September 17,2021

Considering the downside

Gold drops on some upbeat economic data

The gold price dipped -2.4% this week to US$1,754/oz, with most of the decline on a single day as strong US retail sales led to a more upbeat outlook on the US economy by the market and drove a move into riskier assets and away from gold.

Considering a scenario of a major decline in equity markets

With equity market valuations looking extremely high, this week we consider a scenario of a major decline in equity markets, what that would mean for gold stocks, and some (quite risky) instruments allowing for gains in declining markets.

Producers and juniors decline as gold slides

The producers and juniors dipped, with the GDX down -3.3%, GDXJ down -1.9% and the Canadian juniors mainly declining, as the gold price dropped abruptly at the end of the week as US retail sales beat expectations.

Producers and juniors decline as gold slides

Figure 4

Figure 1

Considering the downside

Gold declined -2.4% this week to US$1,754/oz, with all of the decline coming at the end of the week as US retail sales beat expectations, improving the market's outlook for the economy and likely driving a shift towards riskier assets and away from the safe haven gold. However, given the massive monetary expansion of the past year, much of pickup in US retail sales is likely driven by inflation, and rising inflation could prompt the Fed to reduce its stimulus and raise rates earlier than expected, which would certainly put pressure on the markets. However, for this week, anyway, the market does not seem to be pricing in this second, more bearish take on the data, and maintaining a more bullish outlook.

Recipe for a weakening market on stimulus withdrawal

This week we consider the growing potential for some downside in equity markets, and how that could affect gold mining stocks, and some ways to curb potential losses in such an outcome, or even profit from such a move (note that most of these options are quite risky and the best option is likely to simply reduce positions and hold cash). While the Fed continues for now to maintain very loose monetary policy, it has already given plenty of indication that it will start to pull back on this stimulus soon at least to some degree. While we believe that any such pullback will be very gradual, and that actual rate hikes are still likely more than a year away, there is still risk to equity markets from such a pullback. This is because equity markets have surged to such high valuations, driven heavily by the monetary stimulus, that even a moderate pullback in the stimulus could potentially drive a major drop in the equity markets.

This could start as prices start to stall without further monetary stimulus, and some more cautious market participants begin moderate selling. As the stimulus is pulled back further, a slightly bearish sentiment could worsen as liquidity-driven gains dry up, and prices start to turn down further. There are two elements to valuations, taking Price/Earnings as an example. So far we have considered the numerator Price, which we assume could be falling. We also need to consider the denominator, Earnings. In the case where the economy and companies' growth has been driven largely by monetary stimulus, a reduction in the money supply could also affect earnings. This could lead to a situation where both prices and earnings are falling, and valuations are actually maintained at high levels. Even worse, earnings could fall faster than prices, where we see the absurdity of valuations actually rising in a worsening market.

Valuations demonstrate the market's expectations of the future levels of growth, and as the decline continues, markets will start to view these valuations as unsustainable, and the only way to return them to reasonable levels is for prices to fall, often significantly. If, in contrast, we are in a period of very low prices and low valuations, which is usually also a period of limited monetary stimulus, or a following a period of very low monetary stimulus, so there are no such excesses. This tends to be a safe, albeit boring, period for investors, and at such a point, stock prices, valuations, and monetary stimulus (not necessarily in that order) have nowhere to go but up.

Key market ratios looking very toppy in historical terms

Looking at historical valuations points to markets being closer to the top of cycle than the bottom. The S&P 500 Price to Earnings Ratio, at 34.7x, has only been higher twice since 1877 (Figure 4), at 46.2x during the dot.com bubble in the late-1990s, and during the 2008-2009 global financial crisis. The S&P 500 Price to Book ratio is at 4.75x, its highest since the 5.04x reached in the dot.com era in 1999, and US total market cap to GDP, at 2.07x, is also at its highest since the 1.83x in 1999. With strong monetary stimulus continuing, we are cautious in calling a peak in valuations, but we the data suggests that we are certainly well above the average.

Key market ratios looking very toppy in historical terms

Two key factors; leverage to the gold price, and general equity market risk

This leads us to consider outcomes for gold stocks during stock market or commodity market declines. We have three major test cases, the 2008-2009 global financial crisis, the precious metals and commodity decline of 2011-2013, and the global health crisis-related of 2020 (Figure 5). During the financial crisis in 2008, while gold dropped about -14% at its trough, the GDX Gold Miners ETF declined a huge - 66% (data for the GDXJ Junior Miners ETF is only available from 2009). From mid2011-2013, gold declined about -23%, but the GDX was down about -61%, and the GDXJ about -79%. In 2020 gold actually remained quite strong, down about -5%, while the GDX was down -35% and the GDXJ about -48%.

Two key factors; leverage to the gold price, and general equity market risk

There are two main issues for gold stocks during these periods. The first core issue is that the decline in the gold price shows the leverage that gold stocks have to the gold price. Gold companies' operating costs tend to be fixed, so in a rising gold price environment, every move in the gold above this fixed level is pure profit, and gold stock earnings rise much more in percentage terms than the gain in gold. In contrast, as gold prices decline, this leverage effect goes into reverse, and a certain percentage decline in the gold price generates a much larger percentage decline in gold producers' profits. We see this effect in 2008-2009 and 2011-2013, with the declines in gold stocks largely driven by the drop in the gold price.

But what about 2020, when there is not a major decline in gold? This brings in the second factor, which is investors broadly selling off all stocks, not only gold miners. This was an issue in both 2008-2009 and 2020, where panicked market players sold off everything (although interestingly in 2020, did not aggressively sell safe haven gold) As perceived risk rises in markets, this is baked into the calculation of equity prices, and stock prices broadly decline, as all equity gets riskier, and investors will pay lower prices to account for this higher risk.

This (often) sudden decline in the risk that the market is willing to accept in a downturn is also the reason that the GDXJ can drastically underperform the GDX during market downturns. The GDX is comprised of producing miners, which have mines, production and proved and probable resources, which form a clearly defined set of valuable assets that can be sold, even if the overall value of these assets will decline as the gold price drops. In contrast, many junior miners are still drilling without even a clearly defined resource, and even if it is defined, its value is still opaque, and the ability to extract it a reasonable cost is often many years away.

There is also the issue that with no revenues, the juniors must constantly raise new capital to keep drilling, and raising that capital can become far more difficult in a bear market where investors become far more cautious about where to invest. The value of the junior gold miners is therefore obviously far more dubious, and the risk clearly far higher than for producers, and therefore junior gold stocks can take a huge hit in a market downturn.

Of the two effects, a gold price decline, or an equity risk-off period, which is worse for gold stocks? Judging from our three test case periods, a protracted decline in the gold price, like that seen from 2011-2013, is worse. This is because this represents such a fundamental negative driver for the industry, in contrast to an equity-risk off period, which might not necessarily drive a major decline in gold, as seen in 2020. As we expect that gold in general will continue to be supported, even if the equity markets take a hit, we are actually more concerned about the second factor, a general equity sell off, than a protracted decline in gold. For more on our views on the outcomes for gold price, please see our weeklies over the past months.

High risk ways advanced investors play downturns; put options and futures

So what actions can be taken by investors if we do start to see a broader equity market decline arise over the next few years? The first, and potentially least risky for the average investors, would be simply to pare back on gold mining stock holdings, move to cash, and wait to buy in a lower prices, or alternatively buy more of the underlying metal as its price may also ease off somewhat.

The second, involves a range of instruments that can be purchased to profit when the price of a mining stock or ETF declines. These include options, including puts, which is usually on a specific stock, a contract where the buyer must buy a stock from the seller at a fixed price below the current price, up until, or on, a specific date. If you own a stock, this would limit the downside for a small a premium. If the stock does not decline, the option expires with no value, but during the period you hold it, an investor has effectively purchased insurance against a decline. Puts may be beyond the scope of the general investor, and where they are needed most, for junior miners, they are often not available because the high downside risk.

Beyond puts, an even more 'nuclear' option, is the futures market, which is extremely risky, and for very advanced or even professional investors. Futures have extreme leverage to the upside and downside, and losses can quickly rise to much higher than the initial equity put in, and require almost constant monitoring, and so should certainly be avoided by average investors. Also, while there are futures contracts on single stocks, they are most often available on broader market indices for equity, and while there may be futures contracts on massive gold stocks like Barrick or Newmont, there are usually no such contracts on junior mining stocks.

Short ETFs and their large tracking error over time (and even for one day)

There is one more option for profiting from down markets, which are Short ETFs. These are much more accessible to the regular investor as they can be purchased the same as any ETF through a regular trading account. Although they can have extreme swings like futures, the downside is limited to zero, and cannot turn negative beyond the initial investment, which is common with the futures markets. As with futures and puts, however, short ETFs are probably best left to advanced investors or professionals.

The idea behind short ETFs is to return the opposite of the performance of a given index for a single trading day. Proshares Short S&P ETF, for example, aims to return the opposite of the daily return in the S&P 500 Index. If the index drops -1.0%, then the Short ETF theoretically should gain 1%, and if the Index rises 1.0%, the Short ETF will lose -1.0%. The 'aims to' part of the equation is important, because given the use of underlying derivates to execute this, in real time during the trading day, there is often not an exact match, which is called 'tracking error'.

Also, this tracking error compounds over time, so most Short ETFs will see a significant mismatch with the performance of the underlying index after only a few weeks. For example, after a month, if the underlying Index drops -5.0%, rather than seeing the 5.0% gain in the Short ETF as we might theoretically expect, the gain may be much less than 5.0%, or even negative, in case of extreme market volatility. Therefore, these instruments are generally only for short-term trades, and even then, should be used with caution. Adding to the both the risk-reward and tracking error of these instruments is the availability of double and triple short ETFs, where if the Index was to drop -1.0%, they would theoretically return 2.0% or 3.0% on the day.

There are Short ETFs covering broader indices like the S&P 500 down to individual sectors like financials, energy or real estate. The ETFs based on large equity indices tend to have better tracking error, while the smaller and more volatile the sector, the greater the tracking error tends to be. There are Short ETFs for many metals, including gold, silver and others, but these deal with movements in the underlying metal, not of the mining stocks. Also, there are both Double Short ETFs, meaning that if the Index declines -1.0%, the ETF should go up 2.0% on the day.

For gold mining stocks, there are only two Short ETFs, Direxion Gold Miners Bear 2X ETF, based on the NYSE Arcas Gold Miners Index, and Direxion Gold Junior Miners Bear 2X ETF, based on the MVIS Junior Gold Miners Index. There are no major Single Short ETFs for gold mining stocks, so investors would need to be pretty convinced of the direction of trading on the day, and a wrong call could be quite costly. Also, over a very long period, the tracking error of many ETFs can erode its value to very small percentage of the original value as we can see in the long-term performance of the two Direxion short gold miners ETFs (Figure 6).

Short ETFs and their large tracking error over time (and even for one day)

Figure 1

We can see how the tracking error works in practice in Figure 7, with the last two weeks of trading for the Direxion gold miners and junior gold miners short ETFs compared to their underlying indices. For each day, theoretically the ETFs should return twice the negative of the index, with, for example, the -0.5% return of the NYSE Arca Gold Miners Index on September 1, 2021, returning 1.0%.

However, we can see that the Direxion Gold Miners actually returns 1.5%, showing substantial tracking error, and on no day in the last two weeks do either of the ETFs actually hit the target return. The compound tracking error is shown by the returns over the whole two weeks, with NYSE Arca declining -1.3%, which we might expect to result in around a 2.6% gain in the Short ETF, but actually only returning 1.5%. This tracking error tend to compound over time, and lead to a general decline in these instruments, barring sharp market declines which can see the ETFs shoot up.

While the Direxion gold miners short ETFs have a very large tracking error even over a short period, there are actually short ETFs that have remarkable good tracking error, even over long periods of time, the S&P 500 Short ETF (SH), and Double Short ETF (SDS). The S&P gained 32% over the past two years, and SH has lost -27%, which is remarkably close to what we could theoretically expect, and the SDS -48%, which is a somewhat wider tracking error, but still quite low. While most Short ETFs, especially for sector ETFs, especially if they are Double or Triple Short, will have nowhere near the low level of tracking error as SH or SDS, the Direxion Short Gold Miner ETFs could be considered in a general market decline to potentially offset some sector risk, even while holding onto to mining stock equity positions.

Figure 2

Short ETF risks beyond tracking error

Beyond just the tracking error, there are other risks with the Short ETFs. The derivative contracts that comprise the short ETFs are not backed by anything concrete. So not only can they easily go to zero, but there is also the potential risk that in a major crash, the parties backing the derivatives making up the short ETFs themselves can have a sudden cash crunch, and become unable to make good on their side of the contract. Therefore an investor could have bought the correct ETF to profit in theory, but the contracts backing your bet aren't actually paid out.

All this said, this situation with derivative counterparties unable to complete their contracts is rare. The companies that set up these instruments will have tested their systems for extreme market events, especially since these instruments specifically become more interesting to investors during major market downturns. Even with the major financial disruption in 2008, most of the short ETFs generally did what was intended on a daily basis (taking into account the tracking error) and did not have issues because the underlying sellers of the derivatives themselves went bust. However, the huge spikes in the market did make the Short ETF tracking error even more severe than it already had been.

Short ETF risks beyond tracking error

Producers mainly down on the drop in gold

The producing gold miners were mainly down on the drop in gold (Figure 9). B2Gold reported that it would issue a cash dividend of $0.04/share, Pretium reported results from its Phase 3 resource expansion drill program at the North Block at Brucejack. Yamana released drill results from Wasamac and provided an update on its generative exploration program, including Lavra and Velha and Borborema in Brazil. SSR Mining reported drill results from five zones of Seabee, and Iamgold reported assays from its winter 2021 drill program at the Lac Gamble zone of the Rouyn Gold project (Figure 11).

Canadian juniors mainly decline as gold slips

The Canadian juniors were mostly under pressure as gold dropped (Figure 10). For the Canadian juniors operating mainly domestically, Victoria Gold reported its highest monthly production so far in August 2021 at 20,744 oz Au, and its inclusion in the TSX30 for 2021. Great Bear reported an update on geological and modelling results from the Auro2 domain, Artemis Gold issued an updated Feasibility Study, New Found Gold reported drill results from the Keats Zone at Queensway and Probe Metals appointed Ms. Ann Lamontange as its director of infrastructure, environment and sustainability (Figure 12). For the Canadian juniors operating mainly internationally, Rupert released its maiden resource estimate for Ikkari, Lumina reported a $C16mn private placement, a concurrent C$10mn non-brokered private placement and upsized of its credit facility with Ross Beaty from C$5mn to C$6mn. Integra reported a US$15mn private placement and Mako provided an updated on its operations at San Albino (Figure 13)

Canadian juniors mainly decline as gold slips

Figure 2

Figure 3

Disclaimer: This report is for informational use only and should not be used an alternative to the financial and legal advice of a qualified professional in business planning and investment. We do not represent that forecasts in this report will lead to a specific outcome or result, and are not liable in the event of any business action taken in whole or in part as a result of the contents of this report.