Bullish On Gold? We Are.

Gold had a great 2016 right up until the election in November.
The big run on equities after the election was largely driven by speculation on what Trump might do for the economy. With the prospect of economic growth—and thus inflation—good news for stocks and the dollar, gold was crushed.
Fast-forward to 2017, and gold is outperforming everything. The yellow metal is now up 4% so far this year—compare that to the Dow Jones Industrial Average’s 0.7% gain, and the S&P 500 index’s 1.4% gain—in a clear signal that the post-election exuberance has waned.
That excitement that had pushed stocks to new highs on the hope of new fiscal stimulus, tax cuts, and looser regulations, seems to now have been replaced by want for details and doubt over whether Trump can deliver.
Of course, Trump isn’t the only reason for the good news for gold.

If You Don’t Own Gold, You Know Neither History Nor Economics

• The bull case for gold is getting stronger for monetary, fundamental, and technical reasons.
• Gold miners offer a positive asymmetric risk reward opportunity.
• However, in the short term, anything is possible.

Introduction
I’ve borrowed the title of today’s article from Ray Dalio, the manager of the $150 billion Bridgewater hedge fund.
Historically I have been against owning gold as it is not a yielding asset. However, after seeing how the global monetary base expands and will probably expand further when the next recession comes along, it’s a good time to contemplate an investment in gold as a hedge against human stupidity and greed.
Today, I’ll elaborate on the bull case for gold, the risks, investment options, and why I think some of those options have extremely positive asymmetric risks.
The Monetary Case For Gold
We are now almost nine years into the expansive part of the economic cycle. The current market sentiment is in greed mode, consumer sentiment is at levels not seen since before 2008, and valuations are at historically extremely high levels. In such an environment, nobody thinks about a recession. Unfortunately, a recession will come along. I don’t know when, but I know that when it comes it is going to take the world by surprise.
Don’t worry, it isn’t going to be bad because governments will do the only thing they know, increase monetary stimulus in order to stimulate the economy. The problem is that governments around the world don’t have more space for normal monetary easing through lower interest rates because interest rates are close to zero.

Figure 1: The “Gas in the tank” is close to empty. Source: Bridgewater.

Now, if you think the FED will manage to significantly increase interest rates before the next recession comes, here is some data that might change your mind. Higher interest rates immediately tighten credit which leads to lower investments, spending, and GDP. The pending home sales index was down 2.5% in November. If interest rates continue to climb, there will be less demand for homes.







Figure 2: Pending home sales index. Source: National Association of Realtors.
Higher interest rates have immediately impacted business investments. Investments are currently only 66% of the 2015 peak and if interest rates continue to climb, this percentage will be even lower.

Figure 3: Domestic business investment. Source: FRED.

If you think you see a pattern in the above figure telling you that when business investment declines a recession is around the corner, don’t worry because economists don’t forecast a recession for now as positive sentiment is extremely high.
If you’ll allow me some irony, it looks like the global economy is addicted to low interest rates and nobody wants to go to rehab. Fortunately, there are central banks that will continue to provide liquidity at any cost in case of a crisis. As interest rates are close to zero, they will have to use new monetary tools, likely in the form of “helicopter money.”
When that happens, gold will be a good place to be.
As more money becomes available, it should be worth less, and gold should be worth more.

Figure 4: Central banks’ balance sheets and gold price. Source: Goldcorp.

The price of gold has diverged from this pattern in the last 4 years as economies have strengthened, but it should return to the mean when turmoil comes along.
The Fundamental Case For Gold
As gold prices have been declining for the past 4 years, investments in the industry have severely declined and new gold discoveries are at historical lows due to the fact that the low hanging fruit has been mined.

Figure 5: Exploration is not replacing the gold produced. Source: Randgold.

Less successful exploration leads to lower grades which consequently leads to higher production costs and eventually less supply.

Figure 6: Expected gold supply. Source: Randgold.

The fundamental case has its risks. On average, all-in sustaining production costs come in at below $1,000 per ounce for the major gold producers and cash costs are even lower, so there is more space for gold to decline, especially if the global economy continues to do well.
The Technical Case For Gold
After four bad years, gold has reached a bottom and the 2016 rally looks like the start of a new bull market, especially if the above described economic scenario develops.

Figure 7: A technical view on gold. Source: McEwen Mining.

However, gold will always be gold and its price will be driven by sentiment in the short-term. Therefore, expect anything and position yourself accordingly. Dollar cost averaging is a good strategy, read more about it here.
Investment Vehicles
There are several ways to invest in gold.
The lowest risk option is to buy gold directly or through an ETF like the iShare’s Gold Trust (IAU). IAU is up 8.88% year-to-date.
A more volatile investment would be to invest in gold miners. The iShares MSCI Global Gold Miners ETF (RING) tracks the performance of a basket of global gold miners. The ETF is up 62.57% year-to-date which shows the increased volatility miners have compared to physical gold. But, RING is getting close to historical lows again.

Figure 8: RING – Global gold miners ETF. Source: iShares.

If the bull scenario for gold develops, the gold miners ETF could easily return to the values from 2012 which would triple your investment. As you can lose 100% in the worst-case scenario where all gold miners go bankrupt—something very unlikely—and gain more than 200%, this is where the positive asymmetric risk situation comes from. Of course, only a fraction of your portfolio, that you can afford to keep volatile, should be invested in gold miners.
If you are certain about where gold prices will go in the next few months, then a great investment would be the Direxion Bull (NUGT) and Bear (DUST) Gold Miners 3x Shares ETFs, but expect a crazy ride for sure.

Figure 9: Direxion Daily Gold Miners Index Bull 3X. Source: Nasdaq.

Investors who prefer a precious metal used in the industry should read our article on silver available here.
By Sven Carlin

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