Episode #8 - Fall Precious Metals Update
Sprott Market Strategist Paul Wong joins host Ed Coyne for a timely update on gold and gold miners. They focus on gold's wild ride in 2021 and analyze the impact of the Fed's monetary policy. Paul provides fascinating insights into the state of the precious metals complex.
Ed Coyne: Welcome to Season 1, Episode #8 of Sprott Gold Talk Radio. I'm your host, Ed Coyne, Senior Managing Director at Sprott Asset Management. Joining me today is Sprott's Paul Wong, who serves as Sprott's market strategist. With the summer behind us and fall quickly approaching, I thought it would be timely to have Paul join us and give us his views on both gold and gold equities through a technical lens. Hello, Paul, and thank you for joining us on Sprott Gold Talk Radio.
Paul Wong: Thank you.
Ed Coyne: Before we dig into the current state of both gold and gold equities, please tell our listeners a little bit about yourself as well as your position at Sprott.
Paul Wong: Sure, I have more than 30 years of experience in the industry, about 25 years as a portfolio manager specializing in natural resources, including precious metals. I've also been a proprietary trader. I've managed quant funds, been on asset mix committees, and before that, I used to be a geologist, and my role at Sprott is to provide market insights into the precious metals complex.
Ed Coyne: Fantastic. I know I get many great sound bites and advice from you on how to think about the trade. And I'm hoping today our listeners will walk away with some nuggets of wisdom regarding the physical gold market and the equity market.
As investors return from a much-needed summer break, Paul, can you give us a few highlights on what happened over the summer? It was a bit of a wild ride and few investors realized it because we were all off, hopefully, enjoying some much-needed sun and some relaxation. Before we get into the market today, talk a little bit about what's happened over the last few months.
Paul Wong: To summarize quickly, it was about a lack of liquidity. We reached a low point in gold. Gold was oversold in March. We had a rally from there through May and then around the end of June, we had the FOMC [Federal Open Market Committee meeting on June 16, 2021]. We had had a gold rally up to that point. It was based on the high inflation numbers that were being printed, really high, higher than expected. Inflation expectations were absolutely through the roof surprise-wise. And then the FOMC came and then we basically had a movement of dot plots, which the market quickly interpreted as the tapering was going to come sooner than expected. And so we had a huge sell-off in gold after that. Basically, gold was oversold and then it started to rally. Then we had the flash crash in August, and then gold recovered after that.
But through it all, gold essentially has been flat over a wild ride. But the real point is the lack of liquidity and the confusion it’s caused in the marketplace. Inflation surprised everyone. The Fed tapering situation again, surprised everyone and liquidity overall, not just in the gold area, but in the overall market was steadily declining. With that, you're left with quantitative and algorithmics trading the precious metals complex. That's why we've seen these out-of-the-blue $20-30 gap-ups or gap-downs in the precious metals area. But in the last several months, gold has been essentially flat.
Figure 1. Gold Bullion's Recent Price Performance: January 2020-August 2021
Source: Bloomberg. Data as of 8/31/2021.
Ed Coyne: One thing we certainly all know and probably can agree on is gold certainly loves confusion, particularly over a full market cycle. I think this volatility — for those that are looking to invest in gold either returning to the trade or maybe investing in it for the first time — can potentially give them some wonderful windows of opportunity to come into the trade and think about it over the next couple of years as a natural hedge. I think this summer is a good kind of acid test, as it were, of what you can expect from time to time with, in our view, a long-term directional move up and to the right for the gold trade.
Paul, in your most recent letter, you talk a lot about the Fed's tapering timeline. We've seen it in the news. Many investors are talking about it. What might that mean for gold going forward? And as we've seen in the past, what could happen or what should happen is often very different. How is this potential taper different from the ones we've seen in the past?
Paul Wong: This taper will probably be one of those you sell on the rumor and buy on the news. Gold's been seeing this taper concern starting around late January, so we're several months into it. We've had several iterations on the trade already. No one really should be surprised now. The 2013 Taper Tantrum was initiated by the Fed. The Fed was saying we're going to pull back on the accommodation and we're going to tighten things up a bit
This cycle, the Fed has never said anything like that. If anything, it keeps reiterating that it hasn't made sufficient progress. Every major speech from the primary committee of the Fed has pointed toward a very patient and gradual approach to tapering. The fear is coming from the bond market this time, and that's a big difference. The Fed are the ones with the printing press. They're the ones with all the power. The bond market doesn't matter as much anymore. The days of the bond vigilantes are long gone. With quantitative easing, the Fed is printing $120 billion a month. It doesn't matter what the bond market really says in the medium to long term. Short term, yes, they can have an influence. That's about it.
Ed Coyne: Let's talk about bonds for a second, because to your point, we've seen more investors look at gold potentially as a compliment too, or in some cases even as a replacement to their bonds. With bonds yields low to negative, the opportunity cost of owning physical gold has all but evaporated. Based on your technical analysis, when you have low to negative yields, what has that traditionally done for the value of gold over time?
Paul Wong: It's increased the value of gold. Just look at the data going back since the end of Bretton Woods , which is the last gold standard we had, you'll see real rates as the real primary driver of gold. If you go back 30 years, I think the R-squared is 0.88. If you look back at the last ten years, it's about 0.78. In the last three years, it's been about 0.9 or 0.98. I think it's extremely high. It's always consistently high.
Real rates are one of the primary drivers of gold. And the reason is quite simple. When you have negative real rates, you're destroying wealth on a real inflation-adjusted basis. In the last few weeks, we just made all-time lows in terms of real rates, and we're likely to keep compressing; we're likely to keep heading lower in terms of real rates. Financial repression is one of the key tools the Fed uses to support what you're seeing on the spending side.
Ed Coyne: Wealth destruction goes hand in hand with purchasing power or lack of purchasing power, which brings me to the U.S. dollar. The U.S. dollar is another one of those benchmarks that the market tends to look at. I guess it's three things: bonds or real rates, the S&P 500 — as a proxy for the general equity market — and then the direction or value of the U.S. dollar to gold. Talk about what the strength or volatility in the U.S. dollar means for gold over time.
Paul Wong: Gold is priced in U.S. dollars and so as the U.S. dollar becomes devalued, the value of gold goes up. A simple case in point: I mentioned Bretton Woods earlier. That's when the U.S. went off the gold standard. Since that time, the U.S. dollar-to-gold ratio has lost about 97% of its value. If you had a dollar in 1971, that dollar would buy you about two cents of gold today.
Ed Coyne: That's insane to think about.
Paul Wong: It's consistent across every currency, and the U.S. dollar is not the worst. There are far worse currencies like the pound. Investors tend to think short-term, one to two years, in terms of how gold performs. But if you stretch back the time periods long enough, you'll see similar types of performance in gold. And the reason being is that we are in a U.S. dollar debasement process, and that's what a fiat currency is. The only question is, how hard are you stepping on the accelerator on that debasement?
And right now, the Fed is slamming on it hard. All you have to do is look at the spending that's going on. The U.S. is under, for lack of a better word, a grand experiment. Fiscal spending and monetary policies are off the charts, literally. To accommodate that, the U.S. debt to GDP is running at about 130%. It's the highest it's been since the Second World War. The only way to accommodate all that debt is U.S. dollar debasement and financial repression.
Right now, the Fed is run with a policy of zero interest rates [ZIRP] and average inflation targeting [AIT]. Those two tools essentially guarantee dollar debasement and financial repression, meaning that the U.S. dollar will go lower and real rates will go deeper negative in the long term. That's going to continue for several years. That's why we're so bullish on gold. It's not a short-term process. It's a long-term process. The money has been spent, the bills are coming due.
Ed Coyne: Right.
Paul Wong: It's as simple as that.
Ed Coyne: Sounds like my college days! Many of our listeners have owned or currently own physical gold bullion, but few are invested in the mining stocks. Over the last decade or so, it seems like the relationship between the physical markets, whether it's gold, silver, or the other metals out there, to the mining stocks, has changed slightly from a technical standpoint. What are you seeing out there when you look at the physical metals market — gold, silver, platinum, palladium — to the equities mining those? What has changed from your point of view or your technical analysis? What should investors be thinking about today when they're looking at the precious metals market?
Paul Wong: Two things are going on right now. It's almost a battle of opposites. The mining companies themselves are more capital-disciplined than they've ever been at any point in time that I've ever seen. They are returning levels of return-on-capital and free-cash-flow earnings generation at a level never seen before. You can take almost any evaluation and compare it to the broad equity market, the S&P 500 Index. You'll see that it's about a third of anything; a third of EBITDA, a third of P/E, a third of cash-flow yield.
But you're also seeing a lack of interest in the gold mining equities. It's not selling; it's not buying. The reason behind all that is the continuing growth in passive investing in the broad market; it's hurting virtually almost all sector-specific funds. And the other one is factor investing. Large funds have moved away from analyzing sectors and more towards factor investing. They look for growth metrics and capital investment and they'll assign a group of stocks to that and build a portfolio around it. That's where a lot of the traditional flows have gone.
That's a double-edged sword. You're seeing now that the broad market is trading at near dot-com levels, while gold mining equities are trading at a fraction of that. These are literally generational type lows. Then the question is, can this continue? The adage in the marketplace is yes, it will continue until it can't. Markets tend to be mean reverting. Gold won't trade at these levels forever and it will revert quickly. That's the challenge you have. It's always about the timing aspect.
Here's another interesting tidbit. Since early January 2016, which is the low in the gold equity trade, gold equities have performed in line with the S&P 500 Index. Most people will be shocked to hear that. In the last five years, it's performed inline, it's just at the bottom end of its trade range. Just plot a gold equity index against the S&P 500 Index. Go back to the beginning of January of 2016. You'll see that there are periods when gold equities massively outperform and then they contract, massively outperform and then they contract. And right now we're in the massive contraction phase, and we're actually at the lower end of the channel. There are several reasons why. On a risk-reward basis, if you haven't looked at gold mining equities, there's a good reason to look at it.
Ed Coyne: Gold mining equities seem like the ultimate value trade right now when you look at it from a balance sheet standpoint and a margin expansion standpoint. But to your point, there's a lot of risk-on trades out there in different assets. Wall Street continues to create more ways to lose your money faster than ever before. I do think capital is flowing to other spaces. But what I think is unique about the gold mining stocks today is that these are real companies with real balance sheets and real cash flow. A lot of these other products out there don't have that. You're investing in the future. The mining stocks are the now. They're making money right now, in some cases, paying dividends. I think it's a good time to be thinking about that. And this shifts gears to the last question I want to ask you, which is talking about gold equities or real assets in general. Give us just a couple of things to think about from the general health of the market today.
Paul Wong: You need to be a little bit longer term than perhaps you're comfortable with. The old market adage is markets go up on an escalator and come down on an elevator. That happens quite often.
Gold is the opposite. It goes down on an escalator and comes up in the elevator really quickly. If you take a look at a gold price chart, you'll see that it goes through long periods where it doesn't seem to do anything and then all of a sudden, in a span of four to six weeks, it will gap up 30%. That's the history of gold. That's how it trades because gold is a safe haven asset and safe-haven assets, by definition, are mean-reverting type assets. You have to stop thinking about gold in terms of escalator behavior and instead, think about gold's elevator behavior. The timing is pretty important. After the broader equity market has been on a run, as it has been right now, it will reach a point where it will become unstable for many different reasons.
Market structures have changed dramatically over the last several years, and it's accelerating. You'll see more of an escalator-elevator type action than you're comfortable with. Gold is literally the opposite. And that's why gold in a multi-asset portfolio provides diversification. And diversification, in our sense, is downside protection. When gold runs up, it gives you more firepower at the end of the day to be more invested. It provides staying power.
Ed Coyne: I think you're spot on with that. That's what we try to convey to all of our listeners and our investors. Gold is not here to replace your other assets. Gold is designed to help you stay invested in those assets, knowing you have the staying power to be invested in a full-market cycle.
Paul, I appreciate you joining us today on Sprott Gold Talk Radio. And for all the listeners who liked what Paul had to say, we encourage you to go to our website at sprott.com and sign up for not only Paul's recent report titled, but you can also download past as well as future Insights. Thank you once again for listening to Sprott Gold Talk Radio. I'm your host, Ed Coyne.