Why The Gold Bull Market Is Just Getting Started

Sprott’s Paul Wong Explains Gold’s Bull Market

This past week I was honored, for a second year, to attend by invitation The Sprott Editor Forum. This is a gathering of newsletter writers whose focus is on the mining and resource industries. It is a small group of 11 or 12 letter writers who are invited to meet with senior members of the Sprott Inc. management team at the Sprott headquarters in Toronto. This is an exceptionally talented management team. With respect to the resource industry, I daresay there is none in the world that surpasses its expertise. One point I took away from my meeting with this company’s senior executives is the cross fertilization of intellect and talents that takes place among this team. For example, conclusions about market drivers  gained through the strong quantative skills of Sprott’s senior portfolio manager, Paul Wong, are not only used by his analysts in selecting certain gold stocks but also may be applied by another division of Sprott, like the Private Lending Group in forming lending decisions.

wong-average-returnI want to talk about Sprott Inc. and indeed add it as a recommendation in this letter in the very near future. But I have chosen to highlight Paul Wong this week because I found some of his remarks to be most directly related to the focus of this newsletter. Paul is not a gold bug. But his quant skills and market-savvy perception of reality combined with his rich experience can be extremely helpful to those of us who are gold bugs. Paul may help us discern an exit point out of gold investments. I’m hoping to plug into Paul’s insights as much as possible in the future and share them with you. I believe Paul can be as helpful from a more fundamental side, as Michael Oliver’s superb technical analysis has been to me in being comfortable with my view of the gold markets. Can there be a single bigger requirement for this letter and its readers than to know when to get in and when to get out of gold share investments? I trust Paul Wong along with a regular contributor to this letter, Michael Oliver, above all else, to help me answer that question correctly.

The chart below was taken from Paul Wong’s presentation to the newsletter editors. Paul made the point that is all too painfully felt by your editor and my subscribers and that is that when we are in a gold bull market, gold stocks do phenomenally well. But when that bull market suddenly turns into a bear, the losses are sudden and enormous. This picture of the gold share price cycle based on the S&P/TSX Global Gold Index in U.S. dollars illustrates Paul’s point very clearly.

Gold shares fell 80% after the rise in the price of gold from $35 to $850 in January 1980. Gold shares gained 760% from that bottom in 1982 to the peak in 1996. From that peak to the middle of 2000, a vicious 76% decline was recorded. That was followed by a 607% gain from 2002 to 2011, followed by the painful decline of 80% that we endured through the early days of 2016. Now, since February of this year, we have enjoyed a 100% rise so far, but based on past gains in gold share bull markets, we are still in the early days of this upward move. Still, however, we want to be on the lookout for an opportune time to exit because of the sudden turn downward and the horrendous losses that follow when we fail to exit in time.

The Key Driver for Gold and Gold Shares

wong-global-investment-thesisSo what are the fundamentals that will keep this gold share bull market driving a lot higher? And what should we look for to tell us it’s over? The answer is very simple, according to Paul: Keep your eyes on “real” interest rates. By “real” interest rates of course we mean the interest rates minus inflation, with inflation being defined by the CPI. For the sake of this discussion, let’s set aside the idea that the CPI grossly understates inflation. Paul’s chart below shows the relationship of “real” interest rates with the gold price. Declining real rates are correlated with rising gold prices. To be sure, there is sometimes a lag time between the movement in real rates and the price of gold. For example, gold peaked in 2011 even as real interest rates continued to decline into late 2012. In my view, that is explained by the fact that a large portion of the investment community continued drinking the Fed’s Kool-Aid. Mainstream investors believed in the credibility of the Fed and its fairytale that the economy would inevitably get stronger as a result of massive QE. As such they believed that real interest rates would inevitably rise, thus making gold ownership unattractive. But now, this new cyclical bull market has been born as the real rate of interest has not only begun to rise but has also broken through the trend line, illustrated by the broken red line on Paul’s chart shown below. The correlation between lower real rates of interest and a rising gold price over time is clearly shown by the Bloomberg chart below.

The rise in the gold price in the chart above suggests that as real rates of interest have declined, investors are again losing faith in the Fed and not drinking its Kool-Aid.

Of course, the ongoing propaganda from the Fed would have you believe that its policies will indeed result in strong economic growth in the future, despite its perpetual past failures. But if you buy the Fed’s propaganda, I have a bridge or two to sell you located close to my home here in Queens, NYC.  If you are really seeking the truth about our economic situation, I would suggest you digest a reality pill or two from David Stockman, who has never been shy in speaking the truth, even to his boss during the early 1980s—namely, President Ronald Reagan. You might start by listening to my recent interview with David Stockman here:  http://davidstockmanscontracorner.com/david-stockman-interview-30-years-of-misrule-by-the-wall-street-washington-elites/.

I should mention two more factors Paul pointed out that make gold shares look very attractive at this time. First, the price of senior gold producers to their cash flows remains near historical lows, as you can see from the following chart. We are nowhere near the danger zone outlined in red.

wong-price-to-cash-flow-multiples

Secondly, the long-term gold equity to gold bullion ratio remains at historically low levels.

wong-long-term-gold-equity-to-gold-bullion-ratio

Bottom Line: We are very early in this gold bull market and we should enjoy at least a couple more years of substantial upside gains for our junior gold share recommendations, especially those that are successful in outlining commercially viable gold deposits. But, we want to be vigilant in watching real interest rates so we can avoid the seemingly inevitable painful downturn. Stay tuned!