Gold During Times of Market Stress

Both gold and gold stocks should do well, but the timing may be different

A miner holds up a piece of quartz with gold in Jamestown, Calif., in this file photo. Gold stocks have historically led the gold price movement. David Paul Morris/Getty Images

There is great consternation in the gold investing world, as gold looks poised to break out and gold stocks remain moribund or even ready to break down.

Under normal circumstances, gold stocks should do even better than the underlying asset, especially in times of market stress. The ownership structure of stocks and gold itself explains the divergence in price performance.

The GDXJ Junior Miners ETF remains 76 percent lower compared to gold’s 8.3 percent loss over the last seven years, and since the big bounce in gold stocks in 2016, gold has been trending higher and gold stocks lower.

This is all the more disconcerting because the “gold stocks usually lead gold stocks” adage broke down completely long before the bear market hit gold itself.

There aren’t many good explanations for why gold stocks predict the future better than gold itself, but the two markets are inhabited by very different animals.

Different Ownership

Gold stocks, especially junior ones, are in large part owned by Australian and Canadian retail accounts, influenced by hysterical newsletter writers, unscrupulous promoters, venal brokers, and corrupt Canadian banks.

The bullion market, on the other hand, is the purview of money center banks and sovereigns. The director of the Market Operations Department of the Banque de France, for example, admitted in 2013: “We are still active in the gold market for our own account. We have a desk dedicated to FX activity, which is small, but now we are diversifying into gold, meaning that we are in the market nearly on a daily basis.”

It may just be that undercapitalized retail investors are far more sensitive to capital flows than the great banks and central banks, and thus they react first.

The general pattern since the beginning of this credit cycle in 1980 has been that central bank stimulus leads to nominal increases in gold but underperformance in real terms, while central bank tightening leads to nominal decreases in gold but outperformance in real terms. If this pattern were to hold, then Federal Reserve tightening would squeeze retail holders, prompting them to sell gold stocks, and sell gold only later.

Historical Performance

However, this pattern may not hold this time around, and gold and gold stocks should do well if and when the current credit bubble collapses. After the great crash of 1929, for example, Homestake Mining Company (one of the largest gold miners in the world) did indeed fall 22 percent in the three weeks following the crash, even as the demand for gold itself soared.

Later, and despite the fact that investors large and small were being wiped out, Homestake tripled by the time the stock market bottomed, and it nearly tripled again after President Franklin D. Roosevelt devalued the currency against gold, which rose from $20 to $35 under the scheme.

The point is that gold stocks do not need capital inflows to make them go higher. Once the gold price rises, gold mining margins explode in a true credit collapse, enabling self-funded expansion along with large dividends. Then equity prices rise not because buyers increase their bids, but because sellers raise their asking prices.

Canadian and Australian retail investors are undoubtedly under large pressure at this moment, resulting in a lack of demand for mining stocks. The real estate bubbles in those two countries are poised to collapse, and the hot money, instead of going into junior gold projects, has been consumed by crypto scams and marijuana projects, starving the junior gold mining sector of capital.

As soon as gold breaks out, however, the cash flow generation of the operating companies will make the industry as a whole self-funding, and there will be a scramble to acquire good development and exploration projects.

In addition, Trump’s recent tax cuts, combined with enormous spending increases and Fed tightening, will likely bring this credit-supercycle to a close in the near future.

Recent developments that include the further entrenchment of the war party (which will require corresponding further spending increases) can only accelerate the process, as gold senses.

It is certainly possible that, like Homestake, gold stocks will fall when the broader markets crash. But the growth of our credit bubble has been the same as all of the others in history, and there is no reason to think that its collapse will be any different either, resulting in good performance for gold and gold stocks.

Dan Oliver is the principal at gold mining fund Myrmikan Capital LLC.