of prudently diversifying their stock-heavy portfolios with counter-moving gold.  Gold investment demand will soar again like in early 2016 after the last stock-market correction.  Once gold resumes powering higher, capital will flood back into its miners’ stocks.

Gold’s potential upside next year is likely much greater than most think possible.  This week the famous hedge-fund investor Doug Kass of Seabreeze Partners Management wrote about the 15 surprises that he expects in 2018.  He sees these red-hot stock markets steadily declining all year long partially due to extreme overvaluations today.  Kass writes, “Dip buying is not rewarded, but shorting the rips is rewarded next year.”

That will help reignite massive investment capital inflows into gold.  Kass is forecasting, “Interest in gold, which has been sidelined for months amid the cryptocurrency frenzy, regains popularity, reverses direction from the lower left to the upper right and moves higher in price.  In an abrupt and swift flight to alternative safety, gold makes new all-time highs and becomes the single best-performing asset class in 2018.”

That’s a major gold rally next year, as gold’s existing all-time high in nominal terms is $1894 which came in August 2011.  That would require a 50% gold surge in 2018, which wouldn’t be outside the realm of plausibility if the stock markets roll over into a new bear market on central banks’ unprecedented radical tightening.  Again after that last stock-market correction in early 2016, gold blasted 29.9% higher in just 6.7 months.

Of course the gold-stock upside in such a banner year for gold would be epic, especially starting with this sector so wildly undervalued fundamentally today.  While I’m not as bold as Doug Kass to predict new all-time gold highs in 2018, it wouldn’t surprise me one bit to see this metal power 20% to 30% higher next year.  That seems fairly conservative if the long-central-bank-delayed stock bear finally starts awakening.

The potential gains in the gold miners’ stocks during such a major new upleg are actually quite easy to estimate fundamentally.  This last chart looks at the HUI/Gold Ratio, which simply divides the daily HUI close by the daily gold close.  This HGR acts as a proxy for that core fundamental relationship between gold, miners’ profits, and their stock prices. This really drives home the coiled-spring nature of gold stocks today.

This week the HGR was way down near 0.147x, meaning the HUI was running at just over 1/7th of gold’s prevailing price.  While that means nothing in isolation, the context provided by this long-term HGR chart reveals how absurdly cheap the gold stocks remain relative to the metal which drives their earnings.  The only year in modern history where gold stocks were cheaper was 2015, the end of an exceptional secular bear.

Early in 2016 gold stocks per the HUI yardstick slumped to a fundamentally-absurd 13.5-year secular low as I pointed out in real-time.  Though gold was trading near $1087, still way above this industry’s all-in sustaining costs, the HUI was trading at levels last seen when gold was near $305 in July 2002!  Such an extreme anomaly couldn’t and didn’t last, resulting in the battered gold stocks nearly tripling in only a half-year.

That coiled-spring reaction perfectly illustrates how explosive gold-stock upside is after this sector suffers a long, low drift resulting in extremely-bearish psychology.  If today’s 0.15x HGR was actually righteous, it would’ve been seen plenty of times in modern history.  But it wasn’t.  Such extremely-low gold-stock price levels relative to gold were only able to persist briefly after a long secular bear, they weren’t sustainable.

Remember the Fed started aggressively levitating the US stock markets in early 2013, wreaking havoc on alternative investments led by gold.  The gold market’s last normal years were sandwiched between 2008’s stock panic and 2013’s radical Fed distortions.  That’s the best recent baseline for where the HGR ought to trade.  And between 2009 to 2012, this key fundamental ratio for gold-stock valuations averaged 0.346x.

To simply mean revert back up to those last normal levels relative to today’s gold prices, the major gold miners dominating the HUI and GDX would have to power 136% higher from here.  To merely restore some semblance of normalcy fundamentally, the gold stocks literally need to more than double even at this week’s prevailing $1265 gold levels!  Their prices can’t stay disconnected from their earnings forever.

But if gold indeed powers higher in a major new upleg next year as central-bank tightening drags stock markets lower, the gold-stock upside is far greater.  At my conservative 20% to 30% gold rally in 2018, this metal would climb to $1518 to $1644.  That yields HUI targets from 525 to 569, which are 183% and 206% higher than this week’s low levels.  The gold stocks easily have the potential to triple in 2018 alone!

But that’s pretty conservative because it’s purely fundamentally-based, ignoring the impact of sentiment.  All markets are cyclical, including gold stocks.  Extreme undervaluations relative to gold are followed by overvaluations as the pendulum swings back the other way.  Mean reversions after extremes never just stop in the middle at neutral sentiment.  Their momentum leads them to overshoot to the opposite extreme.

This natural cyclical reaction makes gold stocks’ potential upside far more impressive.  A proportional overshoot in HGR terms heralds radically-higher gold-stock prices ahead.  This week the HUI is 0.20x under its post-panic-average 0.346x HGR.  As trader psychology gradually swings from extreme fear back to extreme greed as gold stocks climb, it wouldn’t be a stretch at all to see the HGR shoot 0.20x over to 0.546x.

That would likely mark a major topping, not lasting long.  But such an overshoot HGR at 20% to 30% higher gold prices would yield gold-stock-bull peak targets of 829 to 898 on the HUI.  That’s a staggering 346% to 384% higher than this week’s levels!  Where else in all the stock markets does a sector have the potential to quadruple or quintuple in the coming years?  Gold and gold stocks climb even during stock bears.

If Doug Kass’s 2018 surprise proves correct and gold regains its all-time high of $1894 with a 50% rally, gold stocks’ probable upside is wealth-multiplying.  It yields a neutral-sentiment HUI target at that 0.346x HGR of 656, and a crazy 1036 on a sentiment mean reversion to a 0.546x greed-drenched HGR!  These make for respective potential gains of 254% to 458% in the major gold miners’ stocks, dwarfing all other sectors.

Don’t get bogged down in HUI upside targets, they only serve to illustrate a critical point for investors and speculators today.  Gold stocks are not only wildly undervalued at today’s gold prices, but even more so compared to where gold is heading in its own still-very-much-alive bull market.  Even if you think gold stocks only have 50% to 100% upside, that’s vastly better than everything else in these overvalued stock markets.

Once gold starts powering higher decisively enough to catch investors’ attention, the gold stocks will be off to the races like in early 2016.  Like bitcoin this year, the more gold stocks rally the more traders will take notice and deploy capital.  This process will soon become self-feeding, with more buying fueling higher prices leading to still more buying.  That will yield massive gains to early contrarians who bought in low.

That begs the question what are you going to do about it?  Are you tough enough mentally to invest like a contrarian, to buy low and out of favor when few others are willing?  Can you handle fighting the crowd, making unpopular investments?  Or will you take the mainstream approach, which is waiting to buy gold stocks until they’ve already doubled from here?  The biggest gains are won by the early birds who buy the lowest.

While investors and speculators alike can certainly play gold stocks’ coming breakout rally with the major ETFs like GDX, the best gains by far will be won in individual gold stocks with superior fundamentals.  Their upside will trounce the ETFs, which are burdened by over-diversification and underperforming gold stocks.  A carefully-handpicked portfolio of elite gold and silver miners will generate much-greater wealth creation.

At Zeal we’ve literally spent tens of thousands of hours researching individual gold stocks and markets, so we can better decide what to trade and when.  As of the end of Q3, this has resulted in 967 stock trades recommended in real-time to our newsletter subscribers since 2001.  Fighting the crowd to buy low and sell high is very profitable, as all these trades averaged stellar annualized realized gains of +19.9%!

The key to this success is staying informed and being contrarian.  That means buying low when others are scared, like late in this year’s vexing consolidation.  An easy way to keep abreast is through our acclaimed weekly and monthly newsletters.  They draw on our vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks.  For only $12 per issue, you can learn to think, trade, and thrive like contrarians.  Subscribe today, and get deployed in the great gold and silver stocks in our full trading books!

The bottom line is the gold stocks still look like a coiled spring today despite the extreme bearishness plaguing them.  Following its long drift in 2017, this battered sector is ready to stage a massive breakout upleg in 2018.  The gold miners’ stocks remain deeply undervalued relative to current gold prices, let alone where this metal is heading.  And gold will likely power much higher next year as stock markets roll over.

These bubble-valued stock markets artificially levitated by the central banks are about to face the largest monetary tightening in world history, literally trillions of dollars in the next couple years alone.  Gold will quickly return to favor as usual when stocks materially weaken.  The resulting investment capital inflows will lift gold, really boost gold miners’ profits, and motivate traders to return en masse to this abandoned sector.

Adam Hamilton, CPA

December 22, 2017

Copyright 2000 – 2017 Zeal LLC (www.ZealLLC.com)

 

Gold has been battered lower in recent months as gold-futures speculators fled in dread of the Fed-rate-hike boogeyman.  As universally expected, the Fed’s 5th rate hike of this cycle indeed came to pass this week.  When gold didn’t collapse as irrationally feared, the cowering futures traders were quick to start returning.  Past Fed rate hikes have actually proven very bullish for gold, and this latest one will be no exception.

Back in early September, gold was sitting pretty near $1348.  It had rallied dramatically out of its usual summer-doldrums low in its typical major autumn rally, blasting 11.2% higher in just 2.0 months.  But even way back then, Fed-rate-hike fears for the FOMC’s December 13th meeting started creeping in.  When gold peaked on September 7th, federal-funds futures implied December rate-hike odds running just 32%.

Over the next 8 trading days leading into the September 20th FOMC meeting where the Fed birthed its unprecedented quantitative-tightening campaign, those rate-hike odds climbed as high as 62%.  That day’s FOMC statement and subsequent Janet Yellen press conference blasted the December rate-hike odds even higher to 73%.  So gold slumped back down to $1300 as futures speculators sold in trepidation.

By early October as these futures-implied rate-hike odds hit 93%, gold fell as low as $1268. Over the mere one-month span where December rate-hike odds nearly tripled from 32% to 93%, gold dropped 5.9% on heavy spec gold-futures selling.  That erased nearly 6/10ths of its autumn rally, which really weighed on sentiment.  Gold still managed to stabilize around the $1280s in late October and November.

Starting early last month, federal-funds futures traders became so totally convinced the Fed would hike this week that their implied odds hit 100%.  They stayed pegged at total certainty for 27 trading days in a row.  Gold was able to stage a minor rally to $1294 surrounding Thanksgiving, but speculators resumed dumping gold futures in early December.  Thus gold fell as low as $1242 leading into this week’s FOMC decision.

Gold-futures speculators have always deeply feared Fed rate hikes.  Their rationale is simple and sounds logical.  Since gold pays no interest or dividends, it will struggle to compete with bonds and stocks in a higher-yielding world following Fed rate hikes. Therefore gold investment demand will wane, leading to lower gold prices.  Speculators always attempt to front run their forgone conclusion by selling gold futures.

This scenario has played out for three Decembers in a row now.  The Fed kicked off this rate-hike cycle back in mid-December 2015 with its first rate hike in 9.5 years.  A year ago in mid-December 2016 the FOMC made its second rate hike.  And following two more hikes earlier this year, the Fed’s newest mid-December hike this week was the 5th of its current cycle.  Gold-futures speculators sold aggressively into all.

So gold’s slump into this week on more Fed-rate-hike fears is certainly nothing new.  The lead in to this December FOMC meeting is starting to feel like that old Bill Murray movie Groundhog Day.  So the key question gold investors need to ask today is how did speculators’ excessively-bearish gold-futures bets play out after the prior couple Decembers’ rate hikes?  Did gold crumble in the face of higher rates as feared?

This first chart superimposes gold during this current Fed-rate-hike cycle over speculators’ collective long and short positions in gold futures.  Gold is rendered in blue, and speculators’ total number of upside and downside contracts in green and red respectively. This gold-futures data comes from the CTFC’s weekly Commitments of Traders reports, which are published every Friday afternoon current to the preceding Tuesday.

Gold-futures speculators have long been utterly convinced gold’s mortal nemesis is Fed rate hikes and the resulting higher prevailing interest rates.  They fervently believe a sterile asset like gold simply can’t compete in a rising-rate environment.  And to their credit, these elite traders sure aren’t afraid to put their money where their mouths are.  Their trading surrounding past December hikes illuminates gold’s path today.

Way back in December 2008, the Federal Reserve panicked and slashed interest rates to zero for the first time in its history.  For years after that, top Fed officials talked about normalizing rates but never had the courage to start.  But finally in late October 2015, the FOMC started getting serious about ending its ridiculous ZIRP anomaly.  The Fed warned it might “be appropriate to raise the target range at its next meeting”.

That would be December 16th, 2015.  Since there hadn’t been a Fed rate hike in nearly a decade, the gold-futures speculators freaked out.  Extreme selling erupted as they rushed to dump gold-futures long contracts while catapulting their short positions higher.  So between mid-October and early December that year, gold plunged 11.4% to a major new secular low.  Surely rate hikes doomed zero-yielding gold!

After years of broken promises to end ZIRP, the Fed indeed hiked for the first time in 9.5 years in mid-December 2015.  Gold rallied 1.1% that day, but plunged 2.1% the next to edge down to a brutal 6.1-year secular low of $1051.  With relatively-low longs and extreme record short positions, speculators had heavily bet that was just the beginning of gold’s woes.  Their positions were exceedingly bearish into that hike.

But gold didn’t collapse as they expected, it stabilized.  Speculators had sold such huge amounts of gold-futures contracts that their selling was exhausted.  Thus they had no choice but to start unwinding their own hyper-leveraged bearish bets.  So after that initial Fed rate hike of this cycle, speculators first bought to cover their extreme shorts and then aggressively bought long contracts.  This is readily evident in this chart.

So instead of cratering on the brand-new Fed-rate-hike campaign, gold skyrocketed on massive gold-futures buying by the very speculators convinced rate hikes would slaughter it.  Over the next 6.7 months gold blasted 29.9% higher into its first new bull market since 2011!  One of its primary drivers was these speculators adding 249.2k gold-futures long contracts while cutting 82.8k short ones over that gold-surge span.

Unfortunately gold-futures speculators command a super-disproportional wildly-outsized impact on gold price levels because of these contracts’ extreme inherent leverage.  Each contract controls 100 troy ounces of gold, which is worth $125k this week.  Yet speculators are now only required to maintain $4450 margin in their accounts for each contract held, which equates to incredible maximum leverage to gold of 28.1x!

That means any amount of capital deployed in gold futures by speculators can have up to 28x the price impact on gold as investors buying it outright.  28x is exceedingly dangerous though, as a mere 3.6% adverse move in gold prices would wipe out 100% of the capital bet by futures speculators.  This forces them to have an ultra-short-term focus in order to survive.  They can’t afford to be wrong for very long.

While their collective conviction that Fed rate hikes are like Kryptonite for zero-yielding gold might sound logical, history proves just the opposite!  Back before that initial Fed rate hike of this cycle, I undertook a comprehensive study of how gold reacted in every Fed-rate-hike cycle in modern history.  If speculators were right about Fed rate hikes’ bearish impact on gold, it would be fully confirmed in past Fed-rate-hike cycles.

The history was stunning, as you can read about in an update on this groundbreaking work we published in March 2017.  Prior to today’s rate-hike cycle, the Fed had executed fully 11 between 1971 and 2015.  They are defined as 3 or more consecutive federal-funds-rate increases with no interrupting decreases.  During the exact spans of all 11, gold averaged a strong 26.9% rally!  Fed rate hikes are actually bullish for gold.

Breaking down this critical historical precedent further, gold rallied big in 6 of these cycles while slumping in the other 5.  It averaged huge gains of 61.0% in the majority in which it powered higher!  Generally the lower gold was relative to recent years when entering a new rate-hike cycle, and the more gradual those Fed rate hikes were, the better its upside performance.  Both conditions describe today’s 12th cycle perfectly.

And in the other 5 where gold suffered losses, they averaged an asymmetrically-small 13.9% retreat.  The futures speculators’ cherished notion that Fed rate hikes crush gold is totally false, an irrational myth they deluded themselves into believing.  You’d think with tens of billions of dollars of capital at stake with extreme leverage these elite traders could take the time to study historical precedent on gold and rate hikes.

While gathering and crunching all this data since 1971 certainly isn’t trivial, why not simply look to the last Fed-rate-hike cycle for some guidance?  Between June 2004 to June 2006, the FOMC hiked the FFR at every meeting for 17 consecutive hikes.  Those totaled 425 basis points, more than quintupling the federal-funds rate to 5.25%.  If higher rates and yield differentials slay gold, it should’ve plummeted at 5%+.

Yet during that exact span, gold powered 49.6% higher!  There’s literally zero chance today’s hyper-easy Fed will dare hike rates 17 times or get anywhere near 5%.  The new Fed chairman Jerome Powell that Trump nominated to replace Janet Yellen in early February is widely viewed as a Republican clone of the Democratic Yellen.  Powell will stay Yellen’s course, gradually hiking to new norms way below past FFR levels.

But gold-futures speculators didn’t learn their lesson after getting massively burned by their excessively-bearish bets leading into this 12th modern Fed-rate-hike cycle’s opening increase.  They did the same thing again a year later leading into the Fed’s heavily-telegraphed second hike in mid-December 2016.  They aggressively dumped gold-futures longs, and ramped shorts, leading into the FOMC’s year-ago decision.

While irrational rate-hike fears remained a prime motivator to sell gold futures, those decisions certainly were aided by the stock markets.  After Trump’s surprise election win in early November last year, the stock markets rocketed higher in Trumphoria on hopes for big tax cuts soon.  Gold investment demand really wanes when record-high stock markets generate much euphoria, killing demand for alternatives led by gold.

So just like a year earlier, following last December’s second Fed rate hike of this cycle gold dropped to a major low of $1128 the very next day.  In 5.3 months gold had plunged 17.3% partially thanks to gold-futures speculators dumping 164.5k long contracts while adding 25.8k short ones.  But yet again just as their collective bets hit peak bearishness on another Fed rate hike, gold was ready to reverse sharply higher.

The reason is excessive gold-futures selling by speculators is self-limiting.  Despite the market power their extreme leverage grants them, their capital is finite.  They only have so many long contracts they are willing and able to sell, and only so much capital available to short sell gold futures.  So once they near those limits, a reversal is inevitable.  They soon have to resume buying longs again while covering shorts.

So for the second year in a row, gold blasted higher out of its major lows immediately after a December Fed rate hike.  Over the next 8.7 months leading into early September, gold powered 19.5% higher with speculators adding 111.0k long contracts.  They were starting to learn their lesson on shorting a young bull market though, as their total shorts fell just 1.0k contracts over that span.  This 2017 gold upleg was impressive.

Gold not only rallied on balance through the 3rd and 4th Fed rate hikes of this cycle in mid-March and mid-June, but climbed despite this year’s extreme stock-market euphoria generated by the endless new record highs.  Speculators temporarily shorted gold-futures to near-record levels leading into gold’s usual summer doldrums, but that artificial low soon gave way to a powerful autumn rally.  Gold has held strong.

Despite surging Fed-rate-hike odds leading into this week’s universally-expected 5th hike of this cycle, gold was even able to stabilize from early October to early December.  But as the third Fed rate hike in as many Decembers loomed closer, gold-futures speculators again lost their nerve in recent weeks.  That’s readily evident in the newest CoT report before this essay was published, current to Tuesday December 5th.

As another December rate hike looked certain, gold-futures speculators jettisoned 39.2k long contracts and short sold another 17.4k more in a single CoT week!  That total selling of 56.7k contracts was the equivalent of a staggering 176.2 metric tons of gold.  That ranked as the third-largest CoT week of spec gold-futures selling out of the 988 since early 1999.  These goofy traders were freaking out again over a rate hike.

The Fed indeed hiked for the 5th time in this 12th modern cycle as widely forecast, taking the FFR up to a range between 1.25% to 1.50%.  I suspect gold-futures speculators expected top Fed officials’ outlook for 2018 rate hikes to rise from the prior dot plot’s three published a quarter earlier.  But 2018 rate-hike projections didn’t budge, holding at exactly the same average in this week’s newest mostly-neutral dot plot.

So speculators resumed buying gold futures right as the FOMC released its decision and rate-hike projections at 2pm this past Wednesday.  Gold surged 1.0% higher that day, paralleling its 1.1% rate-hike-day gains two years earlier that was about to kick off a major new bull market.  Gold remained up 18.3% in the Fed’s current rate-hike cycle to date, solid gains considering futures speculators’ erroneous beliefs.

Odds are their excessively-bearish bets battering gold in recent months will prove every bit as wrong this December as they did in the last couple years’ Decembers!  Gold will likely again stage a powerful rebound rally into 2018 as these hyper-leveraged traders reestablish long positions.  They don’t have many short contracts to cover, continuing last year’s trend.  Leveraged shorting of a healthy bull market is suicidal.

 

Just like following the prior couple Decembers’ Fed rate hikes, gold investment buying will likely resume as well.  Through speculators’ collective trading’s adverse impact on gold leading into hikes, investors too get worried about gold in higher-rate environments.  But once another Fed rate hike passes and gold doesn’t collapse on cue as expected, investors resume buying.  Their inflows are the most important of all.

While gold investment is usually done outright with no leverage, investors’ vast pools of capital dwarf the gold-futures speculators’ limited firepower.  So gold investment trumps gold-futures speculation.  This final chart looks at the best daily approximation of investment available, the holdings of the leading GLD SPDR Gold Shares gold ETF.  When its holdings are rising, American stock-market capital is returning to gold.

When investors aren’t interested in gold, their lack of buying allows gold-futures speculators to dominate short-term price action.  But once investors buy or sell gold en masse, that easily overpowers whatever the futures traders are up to.  The main reason gold exploded into a new bull market after that initial rate hike in December 2015 was massive differential GLD-share buying by American stock investors in early 2016.

During that same 6.7-month span where gold rocketed 29.9% higher in a new bull, GLD’s physical gold bullion held in trust for shareholders soared 55.7% or 351.1t!  Gold then collapsed after Trump’s election win as GLD’s holdings shrunk 14.2% or 138.9t in 5.3 months leading into last December.  While GLD’s holdings kept slumping after the December 2016 hike, they soon climbed modestly and stabilized in 2017.

Early 2018 is likely to see big gold investment buying much closer to early 2016’s than early 2017’s, which will help catapult gold dramatically higher again.  The extreme record stock-market rally of 2017 that generated such epic euphoria isn’t likely to persist into 2018.  As stock markets finally roll over into a long overdue major correction or more likely new bear market, investment capital will flood back into gold again.

Though few investors realize it yet, 2018 is going to look radically different from 2017.  The major central banks that have injected trillions of dollars of capital since 2008’s stock panic that levitated stock markets are slamming on the brakes.  The Fed is ramping its new quantitative-tightening campaign that destroys the QE money created out of nothing to a $50b-per-month pace by Q4’18, something never before witnessed.

At the same time the European Central Bank is slashing its own quantitative-easing campaign from this year’s €60b-per-month pace to just €30b monthly starting in January.  Together Fed QT and ECB QE tapering will drive $950b of central-bank tightening in 2018 and then another $1450b in 2019 compared to this year!  I explained all this in depth in late October in a critical essay for all investors to fully digest.

As the Fed and ECB reverse sharply from their unprecedented easing of recent years to unprecedented tightening in the coming years, these record-high, euphoric, bubble-valued stock markets are in serious trouble.  As they roll over and sell off, investors will rush to prudently diversify their stock-heavy portfolios with counter-moving gold.  There’s nothing more bullish for gold investment demand than weakening stocks.

So contrary to recent weeks’ and months’ erroneous view that Fed rate hikes are bearish for gold, history proves just the opposite is true.  Gold has thrived in the 11 modern Fed-rate-hike cycles before today’s, and it has powered higher on balance in this 12th one. While you wouldn’t know it after this past year’s extreme Trumphoria rally, Fed rate hikes are actually bearish for stocks and thus quite bullish for gold.

The last time investors flooded into gold in early 2016 after that initial December rate hike, gold powered 29.9% higher in 6.7 months.  The beaten-down gold miners’ stocks greatly amplified those gains, with the leading HUI gold-stock index soaring 182.2% higher over roughly that same span!  Gold stocks are again deeply undervalued relative to gold, a coiled spring ready to explode higher in this gold bull’s next major upleg.

At Zeal we diligently study market history so we aren’t deceived by irrational herd sentiment.  This helps us execute better real-world trades, actually buying low before selling high.  As of the end of Q3, this has resulted in 967 stock trades recommended in real-time to our newsletter subscribers since 2001.  Our contrarian strategies are very profitable, as all these trades averaged stellar annualized realized gains of +19.9%!

The key to this success is staying informed and being contrarian.  That means buying low when others are scared, like leading into Fed rate hikes.  An easy way to keep abreast is through our acclaimed weekly and monthly newsletters.  They draw on my vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks.  Easy to read and affordable, they’ll help you learn to think, trade, and thrive like contrarians.  Subscribe today, and get deployed in the great gold stocks on our trading books before they surge far higher!

The bottom line is Fed rate hikes are bullish for gold, and this week’s is no exception.  Gold has not only powered higher on average in past Fed-rate-hike cycles, but has rallied strongly in the current one.  After each past December rate hike which gold-futures speculators sold aggressively into, gold dramatically surged in the subsequent months.  These guys always buy after getting excessively bearish, forcing gold higher.

Gold’s next upleg following the Fed’s 5th rate hike since late 2015 is likely to get a massive boost from weaker stock markets.  The same thing happened a couple years ago during the last US stock-market correction.  As the Fed and ECB drastically reverse and slash their liquidity injections in 2018, these wild central-bank-inflated stock markets are in serious trouble.  Gold investment demand surges when stocks weaken.

Adam Hamilton, CPA

December 15, 2017 

Copyright 2000 – 2017 Zeal LLC (www.ZealLLC.com)

 

Bitcoin’s meteoric skyrocketing this year has been astonishing, captivating traders across the globe.  This once-obscure cryptocurrency has exploded into the world’s hottest market. With fortunes being won on paper, everyone is talking about bitcoin.  But with its price shooting parabolic, unfortunately this wild ride has all the hallmarks of a classic popular speculative mania.  And those all end badly, totally collapsing.

In the annals of financial-market history, the word “mania” is never used lightly.  These are very-rare events where some market blasts higher so radically that it captures the popular imagination.  The dictionary definitions of mania include “an excessively intense enthusiasm, interest, or desire” and “a pathological state characterized by euphoric mood, excessive activity or talkativeness, and impaired judgment”.

The seminal book on popular speculative manias is Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds”, first published way back in 1841.  Manias are certainly nothing new, they have been periodically erupting for many centuries if not millennia.  Mackay’s incredible work is one of the few must-read books for every investor.  I’ve read it several times in my life, starting back in college.

Mackay’s title is brilliant, perfectly summing up manias.  They are truly extraordinary popular delusions, illustrating the madness of crowds.  Objectively, this year’s extreme bitcoin action definitely fits that bill.  I say this as a lifelong student of the markets.  Like the objects of lust in past popular manias, bitcoin and its underlying blockchain technology have real potential to change the world.  But that doesn’t justify its price.

As a techie, I started getting interested in bitcoin about 5 years ago, well after its birth in January 2009.  It was intriguing as the world’s first decentralized digital currency, an Information Age end run around the established government fiat-money systems relentlessly being inflated away by central banks.  Bitcoin’s never-unmasked creator going by Satoshi Nakamoto was a marketing genius, wrapping bitcoin in gold terminology.

The “coin” suffix implied bitcoin is money, rather than a virtual fiction with artificial scarcity.  And it used a novel distributed-ledger technology called blockchain.  That is a record of all bitcoin transactions that is broadcast and validated by the entire bitcoin network.  This ensures that bitcoins can be transferred with no counterparty risk, trust is irrelevant.  Maintaining the blockchain is called “mining”, again bringing gold to mind.

The countless computers all over the world participating in recordkeeping for bitcoin’s blockchain work to simultaneously solve complex cryptographic problems, or hashes.  This mining guarantees that all new bitcoin transactions are legitimate.  While it is computationally-intensive which requires much electricity, bitcoin ingeniously awards participating miners with newly-created bitcoins.  That’s a heck of an incentive today!

Somewhat like gold, the bitcoin supply grows at slow and ever-decreasing fixed rates. Today there are around 16.7m bitcoins in circulation.  12.5 new ones are created every 10 minutes and distributed to the miners maintaining the blockchain.  That supply-growth rate will be gradually halved again and again until the bitcoin supply hits its hard-coded maximum of 21m bitcoins after 2110.  So bitcoin’s supply is artificially limited.

Repurposing old computers to mining is what sparked my initial interest in bitcoin.  I run a small financial-research company where we must periodically replace our high-end computers.  So I investigated putting some of our old put-out-to-pasture ones to work mining bitcoins, but at the time the electricity cost well exceeded the resulting bitcoins’ value.  Back then bitcoin mining didn’t require specialized custom-made rigs.

When bitcoin was younger, normal computers could solve the necessary cryptographic hashes to keep the blockchain up to date.  As this distributed ledger grew, more-powerful high-end computer-graphics cards were needed.  Today bitcoin mining requires computers with processors designed from scratch to do nothing but grind on the blockchain, called application-specific integrated circuits.  They get very expensive.

Truly bitcoin and its brilliant blockchain distributed-ledger system are amazing technologies.  They will ultimately reshape how we buy and sell goods and services, shifting the balance of power in currencies back away from centralized governments.  It’s hard not to be a bitcoin enthusiast.  That being said, it’s critical for traders to divorce bitcoin’s extreme mania price action from these technologies’ future potential.

For 18 years now, I’ve written an essay like this nearly every week.  Wednesday mornings I decide on a market topic, research it, and build any charts.  So our Zeal charts are always current to Wednesday’s close.  Then on Thursday I write and proof each essay before publishing it Friday morning.  Normally that day-and-a-half between finalizing the data and releasing an essay doesn’t matter, but bitcoin’s mania is crazy.

Bitcoin trades nonstop around the world, with transactions always happening and the blockchain always being updated.  Around the normal US stock-market close this Wednesday, each bitcoin was priced at $12,968.  So all the data, charts, and analysis in this essay is based on that ancient price.  Merely 18 hours later as I pen this essay, bitcoin has rocketed another 18.6% higher to $15,379!  Its ascent is meteoric.

So who knows how high bitcoin will be when you read this.  But the higher bitcoin skyrockets, the more it emphasizes the extreme danger inherent in this popular speculative mania!  Bitcoin is absolutely deep in a monster bubble, defined as “an increase in the price of a market that is not warranted by economic fundamentals and is usually caused by ongoing speculation in the expectation that the price will increase further”.

This first chart looks at bitcoin prices over the past couple years or so.  Bitcoin has rocketed parabolic in 2017, soaring vertically in what looks exactly like a popular mania blowoff top.  Vertical parabolic gains are mathematically impossible to sustain for long, as they would soon suck in all the available money on the entire planet!  If this chart doesn’t terrify you, you should go read Mackay’s mania book before it’s too late.

Bitcoin was no slouch in 2016, soaring 123.6% higher in what looked like a late-stage bull market.  That is hardly a blip on today’s chart though, as that morphed into a full-blown popular speculative mania this year.  As of Wednesday’s sub-$13k price, bitcoin had skyrocketed 1251.9% higher year-to-date and a mind-boggling 1565.6% higher since its early-January low!  These mania technicals are extreme beyond belief.

Like gold and many other investments including lots of stocks, bitcoin produces no cash yields and thus can’t be valued with conventional valuation analysis.  So no one has any idea what it’s worth.  The range of guesses is vast, running from zero to hundreds of thousands of dollars per bitcoin!  But even in the absence of any fundamental valuation, bitcoin’s price action itself proves it’s exceedingly expensive today.

Obviously Wednesday wasn’t this bitcoin speculative mania’s peak, but let’s assume it was to use as a reference point for analysis.  Bitcoin’s “terminal gains” as of the middle of this week were astounding.  In the past month alone it had soared 87%, nearly doubling!  It had skyrocketed 197% in 2 months, 280% in 4 months, and 459% in 5 months.  This left bitcoin radically overbought, trading at 3.70x its 200-day moving average.

The problem with such extreme mania price gains is they soon collapse under their own weight.  Over the past week ending Wednesday, bitcoin was surging an average of 5.9% per day.  Two of those days had 9.7% gains.  Literally nothing can rally 5% to 10% per day for long, as the math is truly impossible.  Think of that old rule of 72, which is used to approximate how long it takes for any investment to double in price.

It is normally applied to years, where 72 is divided by the average annual return to figure out about how many years it will take to grow 100%.  72 divided by 7% for example works out to about a decade to see 100% gains.  But at 5% or 10% compounded daily as bitcoin is doing, its total value will double in just under 14.3 and 7.3 trading days respectively! Even to a casual observer that sounds absurd, wildly unsustainable.

Early Thursday morning, the total market value of all bitcoins in circulation was already around $250b.  If bitcoin doubles again over the coming weeks and months, that would soar over $500b.  Just one more doubling after that would take it to a staggering market cap of $1t!  While anything is possible, that seems wildly improbable.  For comparison, the Fed’s latest read on its total M1 money supply is running near $3.6t.

When anything shoots parabolic in a popular speculative mania, exponentially more capital inflows are required to sustain such extreme gains.  It doesn’t take many doublings in price and market cap to suck in all available money on the planet!  While bitcoin certainly enjoys a popular niche, there’s zero chance that global investors will sell sizable fractions of their bond, stock, gold, and cash holdings to buy bitcoins.

Thus extreme gains are never sustainable, as the collective buying power of even populations caught up in manias soon exhausts itself.  Eventually everyone interested in buying bitcoin has already bought, drying up their pools of available capital.  When those massive bubble-fueling capital inflows peak then taper off, market gravity reasserts itself and the stratospheric price starts plummeting back down to terra firma.

Unfortunately naive speculators don’t realize how extreme doublings and quadruplings within a matter of months truly are.  That makes it easier for them to get sucked into mania psychology.  They read about the blistering gains, everyone is raving about the bubble market, so they throw caution to the wind and buy in super-high.  Even worse, many traders rushing to buy into parabolic bubbles borrow money to do it with!

At that point all rationality is thrown out the window, it’s an extraordinary popular delusion as Mackay wisely wrote 176 years ago.  The price is totally disconnected from reality, and the sole reason capital is flooding in is because it is soaring.  That becomes self-reinforcing for a season, buying fueling gains and greed which leads to even more buying.  While exciting, vertical parabolic blowoffs are exceedingly dangerous.

Every popular speculative mania in history has failed spectacularly, the bubbles bursting and crashing, since capital inflows can never grow exponentially for long.  That’s going to happen to bitcoin too, without any doubt.  The deluded speculators who succumb to the temptation to buy in high, especially if they use leverage, are going to get slaughtered.  An infamous past bubble helps illustrate bitcoin’s extreme dangers today.

This final chart again assumes Wednesday was this bitcoin bubble’s peak for the sake of analysis.  The past couple years’ bitcoin action is superimposed over the notorious silver bubble that crested in January 1980.  Both datasets are indexed at 100 at their respective peaks to render them in perfectly-comparable percentage terms.  The bottom axis shows time elapsing before and after the peaks measured in months.

The parallels between bitcoin’s extreme parabolic price action over the past 6 months or so and silver’s in its bubble’s final 6 months are uncanny.  While very rare, popular speculative manias are nothing new.  The terminal gains of bitcoin and silver are remarkably similar as the table above shows.  If these data series were not labeled, today’s bitcoin bubble and the 1979 silver bubble would literally be indistinguishable.

As of Wednesday bitcoin had rocketed 87% in its latest month compared to 104% for the silver bubble in its terminal month.  At 2 months out they were identical at 197% and 196% gains.  The same was true at 3 months with 181% and 179% gains.  In their final 5 months, they skyrocketed 459% and 417% higher.  Their terminal 6 months saw 366% and 402% gains.  This bitcoin bubble is behaving just like the silver bubble!

While bubbles are incredibly exciting and fun when they shoot parabolic, the aftermath is catastrophic for traders who buy high.  Bubbles always burst, leading to full-on crashes that proceed long busts.  Just a month after silver peaked at $48.00 per ounce in January 1980, it plunged 35%.  In the first 2, 3, and 4 months post-peak, silver plummeted 54%, 73%, and 76%!  Bitcoin faces similar extreme downside risks today.

Once this mania bitcoin bubble bursts, and it will, the odds are very high that bitcoin will lose 50% to 75% of its value within a few months on the outside!  Everyone owning bitcoin today must be prepared for brutal near-term downside proportional to this year’s bubble upside.  When a bubble bursts it rapidly destroys most of the paper wealth that bubble created, which was really an illusion all along if not cashed out.

And once popular speculative manias inevitably fail, prices don’t return to those extreme bubble-peak levels for an awfully-long time.  That silver bubble peaked 37.9 years ago, and there are still many silver enthusiasts today.  Like the hardcore bitcoin faithful, plenty of people love silver with a religious-like zeal believing it is the ultimate investment.  In nominal terms, silver didn’t exceed that bubble peak until April 2011.

After taking a staggering 31.3 years to regain January 1980’s high, silver held it for a single day and has never returned since.  And in real inflation-adjusted terms based on the US CPI, silver’s bubble peak in today’s dollars was over $152 per ounce!  Obviously silver has come nowhere close to trading near those same real levels again.  Prices are so extreme after popular speculative manias they may never recover.

A far-milder bubble than both bitcoin and silver arose in the stock markets in late 1999 and early 2000.  Like bitcoin, the technology of the Internet was amazing and would forever change our world.  Yet stock prices got so extreme then that the NASDAQ didn’t revisit its March 2000 closing peak for the first time until April 2015, fully 15.1 years later!  And that only happened because NASDAQ’s components greatly changed.

The history of popular speculative manias proves that even if bitcoin and its underlying blockchain are here to stay, it will likely be many years or decades until bitcoin prices regain their bubble peak wherever that happens to be.  Once this bitcoin bubble inevitably pops, there’s virtually no chance its traders will be made whole again.  They’ll hold through the burst in hopes bitcoin will rebound, but bubble poppings are final.

And it’s not just bitcoin’s extreme price action that reveals it’s in a bubble fueled by a popular speculative mania.  Anecdotal stories abound showing a huge influx of young and naive “investors” who have never lived through a bubble.  The leading bitcoin broker in the US is Coinbase.  Its accounts are exploding as people rush to pour money into this bitcoin mania.  By late November, Coinbase’s active accounts had hit 13.3m!

This is staggering growth, as Coinbase reported just over 5m accounts as 2017 dawned. 13.3m is way bigger than stock broker Charles Schwab’s 10.6m at the end of October, and threatening to rival the 24.9m accounts stock broker Fidelity had at the end of June!  As in all manias, the vast majority of these new bitcoin “investors” have drank the Kool-Aid and believe bitcoin’s technology justifies its extreme price gains.

When markets soar so high all rationality is thrown out the window, the only reason to keep buying is the greater-fool theory.  Late-stage traders buy super-high in the hopes they’ll find an even greater fool to sell even higher to later!  Soaring prices can entice in big new capital inflows for a season, but eventually the price levels get so high that it’s impossible to sustain exponential buying.  Then the bubble bursts, prices crash.

Even if bitcoin and blockchain forever change currencies in the future, nothing justifies doublings and quadruplings in bitcoin prices in a matter of months.  Such extremes are never sustainable, all popular manias fail spectacularly even though the technology investors were excited about lives on and indeed changes the world.  I’m really excited to see bitcoin and blockchain applied to digital gold in coming years.

Gold has been universally valued across the world for millennia, yet it’s impractical to use as money for most transactions.  But if bitcoin-and-blockchain technologies were applied to gold, this metal could easily be subdivided into the tiniest of increments and traded globally.  A gold version of bitcoin would have to be 100% physically backed by gold held in secure vaults in safe, trusted countries.  It’s already being worked on.

But the great value of bitcoin-and-blockchain technologies doesn’t make bitcoin immune from the natural consequences of this year’s bubble.  Bitcoin is far too large now to keep doubling on a monthly basis, it’s impossible.  And there’s never been a past bubble where prices stop soaring but don’t crash, instead just rallying on from there quasi-normally. Greedy traders start selling when the parabola stalls, driving the burst.

One of the reasons bitcoin has skyrocketed is there are virtually no sellers relative to the great herds of new buyers flocking in.  That is all going to change soon, which presents big risks of popping this bubble.  Both the CBOE and CME are set to launch actual bitcoin futures in the next week or so, which will allow professional speculators to not only buy bitcoin but short sell it at scale.  That alone may very well slay this bubble.

Bitcoin is pretty inefficient too, with transactions taking up to 10 minutes to process as the blockchain gets bigger and bigger.  Transaction costs are also skyrocketing, leading some major businesses like the Steam online video-gaming service to stop accepting bitcoin as payment.  Its owner Valve says it now costs about $20 to process a single bitcoin payment, far too expensive for this company’s massive 67m users.

As bitcoin grows, the blockchain itself is getting ever-more unwieldy.  That ledger recording every single bitcoin transfer ever is requiring progressively more computing power to process, making mining for the network much more expensive.  Recent estimates place bitcoin-mining electricity usage at 0.13% of the world total.  A single bitcoin transaction now requires enough electricity to power an American house for a week!

 

As long as bitcoin prices are sky-high, large-scale mining operations to process bitcoin’s cryptographic hashes are profitable.  But when bitcoin crashes after this bubble, computers tasked to mining will likely plunge in parallel.  While the hashes are dynamically adjusted to account for network mining power, this could still increase transaction times as blockchain grows.  That would make bitcoin less attractive as a currency.

As a professional speculator over the past two decades or so, I wouldn’t touch bitcoin with a ten-foot pole today.  Buying into a popular speculative mania that’s already rocketed parabolic is the height of folly, guaranteeing massive losses in the near-future.  If you were shrewd enough to buy bitcoins before the last 6 months, you should be scaling out and taking profits.  One bitcoin expert calls it a “consensus hallucination”.

At Zeal we’ve spent decades studying and trading the markets, building wealth normally and consistently through profitable real-world trading with a contrarian bent.  This means buying low and selling high, so bitcoin is off the table.  But as of the end of Q3 we’ve realized 967 stock trades recommended in real-time in our newsletters since 2001, which averaged stellar annualized realized gains of +19.9% over that long span!

The key to this success is staying informed and being contrarian.  That means buying low when others are scared, not when they are euphoric like in bitcoin’s mania.  An easy way to keep abreast is through our acclaimed weekly and monthly newsletters.  They draw on my vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks.  Easy to read and affordable, they’ll help you learn to think, trade, and thrive like contrarians.  Subscribe today, and build lasting wealth instead of getting obliterated when bitcoin’s bubble bursts.

The bottom line is this year’s bitcoin popular speculative mania has gone parabolic.  Such extreme gains are never sustainable, as they require exponentially-growing capital inflows.  Once this greed-drenched bubble stage is reached, it’s only a matter of time until the burst inevitably follows.  The resulting selling from panicking traders is so violent that most of the mania gains are fully annihilated in a matter of months.

While bitcoin and its blockchain distributed-ledger technologies are amazing and will indeed likely change the world, they don’t justify bitcoin’s extreme vertical gains.  Plenty of past bubbles were based on great new technologies too, but those prices still collapsed once the supply of greater fools exhausted itself.  After skyrocketing so darned fast, bitcoin is certainly the riskiest major investment in the world.  Caveat emptor!

Adam Hamilton, CPA

December 8, 2017

Copyright 2000 – 2017 Zeal LLC (www.ZealLLC.com)

 

The junior gold miners’ stocks have spent months grinding sideways near lows, sapping confidence and breeding widespread bearishness.  The entire precious-metals sector has been left for dead, eclipsed by the dazzling Trumphoria stock-market rally.  But traders need to keep their eyes on the fundamental ball so herd sentiment doesn’t mislead them.  The juniors recently reported Q3 earnings, and enjoyed strong results.

Four times a year publicly-traded companies release treasure troves of valuable information in the form of quarterly reports.  Companies trading in the States are required to file 10-Qs with the US Securities and Exchange Commission by 45 calendar days after quarter-ends.  Canadian companies have similar requirements.  In other countries with half-year reporting, many companies still partially report quarterly.

The definitive list of elite junior gold stocks to analyze used to come from the world’s most-popular junior-gold-stock investment vehicle.  This week the GDXJ VanEck Vectors Junior Gold Miners ETF reported $4.4b in net assets.  Among all gold-stock ETFs, that was only second to GDX’s $8.1b.  That is GDXJ’s big-brother ETF that includes larger major gold miners.  GDXJ’s popularity testifies to the great allure of juniors.

Unfortunately this fame has recently created major problems severely hobbling the usefulness of GDXJ.  This sector ETF has shifted from being beneficial for junior gold miners to outright harming them.  GDXJ is literally advertised as a “Junior Gold Miners ETF”.  Investors only buy GDXJ shares because they think this ETF gives them direct exposure to junior gold miners’ stocks.  But unfortunately that’s no longer true!

GDXJ is quite literally the victim of its own success.  This ETF grew so large in the first half of 2016 as gold stocks soared in a massive upleg that it risked running afoul of Canadian securities law.  Most of the world’s junior gold miners and explorers trade in Canada.  In that country once any investor including an ETF goes over 20% ownership in any stock, it is deemed a takeover offer that must be extended to all shareholders!

Understanding what happened in GDXJ is exceedingly important for junior-gold-stock investors, and I explained it in depth in my past essay on juniors’ Q1’17 results.  GDXJ’s managers were forced to reduce their stakes in leading Canadian juniors.  So capital that GDXJ investors intended to deploy in junior gold miners was instead diverted into much-larger gold miners.  GDXJ’s effective mission stealthily changed.

Not many are more deeply immersed in the gold-stock sector than me, as I’ve spent decades studying, trading, and writing about this contrarian realm.  These huge GDXJ changes weren’t advertised, and it took even me months to put the pieces together to understand what was happening.  GDXJ’s managers may have had little choice, but their major direction change has been devastating to true junior gold miners.

Investors naturally pour capital into GDXJ, the “Junior Gold Miners ETF”, expecting to own junior gold miners.  But instead of buying junior gold miners’ shares and bidding up their prices, GDXJ is instead shunting those critical inflows to the much-larger mid-tier and even major gold miners.  That left the junior gold miners starved of capital, as their share prices they rely heavily upon for financing languished in neglect.

GDXJ’s managers should’ve lobbied Canadian regulators and lawmakers to exempt ETFs from that 20% takeover rule.  Hundreds of thousands of investors buying an ETF obviously have no intention of taking over gold-mining companies!  And higher junior-gold-stock prices boost the Canadian economy, helping these miners create valuable high-paying jobs.  But GDXJ’s managers instead skated perilously close to fraud.

This year they rejiggered their own index underlying GDXJ, greatly demoting most of the junior gold miners!  Investors buying GDXJ today are getting very-low junior-gold-miner exposure, which makes the name of this ETF a deliberate deception.  I’ve championed GDXJ for years, it is a great idea.  But in its current sorry state, I wouldn’t touch it with a ten-foot pole.  It is no longer anything close to a junior-gold-miners ETF.

There’s no formal definition of a junior gold miner, which gives cover to GDXJ’s managers pushing the limits.  Major gold miners are generally those that produce over 1m ounces of gold annually.  For years juniors were considered to be sub-200k-ounce producers.  So 300k ounces per year is a very-generous threshold.  Anything between 300k to 1m ounces annually is in the mid-tier realm, where GDXJ now traffics.

That high 300k-ounce-per-year junior cutoff translates into 75k ounces per quarter.  Following the end of the gold miners’ Q3 earnings season in mid-November, I dug into the top 34 GDXJ components.  That’s just an arbitrary number that fits neatly into the tables below.  While GDXJ included a staggering 73 component stocks in mid-November, the top 34 accounted for a commanding 81.1% of its total weighting.

Out of these top 34 GDXJ companies, only 5 primary gold miners met that sub-75k-ounces-per-quarter qualification to be a junior gold miner!  Their quarterly production is highlighted in blue below, and they collectively accounted for just 7.1% of GDXJ’s total weighting.  But even that isn’t righteous, as these include a 126-year-old silver miner and a mid-tier gold miner suffering temporary production declines.

GDXJ is inarguably now a pure mid-tier gold-miner ETF.  That’s great if GDXJ is advertised as such, but terrible if capital investors explicitly intend for junior gold miners is instead being diverted into mid-tiers without their knowledge or consent.  The vast majority of GDXJ shareholders have no idea how radically this ETF has changed since early 2016.  It is all but unrecognizable, straying greatly from its original mission.

I’ve been doing these deep quarterly dives into GDXJ’s top components for years now.  In Q3’17, fully 32 of the top 34 GDXJ components were also GDX components!  These ETFs are separate, a “Gold Miners ETF” and a “Junior Gold Miners ETF”.  So why on earth should they own many of the same companies?  In the tables below I highlighted the rare GDXJ components not also in GDX in yellow in the weightings column.

These 32 GDX components accounted for 78.7% of GDXJ’s total weighting, not just its top 34.  They also represented 31.4% of GDX’s total weighting.  So almost 4/5ths of the junior gold miners’ ETF is made up of nearly a third of the major gold miners’ ETF!  I’ve talked with many GDXJ investors over the years, and have never heard one wish their capital allocated specifically to junior golds would instead go to much-larger miners.

Fully 10 of GDXJ’s top 17 components weren’t even in this ETF a year ago in Q3’16.  They alone now account for 34.5% of its total weighting.  16 of the top 34 are new, or 44.4% of the total.  In the tables below, I highlighted the symbols of companies that weren’t in GDXJ a year ago in light blue.  Today’s GDXJ is a radical departure from last year.  Analyzing Q3’17 results largely devoid of real juniors is frustrating.

Nevertheless, GDXJ remains the leading “junior-gold” benchmark.  So every quarter I wade through tons of data from its top components’ 10-Qs, and dump it into a big spreadsheet for analysis.  The highlights made it into these tables.  A blank field means a company didn’t report that data for Q3’17 as of that mid-November 10-Q deadline.  Companies have wide variations in reporting styles, data presented, and report timing.

In these tables the first couple columns show each GDXJ component’s symbol and weighting within this ETF as of mid-November.  While most of these gold stocks trade in the States, not all of them do.  So if you can’t find one of these symbols, it’s a listing from a company’s primary foreign stock exchange.  That’s followed by each company’s Q3’17 gold production in ounces, which is mostly reported in pure-gold terms.

Many gold miners also produce byproduct metals like silver and copper.  These are valuable, as they are sold to offset some of the considerable costs of gold mining.  Some companies report their quarterly gold production including silver, a construct called gold-equivalent ounces.  I only included GEOs if no pure-gold numbers were reported.  That’s followed by production’s absolute year-over-year change from Q3’16.

Next comes the most-important fundamental data for gold miners, cash costs and all-in sustaining costs per ounce mined.  The latter determines their profitability and hence ultimately stock prices.  Those are also followed by YoY changes.  Finally the YoY changes in cash flows generated from operations, GAAP profits, revenues, and cash on balance sheets are listed.  There’s one key exception to these YoY changes.

Percentage changes aren’t relevant or meaningful if data shifted from negative to positive or vice versa.  Plenty of GDXJ gold miners that earned profits in Q3’16 suffered net losses in Q3’17.  So in cases where data crossed that zero line, I included the raw numbers instead.  This whole dataset offers a fantastic high-level fundamental read on how the mid-tier gold miners are faring today, and they’re actually doing quite well.

After spending days digesting these GDXJ gold miners’ latest quarterly reports, it’s fully apparent their vexing consolidation this year isn’t fundamentally righteous at all!  Traders have abandoned this sector since the election because the allure of the levitating general stock markets has eclipsed gold.  That has left gold stocks exceedingly undervalued, truly the best fundamental bargains out there in all the stock markets!

Once again the light-blue-highlighted symbols are new GDXJ components that weren’t included a year ago in Q3’16.  And the meager yellow-highlighted weightings are the only stocks that were not also GDX components in mid-November!  GDXJ is increasingly a GDX clone that offers little if any real exposure to true gold juniors’ epic upside potential during gold bulls.  GDXJ has become a shadow of its former self.

VanEck owns and manages GDX, GDXJ, and the MVIS indexing company that decides exactly which gold stocks are included in each.  With one company in total control, GDX and GDXJ should have zero overlap in underlying companies!  GDX or GDXJ inclusion should be mutually-exclusive based on the size of individual miners.  That would make both GDX and GDXJ much more targeted and useful for investors.

Two of GDXJ’s heaviest-weighted component choices are mystifying.  Sibanye Gold and Gold Fields are major South African gold miners, way bigger than mid-tier status and about as far from junior-dom as you can get.  In Q3’17 they both mined way in excess of that 250k-ounce quarterly threshold that is definitely major status.  They are among the world’s largest gold miners, so it’s ludicrous to have them in a juniors ETF.

Since gold miners are in the business of wresting gold from the bowels of the Earth, production is the best place to start.  These top 34 GDXJ gold miners collectively produced 4352k ounces in Q3’17.  That rocketed 121% higher YoY, but that comparison is meaningless given the radical changes in this ETF’s composition since Q3’16.  On the bright side, GDXJ’s miners do still remain significantly smaller than GDX’s.

GDX’s top 34 components, fully 20 of which are also top-34 GDXJ components, collectively produced 9947k ounces of gold in Q3.  So GDXJ components’ average quarterly gold production of 136k ounces excluding explorers was 55% lower than GDX components’ 301k average.  In spite of GDXJ’s very-misleading “Junior” name, it definitely has smaller gold miners even if they’re well above that 75k junior threshold.

Despite GDXJ’s top 34 components looking way different from a year ago, these current gold miners are faring well on the crucial production front.  Fully 22 of these mid-tier gold miners enjoyed big average YoY production growth of 18%!  Overall average growth excluding explorers was 8.2% YoY, which is far better than world mine production which slumped 1.3% lower YoY in Q3’17 according to the World Gold Council.

These elite GDXJ mid-tier gold miners are really thriving, with production growth way outpacing their industry.  That will richly reward investors as sentiment normalizes. Smaller mid-tier gold miners able to grow production are the sweet spot for stock-price upside potential.  With market capitalizations much lower than major gold miners, investment capital inflows are relatively larger which bids up stock prices faster.

With today’s set of top-34 GDXJ gold miners achieving such impressive production growth, their costs per ounce should’ve declined proportionally.  Higher production yields more gold to spread mining’s big fixed costs across.  And lower per-ounce costs naturally lead to higher profits.  So production growth is highly sought after by gold-stock investors, with companies able to achieve it commanding premium prices.

There are two major ways to measure gold-mining costs, classic cash costs per ounce and the superior all-in sustaining costs per ounce.  Both are useful metrics.  Cash costs are the acid test of gold-miner survivability in lower-gold-price environments, revealing the worst-case gold levels necessary to keep the mines running.  All-in sustaining costs show where gold needs to trade to maintain current mining tempos indefinitely.

Cash costs naturally encompass all cash expenses necessary to produce each ounce of gold, including all direct production costs, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses.  In Q3’17, these top-34 GDXJ-component gold miners that reported cash costs averaged just $612 per ounce.  That indeed plunged a major 6.9% YoY from Q3’16, and even 2.5% QoQ from Q2’17.

This was really quite impressive, as the mid-tier gold miners’ cash costs were only a little higher than the GDX majors’ $591.  That’s despite the mid-tiers each operating fewer gold mines and thus having fewer opportunities to realize cost efficiencies.  Traders must recognize these mid-sized gold miners are in zero fundamental peril as long as prevailing gold prices remain well above cash costs.  And $612 gold ain’t happening!

Way more important than cash costs are the far-superior all-in sustaining costs.  They were introduced by the World Gold Council in June 2013 to give investors a much-better understanding of what it really costs to maintain a gold mine as an ongoing concern.  AISC include all direct cash costs, but then add on everything else that is necessary to maintain and replenish operations at current gold-production levels.

These additional expenses include exploration for new gold to mine to replace depleting deposits, mine-development and construction expenses, remediation, and mine reclamation.  They also include the corporate-level administration expenses necessary to oversee gold mines.  All-in sustaining costs are the most-important gold-mining cost metric by far for investors, revealing gold miners’ true operating profitability.

In Q3’17, these top 34 GDXJ components reporting AISC averaged just $877 per ounce. That’s down a sharp 3.7% YoY and 0.2% QoQ.  That also compares very favorably with the GDX majors, which saw nearly-identical average AISC at $868 in Q3.  The mid-tier gold miners’ low costs prove they are faring far better fundamentally today than traders think based on this year’s vexing sideways-grinding stock-price action.

All-in sustaining costs are effectively this industry’s breakeven level.  As long as gold stays above $877 per ounce, it remains profitable to mine.  At Q3’s average gold price of $1279, these top GDXJ gold miners were earning big average profits of $402 per ounce last quarter!  That equates to hefty profit margins of 31%, levels most industries would kill for.  The mid-tier gold miners aren’t getting credit for that today.

Unfortunately given its largely-junior-less composition, GDXJ remains the leading benchmark for junior gold miners.  In Q3’17, GDXJ averaged $33.81 per share.  That was down a serious 28.6% from Q3’16’s average of $47.38.  Investors have largely abandoned gold miners because they are captivated by the extreme Trumphoria stock-market rally since the election.  Yet gold-mining profits certainly didn’t justify this.

A year ago in Q3’16, the top 34 GDXJ components at that time reported average all-in sustaining costs of $911 per ounce.  With gold averaging $1334 then which was 4.4% higher, that implies the mid-tier gold miners were running operating profits of $423 per ounce.  Thus Q3’17’s $402 merely slumped 5.0% YoY, which definitely isn’t worthy of hammering mid-tier gold miners’ stock prices over a quarter lower over the past year.

Gold miners offer such compelling investment opportunities because of their inherent profits leverage to gold.  Gold-mining costs are largely fixed during mine-planning stages, when engineers and geologists decide which ore to mine, how to dig to it, and how to process it.  The actual mining generally requires the same levels of infrastructure, equipment, and employees quarter after quarter regardless of gold prices.

With gold-mining costs essentially fixed, higher or lower gold prices flow directly through to the bottom line in amplified fashion.  That wasn’t really apparent in GDXJ over this past year since its composition changed so radically.  Normally a 4.2% drop in average gold prices would lead to much more than a 5.0% YoY operating-profit decline.  Gold-stock profits generally leverage gold price moves by several times.

Gold itself is overdue for a major new upleg driven by investment demand returning.  As I discussed several weeks ago, investment demand has stalled thanks to the extreme stock-market euphoria.  These bubble-valued stock markets are due to roll over imminently as the Fed and European Central Bank both start aggressively choking off liquidity.  That will strangle this stock bull, reigniting big gold investment demand.

The impact of higher gold prices on mid-tier-gold-miner profitability is easy to model.  Assuming flat all-in sustaining costs at Q3’17’s $877 per ounce, 10%, 20%, and 30% gold rallies from this week’s levels will lead to collective gold-mining profits surging 36%, 68%, and 100%!  And another 30% gold upleg isn’t a stretch at all.  In essentially the first half of 2016 alone after the last stock-market correction, gold surged 29.9%.

The major gold stocks as measured by the HUI, which closely mirrors GDX, skyrocketed 182.2% higher in roughly that same span!  Gold-mining profits and thus gold-stock prices soar when gold is powering higher.  So if you believe gold is heading higher in coming quarters as these crazy stock markets falter, the gold stocks are screaming buys today fundamentally.  That’s especially true of the best mid-tier gold miners.

Since today’s bastardized GDXJ mostly devoid of juniors changed so radically since last year, the normal year-over-year comparisons in key financial results aren’t comparable.  But here they are for reference.  These top 34 GDXJ companies’ cashflows generated from operations soared 65% YoY to $1515m.  That was driven by sales up 96% YoY to $4130m.  That left miners’ collective cash balances $28% higher YoY at $5672m.

Yet top-34-GDXJ-component profits crumbled 38% YoY to $212m.  Again don’t read too much into this since it’s an apples-to-oranges comparison.  Interestingly a single company that was in GDXJ in both quarters is responsible for over 2/3rds of that drop.  Endeavour Mining’s earnings plunged from +$24m a year ago to -$65m in Q3’17, largely due to a $54m impairment charge in its Nzema mine which is being sold.

GDXJ’s component list was much more consistent between Q2’17 and Q3’17.  QoQ these top 34 GDXJ gold miners saw operating cash flows rise 3.9%, sales surge 7.5%, cash on hand fall 7.6%, and profits plummet 72%.  Again an anomaly in a single company is responsible for nearly 9/10ths of this sequential decline.  In Q2 IAMGOLD reported a gigantic $524m non-cash gain on the reversal of an impairment charge!

The massive non-cash gains and losses flushed through net income are one reason why all-in sustaining costs offer a better read on gold-miner health.  If GDXJ’s component list and weightings finally stabilize after this past year’s extreme tumult, we’ll have clean comps again next year.  For now these mid-tier gold miners are generally doing far better operationally than their neglected super-low stock prices imply.

So overall the mid-tier gold miners’ fundamentals looked quite impressive in Q3’17, a stark contrast to the miserable sentiment plaguing this sector.  Gold stocks’ vexing consolidation this year wasn’t the result of operational struggles, but purely bearish psychology.  That will soon shift as the stock markets roll over and gold surges, making the beaten-down gold stocks a coiled spring today.  They are overdue to soar again!

Though this contrarian sector is widely despised now, it was the best-performing in all the stock markets last year despite that sharp post-election selloff in Q4.  The HUI blasted 64.0% higher in 2016, trouncing the S&P 500’s mere 9.5% gain!  Similar huge 50%+ gold-stock gains are likely again in 2018, as gold mean reverts higher on the coming stock-market selloff.  The gold miners’ strong Q3 fundamentals prove this.

Given GDXJ’s serious problems, leading to diverting most of its capital inflows into larger gold miners that definitely aren’t juniors, you won’t find sufficient junior-gold exposure in this troubled ETF.  Instead traders should prudently deploy capital in the better individual mid-tier and junior gold miners’ stocks with superior fundamentals.  Their upside is vast, and would trounce GDXJ’s even if it was still working as advertised.

At Zeal we’ve literally spent tens of thousands of hours researching individual gold stocks and markets, so we can better decide what to trade and when.  As of the end of Q3, this has resulted in 967 stock trades recommended in real-time to our newsletter subscribers since 2001.  Fighting the crowd to buy low and sell high is very profitable, as all these trades averaged stellar annualized realized gains of +19.9%!

The key to this success is staying informed and being contrarian.  That means buying low when others are scared, like late in this year’s vexing consolidation.  An easy way to keep abreast is through our acclaimed weekly and monthly newsletters.  They draw on my vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks.  Easy to read and affordable, they’ll help you learn to think, trade, and thrive like contrarians.  Subscribe today, and get deployed in the great gold stocks on our trading books before they surge far higher!

The bottom line is the mid-tier gold miners now dominating GDXJ enjoyed strong fundamentals in their recently-reported Q3 results.  While GDXJ’s radical composition changes since last year muddy annual comparisons, today’s components mined lots more gold at lower costs.  These gold miners continued to earn hefty operating profits while generating strong cash flows.  Sooner or later stock prices must reflect fundamentals.

As gold itself continues mean reverting higher, these mid-tier gold miners will see their profits soar due to their big inherent leverage to gold.  GDXJ now offers excellent exposure to mid-tier gold miners, which will see gains well outpacing the majors.  All it will take to ignite gold stocks’ overdue mean-reversion rally is gold investment demand returning.  The resulting higher gold prices will attract investors back to gold miners.

Adam Hamilton, CPA

December 1, 2017

Copyright 2000 – 2017 Zeal LLC (www.ZealLLC.com)

 

This epic central-bank-easing-driven global stock bull is starting to be strangled by the very central banks that fueled it.  This week the European Central Bank made a landmark decision to drastically slash its quantitative easing next year.  That follows the Fed’s new quantitative-tightening campaign just getting underway this month.  With CBs aggressively curtailing easy-money liquidity, this stock bull is in serious trouble.

The US flagship S&P 500 broad-market stock index (SPX) has powered an incredible 280.6% higher over the past 8.6 years, making for the third-largest and second-longest bull market in US history!  The resulting popular euphoria, a strong feeling of happiness and confidence, is extraordinary.  So investors brazenly shrugged off the Fed’s September 20th QT and the ECB’s October 26th QE-tapering announcements.

That’s a grave mistake.  Extreme central-bank easing unlike anything witnessed before in history is why this stock bull grew to such grotesque monstrous proportions.  Without QE, it would have withered and died years ago.  Central banks conjured literally trillions of new dollars and euros out of thin air, and used that new money to buy assets.  This vast quantitative easing inarguably levitated the world stock markets.

QE greatly boosted stocks in two key ways.  Most of it was bond buying, which forced interest rates to deep artificial lows nearing and even under zero at times.  This bullied traditional bond investors looking for yield income into dividend-paying stocks.  The record-low interest rates fueled by QE were also used to justify extremely-expensive stock prices.  QE aggressively forced legions of investors to buy stocks high.

The super-low borrowing costs driven by QE’s crushing downward pressure on interest rates also unleashed a vast corporate-stock-buyback binge unlike anything ever witnessed.  Corporations borrowed trillions of dollars and euros to use to buy back their own stocks, boosting their stock prices.  QE both enabled and provided the incentives for this anomalous extreme financial engineering, indirectly levitating stock markets.

Stock traders’ apparent belief over this past month that the Fed starting to reverse its QE through QT and the ECB greatly slowing its QE will have no meaningful impact on QE-levitated stock prices is absurd.  The simultaneous reversal and slowing of QE in the States and Europe is a hellstorm relentlessly bearing down on hyper-complacent traders.  It’s the financial equivalent of a Category 5+ super-hurricane, a juggernaut.

This Thursday the ECB announced it is slashing in half its ongoing QE bond monetizations from their current €60b-per-month pace to €30b per month for the first 9 months of 2018.  After that the ECB’s QE will likely cease entirely, since it is running out of available bonds to buy because the ECB’s total QE has been so vast.  That means ECB QE will collapse from €720b this year to €270b next year, a radical 62.5% plunge!

The idea that stock markets won’t miss €450b of ECB bond buying next year is ludicrous.  The ECB has been monetizing bonds continuously with at least a €60b-per-month pace since March 2015.  That will make for colossal total QE from then to December 2017 exceeding €2040b, growing to over €2310b by September 2018.  €60b per month falling to €30b for most of next year and then likely zero will have a huge impact.

At current exchange rates, that €450b drop of ECB QE from 2017 to 2018 translates into $530b.  That is likely enough all alone to tank global stock markets reliant on aggressive central-bank QE like crack cocaine.  But add that on top of the Fed’s first-ever quantitative tightening now getting underway, and 2018 will see the greatest central-bank tightening in history.  How can that not drive an overdue stock bear?

I discussed the Fed’s new QT campaign and likely market impact in great detail a month ago right after it was announced.  While the Fed’s own QE bond buying formally ended in October 2014, it held all those bonds on its balance sheet until this month.  Starting this quarter, the Fed is allowing $10b per month to roll off as they mature.  That effectively destroys the money created to buy those bonds, removing QE capital.

$10b per month isn’t much initially, but the Fed is slowly ramping that to a target of $50b per month by Q4’18.  The math is simple.  Total Fed QT in 2017 will only run $30b, a rounding error relative to the vast size of QE’s trillions of monetized bonds.  But in 2018 that Fed QT will add up to $420b.  Add that to the $530b of ECB QE here in 2017 but not coming in 2018 due to the taper, and markets face $950b of CB tightening!

Can the world’s two most-important central banks collectively withdraw almost a trillion dollars of liquidity in 2018 alone without blowing a gaping hole in these lofty stock markets?  Not a freaking chance!  And 2019 looks even worse.  Total ECB QE will likely run at zero, down from €720b this year.  That translates into $850b.  And the Fed’s QT will run at its terminal full speed of $600b annually.  That adds up to $1450b!

So on top of 2018’s $950b less of ECB QE and new Fed QT compared to this year, 2019 faces another $1450b of collective tightening from the Fed and ECB relative to 2017.  That means $2.4t of central-bank liquidity that exists in this record stock market year will vanish over the next couple years.  I can’t imagine a more-bearish omen for excessively-large QE-inflated stock bulls than such a vast reversal of CB flows.

This first chart ought to shatter the Wall Street myth that today’s monster stock bull was driven by profits instead of extreme central-bank QE.  It superimposes the SPX over the Fed’s balance sheet, which is where those QE-financed bond purchases rest.  This is the most-damning chart in the stock markets, no mean feat at such extremes.  Fed QT and far-less ECB QE is the stuff of nightmares for QE-inflated stock markets!

While the Fed initially birthed QE back in late 2008’s first stock panic in a century, QE’s primary impact on the stock markets started in early 2013.  That was soon after the Fed first launched and then quickly more than doubled its third QE campaign.  QE3 was radically different from QE1 and QE2 in that it was open-ended, with no predetermined size or duration.  That gave it a gargantuan impact on stock psychology.

Whenever the stock markets started to sell off, Fed officials would rush to their soapboxes to reassure traders that QE3 could be expanded anytime if necessary.  Those implicit promises of central-bank intervention quickly truncated all nascent selloffs before they could reach correction territory.  Traders realized that the Fed was effectively backstopping the stock markets!  So greed flourished unchecked by corrections.

This stock bull went from normal between 2009 to 2012 to literally central-bank-conjured from 2013 on.  The Fed’s QE3-expansion promises so enthralled traders that the SPX went an astounding 3.6 years without a correction between late 2011 to mid-2015, one of the longest-such spans ever!  With the Fed jawboning negating healthy sentiment-rebalancing corrections, psychology grew ever more greedy and complacent.

QE3 was finally wound down in October 2014, leading to this Fed-evoked stock bull soon stalling out.  Without central-bank money printing behind it, the stock-market levitation between 2013 to 2015 never would’ve happened!  Without more QE to keep inflating stocks, the SPX ground sideways and started topping.  Corrections resumed in mid-2015 and early 2016 without the promise of more Fed QE to avert them.

2013 was the peak-QE3 year, when the Fed monetized a staggering $1020b in bonds through QE.  Such vast central-bank liquidity injections catapulted the SPX 29.6% higher that year!  The Fed tapered QE3 in 2014, which added up to $450b of additional bond buying that year.  And the SPX only rallied 11.4%.  Fed QE dropped by 56% between 2013 and 2014, and stocks’ rallying shrunk 62%.  That’s certainly no coincidence.

Then in 2015 when Fed QE was zero, the SPX slipped 0.7%.  See the pattern here?  The more QE from central banks, the more the stock markets rise.  Those vast capital injections from the Fed levitated the US stock markets by forcing yield-starved bond investors into stocks and facilitating immense corporate stock buybacks.  This QE-driven stock bull peaked in mid-2015 soon after the Fed ceased its own QE!

The bear market that follows every stock bull should’ve started in late 2012, but the Fed warded it off with its massive open-ended QE3 campaign.  That ultimately totaled $1590b before it ended in late 2014, when the delayed stock bear should’ve begun.  Indeed it looked like it had, as the SPX started rolling over without Fed QE boosting it.  The SPX suffered its first corrections in 3.6 years in mid-2015 and early 2016.

There’s a stellar probability the dominant reason the overdue stock-market bear didn’t arrive in 2015 was the ECB started its own QE campaign in March that year.  The ECB effectively took the QE baton from the Fed, keeping world stock markets levitated through massive liquidity injections.  ECB QE levitated European stock markets through the same mechanisms as the Fed QE had earlier levitated the US ones.

The global stock markets are heavily interconnected.  Both rallies and selloffs in either the United States, Europe, or Asia often create the psychology necessary to drive similar moves in the other markets.  So the ECB’s QE directly buoying European stock markets bled into US stocks, fending off the overdue bear that the end of the Fed’s QE should’ve awoken.  It was hopes for more ECB QE that rekindled this tired bull.

The Fed’s QE3 bond buying was tapered to zero in November 2014.  From that announcement in late October that year, the SPX would rally another 7.3% into May 2015 on sheer momentum and euphoria.  After that it drifted sideways to lower for the next 13.7 months, suffering two corrections.  It wasn’t until July 2016 that a new bull high was finally seen.  That was soon after the UK’s surprise Brexit vote to leave the EU.

That June 2016 referendum stunned European leaders, potentially threatening their entire project to unite Europe.  Thus the ECB’s central bankers rushed to vociferously promise to do anything necessary to maintain market stability through the Brexit process.  So the SPX only broke out of its mounting bear trend thanks to hopes for more ECB QE!  That rally soon fizzled until Trump’s surprise victory unleashed Trumphoria.

This extreme Trumphoria stock rally since early last November was driven by euphoric hopes for big tax cuts soon, not central-bank easing.  But without the ECB’s colossal €720b or the equivalent of $850b in QE over the past year since the election, odds are this Trumphoria rally would’ve either been far more muted or never even existed.  The Fed’s QT and ECB QE tapering are grave threats to QE-inflated stock markets.

The chart above proves how heavily dependent the SPX is on the Fed’s balance sheet, which has never materially shrunk before 2018.  The European stock markets have seen a similar phenomenon as the ECB’s balance sheet ballooned under QE.  Germany’s flagship DAX stock index is Europe’s leading one.  In 2016 the DAX rallied 6.9% on over €720b of ECB QE.  So far this year the DAX is up 12.8% on €600b of QE YTD.

There is absolutely no doubt these global stock markets are greatly reliant on extreme central-bank QE to keep levitating to new record highs.  So the stock markets are in world of hurt in 2018 and 2019, with total central-bank liquidity from the Fed and ECB falling by $950b and $1450b respectively relative to 2017!  There’s probably never been a greater bear-market catalyst than record QE being thrown into reverse.

If the Fed’s QT and the ECB’s QE taper proves so devastating to stocks, won’t these central bankers simply stop doing it?  They certainly don’t want to tank stock markets, as both the US and European economies really need high stocks’ wealth effect to thrive.  If stock markets fall enough to spawn some real fear in Americans and Europeans, they will pull in their horns on spending which hurts the real economies.

Still I suspect the Fed and ECB won’t and can’t stop their new tightening campaigns for several reasons.  Both central banks are doing everything they can to be as gradual and transparent as possible to avoid spooking markets, which is wise.  Such slow rampings of the Fed’s QT and the ECB’s QE taper aren’t likely to spark a sharp stock-market plunge.  They’ll just gradually turn the screws to stocks, slowly forcing them lower.

Major bear markets tend to cut stock prices in half, although worse losses are likely after such extreme fake central-bank-goosed bull-market toppings.  But these bears that inevitably follow bulls generally play out over a couple years.  There are about 250 trading days per year, so a 50% loss spread across two years works out to a trivial average of 0.1% per day!  No one will panic if CB tightening slowly boils the bulls.

And the reason both the Fed and ECB are tightening is to reload easing ammunition for the inevitable next financial crisis.  The more QE the Fed can reverse with QT, and the less the ECB’s balance sheet bloats, the more room they will have to relaunch QE when they get scared again in the future.  Central bankers know it’s critical to slow, stop, and unwind QE so they rebuild room to aggressively ease again later.

Finally both the Fed and ECB spent long months if not years preparing traders psychologically leading into these CBs’ QT and QE tapering.  If either central bank chickens out and pulls back in response to stock markets slowly rolling over, that itself risks igniting intense selling.  The only reason the CBs would slow their crucial normalizations from extreme QE is if they feared another looming massive financial crisis.

Traders would read any course change to less tightening by either central bank as an admission of serious problems in global markets, and rush for the exits.  Not carrying through on these carefully-laid tightening plans would also severely hobble these CBs’ credibility, and thus their future abilities to calm markets in a crisis.  The die is cast on Fed QT and ECB QE tapering, it can’t be changed without creating big problems.

If this radically-unprecedented transition from extreme easing to extreme tightening was happening in normal fairly-valued stock markets, it would still ominously portend a major bear.  But thanks to these goofy central banks artificially enlarging and prolonging this stock bull through their QE, stocks have soared way up to bubble valuations!  The extreme overvaluation rampant in stock markets today greatly magnifies the risks.

This last chart looks at the average trailing-twelve-month price-to-earnings ratio of the 500 SPX stocks, both in simple-average and market-capitalization-weighted-average terms.  The past year’s Trumphoria rally on big-tax-cuts-soon hopes catapulted valuations into nosebleed bubble territory.  Such extremes would herald an imminent bear market even if the most extreme CB easing in all of history wasn’t reversing.

This is a complex chart with dire ramifications for investors, which I last discussed in depth in late June.  For our purposes today on central banks starting to strangle this extreme bull they’ve nurtured, look at the blue SPX-valuation lines.  The average SPX-component P/E ratio in both simple and MCWA terms is now over 28x.  At Zeal we calculate this crucial valuation data each month-end, so September’s is the latest.

Weighted by market capitalization, the SPX stocks’ average P/E in late September was 28.7x earnings!  In simple-average terms, it looked even worse at 29.3x.  These numbers are conservative too, because we cap all trailing-twelve-month P/E ratios at 100x to avoid outliers skewing the overall average.  Amazon alone with its insane 250x P/E would catapult these up to 31.7x and 29.6x respectively.  Valuations are extreme.

The US stock markets’ average trailing P/E over the past century and a quarter is 14x, which is fair value.  Double that at 28x is formally a bubble, where we are today.  Euphoric traders get so excited about stock markets rallying forever that they are willing to pay any price to get in, eagerly buying stocks high instead of prudently waiting to buy low.  The higher the prevailing valuations, the greater the downside risk stocks face.

While valuations aren’t a market-timing tool, bubbles always eventually pop.  There are no exceptions to this rule in history.  When bubbles fail stocks fall sharply, entering major new bear markets.  In order to trade at 14x fair value based on today’s corporate earnings, the SPX would have to literally be more than cut in half to 1225ish!  The white line above shows where the SPX would trade at that historical 14x fair value.

Even more ominous, valuation mean reversions following stock prices getting too high in bulls never just stop at the mean.  Instead momentum carries them through 14x to a proportional overshoot below that to undervalued levels.  So there’s a high probability the inevitable next stock bear won’t bottom until stocks are trading well under 10x earnings, which would make for a bigger-than-50% bear from today’s bubblicious levels.

The key point here is stock markets are exceedingly risky on bubble valuations alone after central banks’ unprecedented extreme easing forced them so high for so long.  Even if the Fed wasn’t embarking on QT to reload for future easing, even if the ECB wasn’t tapering QE because it’s running out of bonds to buy, a new stock bear would be a near-certainty on extreme valuations alone.  Bulls are always followed by bears.

But throw in Fed quantitative tightening and ECB quantitative-easing tapering on top of that, and we are set up for one of the worst stock bears on record after one of the biggest and longest bulls ever.  Truly these central banks that fostered this monstrous bull are now starting to strangle it.  The next couple of years are going to see literally trillions of dollars less CB liquidity than the markets have enjoyed in 2017!

Again between Fed QT ramping and ECB QE tapering, 2018 is on track to see a colossal total $950b less capital injected from the Fed and ECB compared to this year.  And based on the Fed’s and ECB’s current plans which are hard to slow or stop without destroying market confidence, 2019’s CB liquidity will come in at another $1450b lower than 2017’s.  We are talking about $2.4t of effective tightening over the next 2 years!

There is zero chance stock markets will be able to ignore such radically-unprecedented CB tightening.  $1.2t a year is a devastating hit to liquidity.  Remember in 2013 the SPX soared 29.6% on $1020b of Fed QE via QE3.  What’s going to happen to stock markets in 2018 when that reverses to -$420b with Fed QT alone, or 2019 at another -$600b with Fed QT running full speed?  Add ECB tapering on top of that.

The unpopular hard truth euphoric investors don’t want to hear is stock markets ain’t gonna be pretty under Fed QT and ECB QE tapering.  For the love of all things good and holy, take this seriously!  Just like in all past stock-market toppings, greed and complacency are extreme so traders have no fear of this imminent central-bank-tightening threat.  But it’s a Category 5+ hellstorm, unprecedented in stock-market history.

Investors really need to lighten up on their stock-heavy portfolios, or put stop losses in place, to protect themselves from the coming valuation mean reversion in the form of a major new stock bear.  Cash is king in bear markets, as its buying power increases as stock prices fall.  Investors who hold cash during a 50% bear market can double their stock holdings at the bottom by buying back their stocks at half price!

Put options on the leading SPY S&P 500 ETF can be used to hedge downside risks.  They are cheap now with euphoria rampant, but their prices will surge quickly when stocks start selling off materially.  Even better than cash and SPY puts is gold, the anti-stock trade.  Gold is a rare asset that tends to move counter to stock markets, leading to soaring investment demand for portfolio diversification when stocks fall.

Gold surged nearly 30% higher in the first half of 2016 in a new bull run that was initially sparked by the last major correction in stock markets early last year.  If the stock markets indeed roll over into a new bear in 2018, gold’s coming gains should be much greater.  And they will be dwarfed by those of the best gold miners’ stocks, whose profits leverage gold’s gains.  Gold stocks rocketed 182% higher in 2016’s first half!

The key to thriving and multiplying your fortune in bull and bear markets alike is staying informed, about broader markets and individual stocks.  That’s long been our specialty at Zeal.  My decades of experience both intensely studying the markets and actively trading them as a contrarian is priceless and impossible to replicate.  I share my vast experience, knowledge, wisdom, and ongoing research in our popular newsletters.

Published weekly and monthly, they explain what’s going on in the markets, why, and how to trade them with specific stocks.  They are a great way to stay abreast, easy to read and affordable.  Walking the contrarian walk is very profitable.  As of the end of Q3, we’ve recommended and realized 967 newsletter stock trades since 2001.  Their average annualized realized gain including all losers is +19.9%!  That’s hard to beat over such a long span.  Subscribe today and get ready before CB tightening crushes stocks!

The bottom line is the Fed and ECB have started strangling this extraordinary stock bull they nurtured.  After being levitated for years by trillions of dollars and euros of quantitative easing, these central banks have started tightening.  The Fed has birthed quantitative tightening, which will increasingly reverse its own extreme QE.  On top of that the ECB will radically slow its own QE next year, for unprecedented tightening.

This is the death knell for QE-inflated stock markets driven to extreme bubble valuations by epic central-bank monetary injections.  The Fed and ECB are finally taking away their easy-money punch bowls, with truly-dire implications for stock markets.  Trillions of dollars and euros of tightening in the next couple years will finally unleash the long-overdue stock bear delayed by QE, which will likely prove proportionally oversized.

Adam Hamilton, CPA

October 27, 2017

Copyright 2000 – 2017 Zeal LLC (www.ZealLLC.com)

 

The junior gold miners’ stocks have spent months grinding sideways near lows, sapping confidence and breeding widespread bearishness.  The entire precious-metals sector has been left for dead, eclipsed by the dazzling Trumphoria stock-market rally.  But traders need to keep their eyes on the fundamental ball so herd sentiment doesn’t mislead them.  The juniors recently reported Q2 earnings, and enjoyed strong results.

Four times a year publicly-traded companies release treasure troves of valuable information in the form of quarterly reports.  Companies trading in the States are required to file 10-Qs with the US Securities and Exchange Commission by 45 calendar days after quarter-ends.  Canadian companies have similar requirements.  In other countries with half-year reporting, some companies still partially report quarterly.

The definitive list of elite junior gold stocks to analyze used to come from the world’s most-popular junior-gold-stock investment vehicle.  This week the GDXJ VanEck Vectors Junior Gold Miners ETF reported $4.0b in net assets.  Among all gold-stock ETFs, that was only second to GDX’s $7.5b.  That is GDXJ’s big-brother ETF that includes larger major gold miners.  GDXJ’s popularity testifies to the great allure of juniors.

Unfortunately this fame has recently created major problems severely hobbling the usefulness of GDXJ.  This sector ETF has shifted from being beneficial for junior gold miners to outright harming them.  GDXJ is literally advertised as a “Junior Gold Miners ETF”.  Investors only buy GDXJ shares because they think this ETF gives them direct exposure to junior gold miners’ stocks.  But unfortunately that’s no longer true!

GDXJ is quite literally the victim of its own success.  This ETF grew so large in the first half of 2016 as gold stocks soared in a massive upleg that it risked running afoul of Canadian securities law.  Most of the world’s junior gold miners and explorers trade in Canada.  In that country once any investor including an ETF goes over 20% ownership in any stock, it is deemed a takeover offer that must be extended to all shareholders!

Understanding what happened in GDXJ is exceedingly important for junior-gold-stock investors, and I explained it in depth in my last essay on juniors’ Q1’17 results.  GDXJ’s managers were forced to reduce their stakes in leading Canadian juniors.  So last year capital that GDXJ investors intended to deploy in junior gold miners was instead diverted into much-larger gold miners.  GDXJ’s effective mission stealthily changed.

Not many are more deeply immersed in the gold-stock sector than me, as I’ve spent decades studying, trading, and writing about this contrarian realm.  These huge GDXJ changes weren’t advertised, and it took even me months to put the pieces together to understand what was happening.  GDXJ’s managers may have had little choice, but their major direction change has been devastating to the junior gold miners.

Investors naturally poured capital into GDXJ, the “Junior Gold Miners ETF”, expecting to own junior gold miners.  But instead of buying junior gold miners’ shares and bidding up their prices, GDXJ was instead shunting those critical inflows to the much-larger mid-tier and even major gold miners.  That left the junior gold miners starved of capital, as their share prices they rely heavily upon for financing languished in neglect.

GDXJ’s managers should’ve lobbied Canadian regulators and lawmakers to exempt ETFs from that 20% takeover rule.  Hundreds of thousands of investors buying an ETF obviously have no intention of taking over gold-mining companies!  And higher junior-gold-stock prices boost the Canadian economy, helping these miners create valuable high-paying jobs.  But GDXJ’s managers instead skated perilously close to fraud.

This year they rejiggered their own index underlying GDXJ, greatly demoting most of the junior gold miners!  Investors buying GDXJ today are getting very-low junior-gold-miner exposure, which makes the name of this ETF a deliberate deception.  I’ve championed GDXJ for years, it is a great idea.  But in its current sorry state, I wouldn’t touch it with a ten-foot pole.  It is no longer anything close to a junior-gold-miners ETF.

There’s no formal definition of a junior gold miner, which gives cover to GDXJ’s managers pushing the limits.  Major gold miners are generally those that produce over 1m ounces of gold annually.  For years juniors were considered to be sub-200k-ounce producers.  300k ounces per year is a very generous threshold.  Anything between 300k to 1m ounces annually is in the mid-tier realm, where GDXJ now traffics.

That high 300k-ounce-per-year junior cutoff translates into 75k ounces per quarter.  Following the end of the gold miners’ Q2 earnings season in mid-August, I dug into the top 34 GDXJ components.  That is just an arbitrary number that fits neatly into the tables below.  While GDXJ had a whopping 73 component stocks in mid-August, the top 34 accounted for 81.5% of its total weighting.  That’s a commanding sample.

Out of these top 34 GDXJ companies, only 4 primary gold miners met that sub-75k-ounces-per-quarter qualification to be a junior gold miner!  Their quarterly production is highlighted in blue below, and they collectively accounted for just 7.1% of GDXJ’s total weighting.  And that isn’t righteous, as these include a 126-year-old silver miner, a mid-tier miner with temporary production declines, and a ramping mid-tier producer.

GDXJ is inarguably now a pure mid-tier gold-miner ETF.  That’s great if GDXJ is advertised as such, but terrible if capital investors explicitly intend for junior gold miners is instead being diverted into mid-tiers without their knowledge or consent.  The vast majority of GDXJ shareholders have no idea how radically this ETF has changed since early 2016.  It is all but unrecognizable, straying greatly from its original mission.

I’ve been doing these deep quarterly dives into GDXJ’s top components for years now.  In Q2’17, fully 29 of the top 34 GDXJ components were also GDX components.  These ETFs are separate, a “Gold Miners ETF” and a “Junior Gold Miners ETF”.  So why on earth should they own many of the same companies?  In the tables below I highlighted GDXJ components also in GDX in yellow in the column showing GDXJ weightings.

These 29 GDX components accounted for 74.6% of GDXJ’s total weighting, not just its top 34.  They also represented 30.1% of GDX’s total weighting.  So three-quarters of the junior gold miners’ ETF is made up of nearly a third of the major gold miners’ ETF!  I’ve talked with many GDXJ investors over the years, and have never heard one wish their capital allocated specifically to junior golds would instead go to much-larger miners.

Fully 12 of GDXJ’s top 17 components weren’t even in this ETF a year ago in Q2’16.  They alone now account for 40.6% of its total weighting.  15 of the top 34 are new, or 45.3% of the total.  In the tables below, I highlighted the symbols of companies actually in GDXJ a year ago in light blue.  Today’s GDXJ is a radical departure from a year ago.  Analyzing Q2’17 results largely devoid of real juniors was frustrating.

Nevertheless, GDXJ remains the leading “junior-gold” benchmark.  So every quarter I wade through tons of data from its top components’ 10-Qs, and dump it into a big spreadsheet for analysis.  The highlights made it into these tables.  A blank field means a company didn’t report that data for Q2’17 as of that mid-August 10-Q deadline.  Companies have wide variations in reporting styles, data presented, and report timing.

In these tables the first couple columns show each GDXJ component’s symbol and weighting within this ETF as of mid-August.  While most of these gold stocks trade in the States, not all of them do.  So if you can’t find one of these symbols, it’s a listing from a company’s primary foreign stock exchange.  That’s followed by each company’s Q2’17 gold production in ounces, which is mostly reported in pure-gold terms.

Many gold miners also produce byproduct metals like silver and copper.  These are valuable, as they are sold to offset some of the considerable costs of gold mining.  Some companies report their quarterly gold production including silver, a construct called gold-equivalent ounces.  I only included GEOs if no pure-gold numbers were reported.  That’s followed by production’s absolute year-over-year change from Q2’16.

Next comes the most-important fundamental data for gold miners, cash costs and all-in sustaining costs per ounce mined.  The latter determines their profitability and hence ultimately stock prices.  Those are also followed by YoY changes.  Finally the YoY changes in cash flows generated from operations, GAAP profits, revenues, and cash on balance sheets are listed.  There’s one key exception to these YoY changes.

Percentage changes aren’t relevant or meaningful if data shifted from negative to positive or vice versa.  Plenty of major gold miners earning profits in Q2’17 suffered net losses in Q2’16.  So in cases where data crossed that zero line, I included the raw numbers instead.  This whole dataset offers a fantastic high-level fundamental read on how the mid-tier gold miners are faring today.  They’re looking quite impressive.

After spending days digesting these GDXJ gold miners’ latest quarterly reports, it’s fully apparent their vexing consolidation this year isn’t fundamentally righteous at all!  Traders have abandoned this sector since the election because the allure of the levitating general stock markets has eclipsed gold.  That has left gold stocks exceedingly undervalued, truly the best fundamental bargains out there in all the stock markets!

Once again the light-blue-highlighted symbols are GDXJ components that were there a year ago.  The white-backgrounded ones are new additions.  And the yellow-highlighted GDXJ weightings are stocks that were also GDX components in mid-August.  GDXJ is increasingly a GDX clone that offers little if any real exposure to true gold juniors’ epic upside potential during gold bulls.  GDXJ is but a shadow of its former self.

VanEck owns and manages GDX, GDXJ, and the MVIS indexing company that decides exactly which gold stocks are included in each.  With one company in total control, GDX and GDXJ should have zero overlap in underlying companies! GDX or GDXJ inclusion should be mutually-exclusive based on the size of individual miners.  That would make both GDX and GDXJ much more targeted and useful for investors.

GDXJ’s highest-ranked component choices made by its managers are mystifying.  This “Junior Gold Miners ETF” has a major primary silver miner as its largest component.  Over half of PAAS’s sales in Q2 came from silver.  And the next two biggest are large South African gold miners.  That country has one of the most anti-shareholder governments in the world now, forcing unconscionable racial quotas on owners.

Since gold miners are in the business of wresting gold from the bowels of the Earth, production is the best place to start.  These top 34 GDXJ gold miners collectively produced 3,583k ounces in Q2’17.  That rocketed 74% higher YoY, but that comparison is meaningless given the extreme changes in this ETF’s composition since mid-2016.  On the bright side, GDXJ’s miners do remain significantly smaller than GDX’s.

GDX’s top 34 components, fully 20 of which are also top-34 GDXJ components, collectively produced 9854k ounces of gold in Q2.  So GDXJ components’ average quarterly gold production of 119k ounces excluding explorers was 61% lower than GDX components’ 308k average.  So even if GDXJ’s “Junior” name is very misleading, it definitely has smaller gold miners even if they’re well above that 75k junior threshold.

Despite GDXJ’s top 34 components looking way different from a year ago, these current gold miners are faring well on the crucial production front.  Fully 19 of these mid-tier gold miners enjoyed big average YoY production growth of 26%! Overall average growth excluding explorers was 12% YoY, which is nothing to sneeze at given gold’s rough year since mid-2016.  These elite GDXJ gold “juniors” are really thriving.

Gold production varies seasonally within calendar years partially due to mining-plan timing.  Gold-bearing ore was certainly not created equal, with even individual deposits seeing big internal variations in their metal-to-waste-rock ratios. Miners often have to dig through lower-grade ore to get to the higher-grade zones underneath.  This still has economically-valuable amounts of gold, so it is run through the mills.

These mills are essentially giant rock grinders that break ore into smaller pieces, vastly increasing its surface area for chemicals to later leach out the gold.  Mill capacity is fixed, with limits on ore tonnage throughput.  So when miners are blasting and hauling lower-grade ore, fewer ounces are produced.  As they transition into higher-grade zones, the same amount of rock naturally yields more payable ounces.

Regardless of the ore grades being blasted and milled, the overall quarterly costs of mining don’t change much.  Operations require the same levels of employees, fuel, maintenance, and electricity no matter how rich the rock being processed. So higher gold production directly leads to lower per-ounce mining costs.  The big fixed costs of gold mining are spread across more ounces, making this business more profitable.

There are two major ways to measure gold-mining costs, classic cash costs per ounce and the superior all-in sustaining costs per ounce.  Both are useful metrics.  Cash costs are the acid test of gold-miner survivability in lower-gold-price environments, revealing the worst-case gold levels necessary to keep the mines running.  All-in sustaining costs show where gold needs to trade to maintain current mining tempos indefinitely.

Cash costs naturally encompass all cash expenses necessary to produce each ounce of gold, including all direct production costs, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses.  In Q2’17, these top 34 GDXJ-component gold miners that reported cash costs averaged just $628 per ounce.  That was indeed down a sizable 1.3% YoY from Q2’16, and 3.0% QoQ from Q1’17.

This was really quite impressive, as the mid-tier gold miners’ cash costs were only a little higher than the GDX majors’ $605.  That’s despite the mid-tiers each operating fewer gold mines and thus having fewer opportunities to realize cost efficiencies.  Traders must recognize these smaller gold miners are in zero fundamental peril as long as prevailing gold prices remain well above cash costs.  And $628 gold ain’t happening!

Way more important than cash costs are the far-superior all-in sustaining costs.  They were introduced by the World Gold Council in June 2013 to give investors a much-better understanding of what it really costs to maintain a gold mine as an ongoing concern.  AISC include all direct cash costs, but then add on everything else that is necessary to maintain and replenish operations at current gold-production levels.

These additional expenses include exploration for new gold to mine to replace depleting deposits, mine-development and construction expenses, remediation, and mine reclamation.  They also include the corporate-level administration expenses necessary to oversee gold mines.  All-in sustaining costs are the most-important gold-mining cost metric by far for investors, revealing gold miners’ true operating profitability.

In Q2’17, these top 34 GDXJ components reporting AISC averaged just $879 per ounce.  That’s down 0.9% YoY and 4.9% QoQ.  That also compares very favorably with the GDX majors, which saw average AISC nearly identical at $867 in Q2.  The mid-tier gold miners’ low costs show they are faring far better fundamentally today than everyone thinks based on this year’s largely-disappointing technical stock-price action.

All-in sustaining costs are effectively this industry’s breakeven level.  As long as gold stays above $879 per ounce, it remains profitable to mine.  At Q2’s average gold price of $1258, these top GDXJ gold miners were earning big average profits of $379 per ounce last quarter!  That equates to hefty profit margins of 30%, levels most industries would kill for.  The mid-tier gold miners aren’t getting credit for that today.

Unfortunately given its largely-junior-less composition, GDXJ remains the leading benchmark for junior gold miners.  In Q2’17, GDXJ averaged $33.30 per share.  That was down a sharp 11% from Q1’s average of $37.46.  Investors have largely abandoned gold miners because they are captivated by the extreme Trumphoria stock-market rally since the election.  Yet gold-mining profits surged in that span.

At Q1’s average gold price of $1220 and Q1’s average top GDXJ components’ AISC of $924, these elite mid-tier miners were earning $296 per ounce on average.  That’s already quite healthy.  But quarter-on-quarter from Q1 to Q2, these top 34 GDXJ components’ operating profits rocketed 28% higher to $379 per ounce.  There’s absolutely no doubt the sharp decline in gold-stock prices in Q2 had nothing to do with fundamentals!

Gold stocks are in the dumps technically because these lofty stock markets keep powering higher.  Even though they are in dangerous bubble territory and the Fed is on the verge of starting to suck capital out of the markets via super-bearish quantitative tightening.  These record stock markets have really retarded investment demand for gold, which tends to move counter to stock markets.  So gold stocks are deeply out of favor.

Gold-stock price levels and psychology are totally dependent on gold, the dominant driver of miners’ profits.  Gold stocks enjoy major profits leverage to gold, which gives their stocks big upside potential when gold rallies.  Gold-mining costs are essentially fixed during mine-planning stages.  Generally the same numbers of employees and equipment are used quarter after quarter regardless of the gold price.

So higher gold prices flow right through to the bottom line, costs don’t rise with them.  If gold rallies just another 3.4% from Q2’s average prices to average $1300 in a coming quarter, profits will surge another 11.1% at Q2’s all-in sustaining costs.  In a $1400-average-gold quarter, merely 11.3% higher from Q2’s levels, gold-mining profits would soar 37.5% higher.  At $1500, those gains surge to 19.3% and 63.9%!

And a 20% gold rally from Q2’s levels is nothing special.  Back in roughly the first half of last year after a sharp stock-market correction, gold powered 29.9% higher in just 6.7 months!  So if you believe gold is heading higher in coming quarters as these crazy stock markets falter, the gold stocks are screaming buys today fundamentally.  Their already-strong profitability will soar, amplifying gold’s mean-reversion upleg.

Since today’s bastardized GDXJ largely devoid of juniors changed so radically since last year, the normal year-over-year comparisons in key financial results aren’t comparable.  But here they are for reference.  These top-34 GDXJ companies’ cashflows generated from operations soared 57% YoY to $1458m.  That was driven by sales up 59% YoY to $3840m.  That left their collective cash balances $34% higher YoY at $6140m.

And top-34-GDXJ-component profits skyrocketed 385% YoY to $751m.  Again don’t read too much into this since it’s an apples-to-oranges comparison.  If GDXJ’s component list and weightings finally stabilize after such extreme tumult, we’ll have clean comps again next year.  We can still look at operating cash flows and GAAP profits among this year’s list of top-34 components, which offers some additional insights.

On the OCF front, 10 of these 34 miners reported average YoY gains of 54%, while 13 of them reported average declines of 33%.  Together all 23 averaged operating-cash-flows growth of 5%.  That isn’t much, but it’s positive.  And it’s not bad considering Q2’17’s average gold price was dead flat from Q2’16’s.  These mid-tier gold miners are doing far better operationally than their neglected super-low stock prices imply.

On the GAAP-earnings front, the 10 miners that earned profits in both Q2s averaged huge growth of 110% YoY!  And out of 14 more miners that saw profits cross zero in the past year, 8 swung from losses to gains.  Total annual earnings growth among those zero-crossing swingers exceeded $536m.  Make no mistake, these “junior” gold miners are thriving fundamentally even at Q2’s relatively-low $1258 average gold.

So overall the mid-tier gold miners’ fundamentals looked quite impressive in Q2’17, a stark contrast to the miserable sentiment plaguing this sector.  Gold stocks’ vexing consolidation this year wasn’t the result of operational struggles, but purely bearish psychology.  That will soon shift as stock markets roll over and gold surges, making the beaten-down gold stocks a coiled spring today.  They are overdue to soar again!

Though this contrarian sector is despised, it was the best-performing in all the stock markets last year despite a sharp Q4 post-election selloff.  The leading HUI gold-stock index blasted 64.0% higher in 2016, trouncing the S&P 500’s 9.5% gain!  Similar huge 50%+ gold-stock gains are possible again this year, as gold mean reverts higher as stock markets sell off.  The gold miners’ strong Q2 fundamentals prove this.

Given GDXJ’s serious problems, leading to diverting most of its capital inflows into larger gold miners that definitely aren’t juniors, you won’t find sufficient junior-gold exposure in this troubled ETF.  Instead traders should prudently deploy capital in the better individual junior gold miners’ stocks with superior fundamentals.  Their upside is vast, and would trounce GDXJ’s even if it was still working as advertised.

At Zeal we’ve literally spent tens of thousands of hours researching individual gold stocks and markets, so we can better decide what to trade and when.  As of the end of Q2, this has resulted in 951 stock trades recommended in real-time to our newsletter subscribers since 2001.  Fighting the crowd to buy low and sell high is very profitable, as all these trades averaged stellar annualized realized gains of +21.2%!

The key to this success is staying informed and being contrarian.  That means buying low when others are scared, like late in this year’s vexing consolidation.  An easy way to keep abreast is through our acclaimed weekly and monthly newsletters.  They draw on our vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks.  For only $10 per issue, you can learn to think, trade, and thrive like contrarians.  Subscribe today, and get deployed in the great gold stocks on our trading books before they surge far higher!

The bottom line is the mid-tier gold miners that now dominate GDXJ enjoyed strong fundamentals in their recently-reported Q2 results.  Despite a flat comp-quarter gold price, they collectively mined more gold at lower costs.  That naturally fueled better operating cash flows and profits.  Today’s low gold-stock prices and popular bearishness are wildly unjustified fundamentally, an anomaly that doesn’t reflect operations.

As gold itself continues mean reverting higher, these mid-tier gold miners will see their profits soar due to their big inherent leverage to gold.  GDXJ now offers excellent exposure to mid-tier gold miners, which will see gains well outpacing the majors.  But if you are looking for the extreme upside likely in true junior gold miners, avoid today’s GDXJ and buy individual stocks.  GDXJ is no longer a “Junior Gold Miners ETF”!

Adam Hamilton, CPA

August 25, 2017

Copyright 2000 – 2017 Zeal LLC (www.ZealLLC.com)