FISCAL/MONETARY UPDATE – A WILD PARTY IS INEVITABLY FOLLOWED BY A MASSIVE HANGOVER, BUT THERE IS A SAFE HAVEN
THE MONTH THAT WAS – IN THE WORLD OF MONEY…..in particular ..GOLD AND THE GOLD MINERS
You don’t need us to tell you that the stock market over the last six months has been the worst in the last fifty years and the bond market worse than any in over one hundred years. It could have something to do with the fact that the US Federal Reserve, joined by other central banks have presided over the largest experiment in financial history. We’ve discussed this many times before, and symptoms such as companies selling at 50-75 times sales, “shiny objects” in the form of trillions of dollars of cryptocurrencies, hundreds of billions of dollars in the form of SPACs that could purchase a trillion dollars of companies “to be determined” are just a few chapters in The Financial Follies of the Early Twenty First Century.
After a modest rally at the end of last month, the stock and bond markets weakened again in June, especially the last few days of the month. Gold mining stocks acted more like “stocks” than gold bullion, which actually held up fairly well. While gold bullion was down only about 1.6% in June, mining stocks were down in the mid teens. However, as we discuss below, the gold mining stocks represent truly extreme value at this price, should be trading two to three times higher relative to the current price of gold bullion and a great deal higher than that once gold bullion does what it will ultimately do.
THE FED (THE PRESUMED GUARDIAN OF THE MONEY)
As we discussed last month, the Federal Reserve is kidding themselves (and lots of investors), as they project the possibility of a “soft landing” for an economy that is already in “stagflation” and about to get worse under the increasing burden of higher interest rates. There is no possible way that interest rates could be raised high enough to stifle the current inflationary trends. That would require short term rates above the rate of inflation, encouraging savings rather than spending, which translates to a level of 8-9% even if inflation comes down to five or six percent from the current rate above 8%. We predict that, within just a couple of months, the Fed will find an excuse to back off from forcing rates higher, even though inflation is far from tamed. That inflation related reality should encourage ownership of (purchasing power protecting) gold related assets.
Aside from higher interest rates, the Fed has promised to reduce their balance sheet that now includes about $9 trillion of fixed income securities, in particular US Treasuries and Mortgage Backed Securities. The printing of fresh capital to finance the federal operating deficit has been an important feature of the Fed’s activity, as shown in the chart below. You can see how the Fed’s balance sheet popped from close to one trillion dollars in the heat of the ’08-’09 financial crisis, continued upward to over four trillion dollars during the great recession. It plateaued for several years, and the Fed’s plan in late 2018 to reduce its size was aborted in early ’19 after the stock market went down by 20%. It is worth noting that the quadrupling of the Fed balance sheet (by printing money out of thin air to buy US Treasuries and Mortgage Backed Securities, keeping interest rates abnormally low in the process) was followed by only about a ten percent reduction before political pressures prevailed and they backed off.
With that history, let’s go to the second chart, which shows what has happened since the Fed announced the current plan to normalize their balance sheet. In early May the Fed announced their plan to start reducing the balance sheet, $47.5B during June, increasing to $95B/month by the fall, a rate of reduction that would then prevail for an unspecified time. More specifically: beginning June 1, it will no longer reinvest proceeds of up to $30 billion in maturing Treasury securities and up to $17.5 billion in maturing agency mortgage-backed securities per month. Beginning September 1, those caps will rise to $60 billion and $35 billion, respectively, for a maximum potential monthly balance sheet roll-off of $95 billion.
The chart just below shows what has actually happened.
You can see that, no matter how you look at it, the Fed’s action has substantially lagged the announced “plan”. If they cannot, for one reason or another, reduce Assets by $47.5B monthly at the beginning of the program, there cannot logically be much confidence in the longer term. Also, if interest rates have been so firm, and the economy has been so soft, when there has been minimal implementation, we can only imagine what the capital markets would do if $95B per month of tightening were imposed.
THE SAFE HAVEN (GOLD) AND THE LEVERAGED SURROGATES, GOLD MINING STOCKS
Gold bullion has in fact provided a relatively safe haven this year, down only a few percent in US Dollars and up materially in almost all other currencies. Gold mining stocks, as we said above, have acted more like “stocks” than bullion itself, which central banks worldwide (even as they debase paper currencies) continue to accumulate in record quantities.
Our conviction regarding the underlying value of gold mining stocks is higher than ever, considering the recent lackluster performance relative to gold bullion itself. The chart just below shows how the gold mining stock index compares to the price of bullion and you can see that the gold miners should be trading two to three times higher, considering an “average” relationship.
Beyond this, precious metal producers are generating the highest profit margins within the commodities sector. Even more impressive: Comparing the GDM gold mining index to the S&P 500: GDM has a P/E 25% lower, a Price/Cash Flow almost 50% lower, a Price/Book Value less than half, an Enterprise Value/EBITDA of about half, a dividend yield almost double with debt/Enterprise Value of only half. In summary: the gold mining stocks provide extreme value in accordance with the legendary 1934 Graham & Dodd tutorial, Security Analysis, that has helped to enrich Warren Buffet and so many other long term value driven investors.