Look at this chart.
Source: Crescat Capital
The number one driver of the gold bull market in recent years is breaking upward. Will gold follow?
We saw on Friday (A golden opportunity, not to be missed) how the gold market from 2000-2012 witnessed numerous pullbacks and shake outs.
Let’s not forget why gold was such an important investment back in 2000.
Led by the stocks and the US, investors had enjoyed a phenomenal decade of returns and exciting growth.
But valuations had become extreme, and some of the shrewdest investors started thinking more about protecting their newfound wealth, rather than greedily trying to make more.
The latter group lost everything, as the Nasdaq crashed over 80% (‘the Nastanked’)
Gold is above all a store of wealth. That’s why the smartest investors looked to it for safety before the tech bubble burst.
It has been for millennia.
I believe we are in an eerily similar place today.
I’m sure you need no reminding of how gold (purple) performed relative to stocks (blue) starting in 2000, but here’s the chart anyway, just in case:Source: Koyfin
That chart tells you why anyone who dismisses gold as a pet rock with no yield can be cheerfully ignored. It smashed stocks for over a decade, rising 540% as the S&P delivered no return, and that’s before even adjusting for inflation.
More recently though, as investors we have been mainly focused on the price.
What has been driving it?
Real interest rates, aka ‘real yields’.
This is the interest rate on a 5-year US government bond, minus inflation. I.e. the inflation adjusted interest rates.
This is what the chart at the top of the page is showing: how real yields have correlated very closely with gold, until just recently. The implication of the author (hedge fund Crescat Capital) is very firm – that gold will catch up with real yields soon.
Real yields have to main variables, clearly, the interest rate on the bond and the inflation expectations of the market.
If real yields are falling (or rising on the inverted chart above), then the purchasing power of your fixed income assets is actually dwindling, even though it may have a slightly positive yield in nominal terms.
Gold meanwhile, can be expected to roughly maintain its wealth over the long term.
So if you expect inflation to be higher in the future, you can expect real yields to be lower, and the gold price to rise accordingly.
There are complications and modifications but that’s broadly the crux of it.
With the fed having printed almost a quarter of all dollars in existence just this year, with commodities prices soaring and oil prices coming back from extreme lows, it’s not a huge leap to see inflation rising for the near future.
If that happens, bond markets with their record high prices and consequently record low yields, will be primed for a pretty catastrophic crash.
Risk-free return on a government bond? Not quite! More like return-free risk at the moment, when you factor in inflation.
If bond markets crash, yields automatically rise as they represent the fixed coupon payment of the bond as a percentage of the price.
And if yields on government and corporate bonds are rising, equities will also fall.
Why? Because financial assets are to a large extent priced relatively. Equity valuations are especially high at the moment because of the mathematics of relative pricing.
Equities, being slightly riskier than bonds, are given a ‘risk premium’. So, if the yield on a bond is 5%, equities can be expected to yield 7-9%, let’s say.
With bonds yields at 0.5% earlier this year, the required return from equities only needed to be about 3% for them to be worth investing in over bonds. That’s the relative aspect of investment and valuation.
A lower yield demanded of equities means that investors will be much more willing to pay higher prices, as the expected yield is earnings divided by the price.
A 3% earnings yield translates to a price to earnings ratio (the inverse measure, which expresses the same thing), of 33.33x.
That’s a key driver of the high prices and even higher valuations we are seeing in US equity markets today.
So here’s the playbook, as I see it.
Inflation starts to pick up. This is a self-reinforcing cycle, but either way it has already begun.
Higher inflation leads to severe hit to the bond market, which concurrently does real damage to a very overvalued and fragile equity market, especially in America.
Meanwhile the conditions for gold are excellent. It is a safe haven during panics, while inflation is eroding the returns of all other assets making gold look more attractive to hold.
Just like in 2000, investors have seen an unnaturally good decade of returns, especially in the last few years.
If we turn our minds to protecting our wealth, rather than making more, larger allocations to gold could be imperative.
Starting in 2012, when the last gold run peaked, the story from 2000 has reversed, with stocks (blue) outperforming gold (purple) enormously.
But gold is now set up in such a way that the next decade could be even more spectacular than the decade long bull market at the start of the millennium.
Our latest in-house research here at Southbank has identified one factor which could see the gold market truly soar.
In a gold bull market, precious metals miners are almost always the best way to maximise returns.
After the gold price fell back in 2012, a number of things happened. Companies went bankrupt, bad managers were fired, and excessive risk was punished.
What’s left behind is a sector where only the best companies have survived, mining output is lower and management teams are more cautious.
This means a golden opportunity.
Why? Because it means mining exploration and investment is lower, putting constraints on supply of the metal.
Supply and demand, as with any financial market, determine the price.
And we think that there could be a very particular aspect of the supply and demand relationship which could be about to send gold and miners shooting up…
If you are investing in gold stocks, you need to read this research.
All the best,
Editor, UK Uncensored.
Jacques Coeur understood the importance of supply and demand. His story is a fascinating one.