100% to 300% Gains in Three Months
Small cap gold stocks have been on fire in 2016. Many are up 50%, 100% or more. It hasn’t mattered much if the company is a profitable gold producer or a pre-revenue gold explorer. If it has anything to do with gold, it’s probably gone up.
I monitor a watch list of small cap gold stocks. And these five are up over 100% so far this year:
Golden Minerals (AUMN) +290%
Harmony Gold (HMY) +282%
Coeur D’Alene (CDE) +172%
McEwen Mining (MUX) +124%
Richmont Mines (RIC) +110%
The breadth of the trend in small cap gold stocks is best displayed by the rally in the Market Vectors Junior Gold Miners ETF (GDXJ), which is up 70% year-to-date. As you’d expect, GDXJ’s performance is highly correlated to movements in the price of gold, which is up 18% YTD. But the fund gets an added kick when gold miners are rallying because it’s geared toward small cap gold stocks (virtually all of the 49 constituents are small- and micro-cap gold stocks).
Leverage is Both Beautiful and Beastly
Why do small-cap gold stocks move so much more than gold, both to the upside and the downside?
I summarized exactly why in 2012 when I was the chief analyst of a commodity-focused newsletter. Here’s how I explained it to my subscribers:
“The popular argument for gold miners is that they enjoy leverage as the price of gold rises. That’s partially true, but it’s only half the story. The other half is that miners have a lot of operational risk. This risk can wipe out any leverage, especially when mining capital costs rise. That’s been the problem over the past year.
“Remember that leverage is a way to multiply gains or losses, usually by borrowing money or investing in fixed assets. Miners attain leverage when a fixed asset base generates more profit per ounce of gold. Generally speaking, this happens when the price of gold rises and a mine cranks out each ounce at a higher profit—usually when it is able to increase production (or increase the grade of gold produced) without capital improvements.
“But when capital costs are rising and the price of gold is either flat or trending down, fat profits get slim pretty quickly. Whereas some manufacturers can make a million widgets for say, $1.00 apiece, then each subsequent widget for only $0.25 each, economies of scale in mining are much more difficult to achieve.
“When miners’ margins come under pressure, their stocks get slammed. Lower profits per ounce drawn out for years in the future wreak havoc on most financial models, and therefore crush target prices for mining stocks. On the flip side, when margins are expected to expand for several years, mining stock target prices rise rapidly.”
Over the last five years, most gold miners have been reining in capital expenditures as the price of gold collapsed from a high over $1,900/oz. to a low around $1,050/oz. And over that timeframe (a period that starts near the prior peak in the GDXJ), the GDXJ is down 77%. Holdings have also been trimmed by over 30%, another reflection of just how bad the bear market for small cap gold stocks has been.
With gold’s recent move above $1,200 per ounce, prospects for the entire group look much improved. If gold stays above that level, gold mining stocks should continue to do well.
Which brings us to the next question. Will gold stay above $1,200/oz.?
To answer that, you need to understand the two powerful forces that tend to push gold higher.
The Fear Trade Can Be Your Friend
Fear is the real reason behind the current move in gold, and as a result, small cap gold stocks. Love also plays a role, but that’s a story for a different day.
The fear trade is largely powered by demand for financial protection and preservation in periods of negative real interest rates (when interest rates are below the rate of inflation). In these times, gold acts like an insurance policy. It is an asset purchased to protect against future calamity, i.e., erosion in the purchasing power of a currency. The gold investor sees fiat currencies—the dollar, euro, yen, etc.—falling in value relative to gold. And he tries to curb the loss of purchasing power by buying gold as a form of long-term savings.
Typically, the value of gold rises as the U.S. dollar declines. This isn’t always the case on a short-term basis, but generally speaking, the inverse correlation holds true over time. Just look at this five-year chart plotting the price of gold (gold line) and the value of the dollar (green line). In particular, note the steep decline in gold and corresponding rally in the dollar starting in July 2014. And most recently, if you look in 2016, you can see that the dollar has fallen by 5%, while the price of gold is up by 18%.
Simply put, gold and gold stocks go up when the value of the dollar declines. That’s the fear trade.
In 2012, I explained why and when the fear trade became so strong:
“The fear trade gained momentum in 1971 when President Nixon broke the gold standard by decreeing that U.S. dollars could no longer be converted into gold. This change came as uncontrolled spending in the U.S. led to a global loss of faith in its ability to cut the deficit and pay its bills. So foreign nations exchanged their dollars for gold.
“Prior to 1971, the gold standard was generally accepted to support global currencies, because for thousands of years, gold lost the least amount of value. That system made sense, until the U.S. lost the ability to pay back its debts if they needed to be backed up with gold.
“After 1971, Germany, Switzerland and France grabbed as much of the U.S.'s gold as they could, exited the Bretton Woods system, which had established previous monetary relationships, and essentially said ‘see you later’ to the dollar. The purchasing power of the Greenback has been going down ever since.
“Since Nixon broke the gold standard, gold has not backed up global currencies in a traditional sense. But the characteristics that made it the supreme currency—it is durable, portable, divisible, and consistent—have helped gold maintain its intrinsic value.
“As a scarce resource, gold’s ultimate supply is finite, i.e., it can’t be manufactured. For a stable form of currency, this is the ultimate criteria. Conversely, currencies such as the U.S. dollar can be printed with the touch of a button by the Federal Reserve. The basic laws of supply and demand state that the more of something there is, the less it is worth. And this is certainly the case of most fiat currencies (a fiat currency is one that derives its value from government regulation and law), which tend to lose their value relative to other currencies as governments print more.”
Money supplies around the world have been growing. And many central banks have implemented negative interest rate policies. Even though the U.S. Fed is looking to raise interest rates, the bottom line is that we’re most likely in an extended period of negative real interest rates. Add in a U.S. dollar that rallied 25% to a 13-year high from July 2014 through late 2015, then took a dramatic turn lower in early 2016, and you had a near-perfect setup for gold to rise.
I don’t pretend to know where the dollar (or gold for that matter) is headed next. But the trend higher for gold and gold stocks is undeniably strong. I have also seen many analysts raise their target on gold prices in 2013 to $1,300/oz., or more. So I believe the market thinks the gold rally has legs.
The bottom line is this: If you’re contemplating an investment in gold, think big. Specifically, think about interest rates and the dollar. If you think interest rates will stay at or below the rate of inflation and that the dollar will go down, you may want to invest in gold.
Once you’ve decided to go with gold, and if you’re looking to speculate to make big money, think small. Specifically, think about small cap gold stocks. You can go with the GDXJ as a simple, diversified play. It should go up when gold mining stocks are expected to enjoy margin expansion. Going this route means investors don’t have to worry about the day-to-day operations of a specific small cap gold miner.
If you have a higher risk tolerance, look at individual small cap gold stocks. As the five I listed earlier show, the rewards can be spectacular.
Another option is to say to heck with the dollar, gold and gold mining stocks altogether—and invest in the world’s scarcest and most important resource. That’s water. You can live without gold, but go a few days without water, and you’ll be in dire straits. In Cabot Small-Cap Confidential, I recently uncovered a simple and straightforward way to invest in water. The company is helping people across the U.S., including those in Flint, Michigan, overcome water shortages and water quality issues.
If you’d like to learn more about this stock, and other breakthrough technology stocks, click here to learn more.
Sincerely,
Tyler Laundon
Chief Analyst of Cabot Small-Cap Confidential 2.0
