Early Innings

From the May 18, 2016 HRA Journal: Issue 251

“Fed Fear” is back.  In the past few sessions we’ve seen the first sizeable decline in gold prices since the rally started early in the year.  “Sizeable” is a relative term.  There are plenty of traders heading for the hills but, really, we’re talking about a 3-4% down move. 

Could it drop further if the Fed really does pull the trigger next month?  Possibly, though I don’t think it would fall more than another $20-30 and I’m not sure we’ll see even that.  As I explained in the last Journal the bulk of the Outside Money coming into the space is basing their decision on the view that we will be in a negative real interest rate environment in most major currency blocks for some time to come.  While those traders will also be influenced by market sentiment and currency gyrations their basic thesis is not the same as a gold bug treating bullion as the “anti-dollar.”

Sector insiders on the other hand are paranoid after such a strong rally. Just about everyone I talked to at the Metals Investor Forum was expecting a “big” pullback.  I think things will, and are, softening but I think a correction is likely to be both small and short.  Wall St seems much more troubled by the idea of an interest rate hike than the gold sector.  Many companies have raised money and are, finally getting back to work.  A busy summer with lots of news will help cushion the blow of marginally lower gold prices.

We’ll be fine.

***

Fear stalks the land...traders cower...looking for cover…could this be the end?

Ok.  Time Out.   Everyone breath into a paper bag.   Yes, it does look like gold is correcting a bit.  Though in this case the operative words are “a bit”.   I’m definitely not seeing anything we should be panicking about yet.  

Panic is generally a bad game plan when it comes to trading.  Not always, mind you.  If markets are literally crashing then “he who sells first sells best” but that is a rare occurrence.  Financial writers and columnists toss words like “crash” around way too frequently for my liking. 

Resource stock traders are paranoid.   Who can blame them?  We’re coming out of arguably the worst bear market in the history of the sector.  As the old joke goes, “you’re only paranoid if they’re NOT out to get you” and for years we’ve had a bullseye painted on our foreheads. 

That sort of thing can be scarring.  I don’t think lifetime traders in the resource space are going to get past the experience very quickly.

Maybe it’s best if we don’t.  Believing a rising tide will lift all boats – and we’re likely to see a market like that before this bull is over – leads to dangerous overconfidence and bad trading habits.

There is definitely no evidence of overconfidence yet.  Quite the opposite.  I talk to resource stock traders everyday.   Many of them are already bemoaning the fact they didn’t bail out on May 1st. 

I’m pretty sure most of the selling pressure, such as it is, has come from sector insiders.   Many of them are already talking about “the top” in junior resource stocks.  I’ve heard “I knew I should have sold that stock” about 100 times in the past week.

Seriously?  Take a look at the charts on the next page.    From top to bottom you’re looking at daily charts for gold, the GDX Gold Miners ETF and the much (and deservedly) maligned TSX Venture index.  Do those charts look like they are falling apart to you?

Let's start at the bottom.  The Venture has just exceeded the closing high on the last trading day of April.   The market was getting frothy and overbought by the end of April but a couple of weeks of sideways action has taken care of that.  

At this point the TSXV index only has to rise by about 20 points to make a new 52-week high.  That doesn’t sound very impressive I know but, except for a very brief period in 2014, this will be the first time we’ve had a new 52-week high in five years!  That, folks, is an ugly market.

In percentage terms the move is even more impressive.  The Venture index has moved up 50% since December and much of that move is concentrated in gold explorers and developers.  We need to keep some perspective here too.  The Venture lost 85% of its value though the 2011-2015 period.  Nonetheless this is a far larger percentage move to the upside than any other since 2011.

There have been concerns voiced by some about the relative lack of volume.  I agree that it’s light compared to “go-go” years like 2010-2011.  I’d be happier if it was higher but part of the shift in the market, as I’ve stated for a couple of years, is increased focus on a smaller number of quality companies.  Ultimately that is a good thing.  Too much bandwidth, and investor dollars, was consumed by “lifestyle” companies during the last couple resource bulls.  That trend isn’t being repeated – yet- and I hope that it isn’t.  Even if overall volumes never match earlier bull cycles if the volume is concentrated in good companies run by management groups really trying to add value it will be a better market for all.

The real and continued news is the strength of the gold indices, and gold itself.   No, gold hasn’t made a new high but it has held up well considering improving economic news out of the US.

I freely admit to skepticism about some of the news.  Strong retail sales don’t seem to jibe with terrible Q1 reporting and guidance from some of the largest retail chains in the US.  Also, the weekly unemployment claim number has been climbing noticeably for about a month now.   I don’t usually pay a lot of attention to that number because it tends to be very noisy.  There does seem to be a negative employment trend developing however which bears watching.   

Jobs are a lagging indicator and a weakening employment picture is one more reason for my skepticism about some of the recent “strong” numbers out of the US.  Maybe things do finally accelerate but I’ll have to see it to believe it.

Major markets continue to hold up and they are getting a big assist from lower bond yields (see the 10 year Treasury yield chart, above).   I don’t think this is a case, necessarily, of bond traders being more negative about the prospects for the US economy. 

The bond market is huge and demand for treasuries will always be high.  I think what has changed is the negative rate environment in other major issuer markets, namely Japan and the EU.  That is driving institutional money that needs to be in bonds (and there is a lot of that) into the US market in search of yield.

Where I’m going with this is that I would not read falling bond yields in the US as a message about what the Fed will or will not do at the next meeting.  Whether I think it’s a good idea or not the I think the odds of a rate increase at the next meeting are far higher than they were a couple of weeks ago.

A rate increase or two in the US, if they happen, doesn’t really alter the overriding narrative that I believe is behind the “outside money” that has recently entered the resource space. 

The chart below from Barclays is a good graphic representation of the situation I’ve been talking about.  It displays the gold price and the real (inflation adjusted) yield for 7-10 year US bonds.  The yield graph is inverted so the higher it is within the graph the more negative the yield.  The chart clearly shows the trend of falling real yields and rising gold prices in the 2009-2012 period.  That is followed by the rising real yields and falling gold prices that created the four-year bear that just ended.  Importantly, it also shows those trends reversing again in the past few months.

I believe the relationship shown in this chart is the main driver behind “generalist” money’s desire to re-enter the space.  There will be corrections within the trend but I don’t see this move changing quickly. 

A 50 or 100-year version of this chart would show similar a similar relationship between real yields and gold specifically and commodities generally. One thing that defined long periods of strong commodity prices in the past were central banks that were “behind the inflation curve”.   Interest rates rose more slowly than the inflation rate so “real” yields remained negative.

The current situation is different.  Negative rates prevailing now are a premeditated attempt by central bankers to create liquidity and bolster economic activity.  The end result is the same however.  Negative real rates. 

There is no evidence that inflation is increasing much in any of the major economic blocks as hard as central bankers are trying to create it.  With all the effort they are putting into avoiding deflation I don’t see any of the world’s central bankers attempting to get “ahead of the curve” any time soon even if inflation starts to rise.

The ECB tried to jump ahead of the curve twice since the financial crisis.  Both moves were disasters that made the situation in the EU far worse and were quickly reversed.  That lesson wasn’t lost on other central bankers.  However the future unfolds I think the negative real rate environment is here to stay for at least the next couple of years and potentially much longer.

A second but also important factor for Outside Money is the simple fact that the miners look relatively cheap still.  Years of cost cutting and consolidation has many mining companies finally returning to profitability. These companies have a long way to go but at least they have the “advantage” of cheap share prices relative to many sectors of the market. 

Continued withdrawals from generalist equity funds indicate traders don’t view the broad indices as cheap any more even if they might believe they still have some upside.  Miners (very inavertedly!) positioned themselves as relative values which has also driven some of the recent buying.

Should we worry about the gold price and by extension gold stocks if the Fed moves in June? I don’t think it’s a fatal problem by any means but if you’re looking or hoping for a pullback in the sector that might generate it.

My view is that the US economy is weaker than the Fed thinks. Even if there is a June rate increase I’m not convinced the bond and equity markets would suddenly start pricing in a string of rate hikes.  It’s quite possible the market would see it as another “one and done” situation.  In that case I don’t think it would generate anything more than a pause in gold’s bull market.

The market has a way of disappointing the largest number of participants.   I spoke to numerous people inside the sector at the Metals Investor Forum in Vancouver that I just finished hosting.  Virtually everyone I talked to is expecting a large summer pullback.

Their concerns about the steepness of the recent run are certainly valid.  Speculative positioning in the gold market is high and many stocks in the sector look overbought.  That is a backdrop that generates corrections, I’m just not convinced yet it would be a large enough correction to change our basic positioning for.

Take profits and bring your average costs down?  Yes, but then you should be doing that anyway.  Blow off full positons then sit back and wait for a chance to buy them back much cheaper?  Not so fast.

Sector insiders convinced there will be a big Summer Swoon are the same people expected a “May pullback” that has yet to materialize.  I view the situation with the gold sector as being similar to the views on the $US late last year.  Everyone and their dog “knew” the $US had to go higher.  So of course it didn’t.  

We may see a similar pattern with gold stocks in the next two or three months.  Many have seen big moves but I assume the selling into the rallies was mainly done by those people I talked to who expect the pullback.  Maybe so, but those stocks are now owned by the “new money” in the playing field.

Unless those new owners concur, expect a pullback themselves and trade accordingly people looking for entry points well below current trading ranges in the next couple of months could find themselves disappointed.  When everyone expects the market to do the same thing it almost always does the opposite.

My base assumption is that we see a relatively flat summer that might include short downdrafts, especially if there is a US rate increase.  I don’t expect the sector to fall enough to justify “selling in May and going away”. 

As compelling as that old market bromide might sound, exiting too early in a new bull market tends to leave you on the sidelines watching others make money before you give up and buy back in higher.  I’d rather take the chance of seeing some holdings get cheaper for a while then price myself out of a rising market because I’m “fighting the last war” and trying to avoid every potential loss.

Before signing off for this issue I wanted to thank all of you that came out for the Metals Investor Forum that I hosted at the Rosewood Hotel Georgia.  It was great to see so many of you there.   The event was a huge success if I do say so myself.  We had a great group of companies presenting along with excellent talks by my colleagues, Brent Cook and Joe Mazumdar of Exploration Insights, Gwen Preston of Resource Maven, Brien Lundin of Gold Newsletter, Jay Taylor of Jay Taylor’s Gold, Energy and Tech Stocks and Jordan Roy-Byrne of TheDailyGold.

Based on feedback from companies they were clearly impressed by the superior quality of the crowd.  That was not surprise to me dear readers as I of course already hold you in high esteem.

I want to thank my friend and partner in MIF Scott Gibson who had so much to do with making the event such a success.   Most of all I want to thank and congratulate my daughter Emma who put in 18 hour days organizing MIF and making sure it came off flawlessly.  Proud and lucky dad?  You’d better believe it!

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