- Investing 5% of your portfolio in gold miners offers you the potential for a twenty-fold upside while the downside is just the invested 5%.
- A macroeconomic analysis shows that there is a high chance that the FED won’t be able to significantly increase interest rates or trim its balance sheet.
- More quantitative easing—similar to what is still going on in Europe and Japan—would easily bring gold above $2,000 per ounce. In that case, I wouldn’t exclude 1,000% jumps for miners.
Lately I’ve been mentioning in a few articles how gold, especially gold miners, are a good hedge for a portfolio. My idea is that if you own gold miners with 5% of your portfolio, you are relatively well protected against whatever surprises we might see coming from the economy.
If the economy does well and gold falls to $800 per ounce, you’ll lose a big chunk of your gold portfolio, but only 4% to 5% of your total portfolio. However, if there is high inflation or more monetary easing due to a recession, gold could easily go above $2,000 per ounce. In that case, I wouldn’t be surprised to see many gold mining stocks to go up five- or even ten-fold giving you an excellent hedge in case of a crisis.
From current prices, just to return to the 2011 high when gold was just above $1,800 per ounce, the stock of Barrick Gold Corporation (NYSE: ABX) would likely go up more than three-fold. This would represent an eight-fold jump from 2015 lows.
Figure 1: Barrick Gold’s stock performance since 2010. Source: Yahoo Finance.
If gold went above $2,000, I wouldn’t exclude a ten to twenty-fold jump for some miners.
For the first time since the last recession, credit growth has turned negative.
Figure 2: Loans and Leases in Bank Credit, All Commercial Banks, percent change on an annual rate. Source: FRED.
So just as the FED started to slightly increase interest rates and give some hints about more tightening, credit—the main factor influencing the economic growth we have enjoyed in the last 8 years—is starting to shrink and, according to not yet official data, has turned negative.
As imperceptible changes in interest rates have already had such a significant impact on demand for credit, it’s very clear that the FED won’t be able to significantly increase interest rates because higher interest rates would quickly lead the economy straight into a recession.
After 8 years of economic growth, a recession is bound to happen. The FED will have to continue with quantitative easing in order to pull the economy back to growth, similar to what the European Central Bank and the Bank of Japan have been doing. In such an environment, currencies are bound to depreciate while gold and other commodities should appreciate.
Additionally, as the FED has been hawkish in the last two years, gold has fallen based on higher interest rate expectations, but not on fundamentals as the FED’s balance sheet is still huge.
Figure 3: Gold followed the FED’s balance sheet but then diverged in 2013. Source: FRED.
The Fundamental Case For Gold
The last 6 years have been terrible for gold miners. Lower gold prices have led to low investments in exploration and mine development.
Figure 4: Exploration is not replacing the gold produced. Source: Randgold.
As the low hanging fruit has been mined, gold prices might really shoot up if there is increased demand for gold as a hedge as new gold discoveries have been low due to lower investments, and because it takes a lot of time to develop new mines. Additionally, given the low investments, gold supply is expected to decline in the next decade.
Figure 6: Expected gold supply. Source: Randgold.
As the macroeconomic and fundamental view has put a positive light on gold, it’s important to see how to expose one’s portfolio to gold to hedge at the lowest cost possible.
How To Invest In Gold Miners – Portfolio Allocation
Now that the gold miners positive risk asymmetry is clear, the question remains, how much of one’s portfolio should be invested in gold miners? The answer isn’t simple because there are many, primarily personal, factors to consider, but I’ll try to give some hints that can help.
The biggest risk to having gold miners in your portfolio is that the economy can continue to do well for the next few years before entering into a recession. If that happens, I wouldn’t be surprised to see gold prices below $1,000. This would be extremely detrimental for gold mining stocks as many would go bankrupt and profits would be negative for the whole sector. Therefore, having a significant portion of your portfolio in gold miners is out of the question.
However, as described in the introduction, even a small part of your portfolio in gold mining stocks can provide an excellent hedge.
As gold is extremely volatile, and gold miners even more so, another good strategy is to invest in gold miners through time. For example, let’s say you decide to allocate 0.5% of your portfolio, which could be a dividend from a long-term investment, into gold mining stocks. In such a scenario, you’re even less exposed to the volatility as if gold mining stocks fall, you just buy a bit more and you are very well hedged against potential future turmoil.
Another extremely important thing is to invest in good gold miners as each is very different. Tomorrow, I’ll describe in detail the top 10 global gold miners and what they offer to the individual investor, their risks and potential rewards, long-term outlooks, and how much are they influenced by changes in the price of gold.
In the past, I’ve been against investing in gold as it’s an asset that doesn’t produce anything. As I’ve watched what global central banks have been doing in the last 9 years, I’ve become a fan of gold, at least as a hedge.
An all-weather portfolio should have gold and other commodities in it as the current economic situation looks very stable but is also on extremely shaky grounds due to cumulating government deficits, the impossibility to significantly raise interest rates in developed countries, and the extreme situation where central banks buy even corporate bonds (Europe).
The macroeconomic picture tells us there could be trouble on the horizon, gold fundamentals look appealing even though gold prices don’t really follow the fundamentals. Nevertheless, if shit hits the fan, gold looks like an amazing place to be.
On top of it, gold miners provide an excellent hedge as their book values—some of them with lots of cash on their balance sheets—provide a margin of safety while the upside is huge given that miners have almost fixed costs. This means that higher gold prices would translate to pure profit.
More about specific gold miners tomorrow.