Relative Performance of Gold Stocks
The quarterly meeting of the Incrementum Fund's Advisory Board took place earlier this month (April 12), and as usual, a special guest was invited to participate. This time we were joined by well-known fund manager John Hathaway (Toqueville Gold Fund). It was a very wide-ranging discussion of the financial markets and the economy, and we hope you will agree with us that it was quite interesting (as always, a PDF containing the transcript is available for download below).
Fund manager John Hathaway, special guest at the Incrementum Advisory Board Meeting this quarter.
One of the issues discussed by John we personally found particularly interesting was his idea as to why gold stocks have exhibited such dismal performance relative to gold this year. This has happened despite the fact that nearly all intermediate and senior producers are run by new managers who seem to be doing a great many things right. One would think that with the new-found focus on cost control and capital discipline, the sector should actually outperform rather than underperform precious metals.
Undoubtedly there are a number of factors playing into this, but John believes that particularly flows into and out of leveraged and unleveraged sector ETFs are exercising an outsized influence. This does certainly ring true to us. Consider for instance the major rebalancing of GDXJ that was implemented in 2017.
The ETF had become unable to properly fulfill its tracking function as many of its component stocks simply didn't have sufficient trading volume. Moreover, the ETF had become so large, it held more than 10% of the issued share capital in some companies. The rebalancing was terrible news for the share prices of companies about to be removed from the ETF - their shares underperformed the sector quite a bit until the exercise was finally bedded down (this happened during a period of sector-wide weakness to boot).
What we were not aware of is that the leveraged ETFs may be an even more important driver in this context. Of course the same thing that exacerbates underperformance in times when interest in the sector wanes also exacerbates outperformance when the sector is back in fashion, such as in the first half of 2016. In the long run it should all balance out, but it is still important to be aware of this, as it inter alia means that one has to be cautious about the "signaling function" of the HUI/gold ratio. We will have more on this in our next gold update.
Leveraged and unleveraged gold junior ETFs - the tails wagging the dog
John inter alia also shared a few of his picks with us, and we think he has the right idea: senior producers are likely to look for acquisitions sooner or later, as reserve replacement is becoming quite an issue for many of them. At the moment there is a strong focus on brownfield exploration and expansion, but eventually the desire to buy out companies that have made enticing discoveries will return (per experience at a time when prices have already moved up quite a bit). Given the current phase of undervaluation and neglect, there are a number of opportunities out there (patience will be required, but we believe it will be well rewarded down the road).
One more thing we wanted to briefly remark on here - because after reading the transcript it occurred to us that it might not come across the way we intended it to - are leading signals for the stock market. Regular readers are probably well aware by now that we have devoted quite a bit of effort to looking into this issue, based on the idea that the "QE" era (now morphing into the "QT" era) has created a number of unique market distortions.
Not only that, but the markets are also subject to structural problems that did not exist before. In fact, the effect of gold sector ETF flows on the performance of gold stocks is an excellent example of such a structural problem, albeit a relatively small and unimportant one compared to e.g. the proliferation of bond ETFs and assorted systematic trading strategies.
At one juncture we briefly address initial unemployment claims, which have a well-known negative correlation to the stock market and have occasionally served as a short term leading indicator of major trend changes. The main point we wanted to make in this context is that one can simply not rely on such indicators giving timely warning signals.
Whether it is the trend in margin debt, the A/D line, unemployment claims or even more firmly anchored (from both a theoretical and empirical perspective) signals such as credit spreads, one has to be mentally prepared for being surprised - as opposed to getting the usual combination of early warning signals that historically tended to ring the bell at major market tops and bottoms. So this is what we meant to convey.
NYSE margin debt - it is widely held that it always peaks ahead of major stock market tops, but we have found out this isn't quite true. In 1937 it lagged stocks by one month, in 1973 it lagged them by 7 months - two of the worst bear markets in history followed.
This time we believe there will be more surprised than usual, but we can of course not prove this - it is just an educated guess. How precisely things will play out will only be known in hindsight.
Lastly, the title of the transcript alludes to the fact that the markets appear to be underestimating the effect of the Fed's passive "QT" operation, which consists of it no longer reinvesting the proceeds from maturing bonds in its portfolio (with the monthly amounts growing every quarter). Since "QE" has created a lot of deposit money (in addition to bank reserves - see for a detailed discussion of the mechanics here: "Can the Fed Print Money?"), it follows that "QT" will end up doing the opposite.
The decrease in assets held by the Fed is accelerating, but remains actually well behind plan at this point (this is mainly due to a technical issue in connection with agency bonds and mortgage prepayments).
In other words, the markets and the economy are increasingly deprived of liquidity. An important point to keep in mind is that the private sector now not only has to fund the renewed acceleration in government deficit spending and the still ongoing expansion in corporate debt, but will also have to retroactively fund old debt that will no longer be bought by the Fed when it is rolled over.
This can only be counteracted by bank credit expansion, but banks are a bit hamstrung by the stricter regulations on capital adequacy introduced in the wake of the GFC. European banks in particular are still weighed down by nearly ?,?1 trillion in NPLs to boot (and their US subsidiaries traditionally do play a considerable role in US domestic credit expansion; European banks are also big players in dollar funding markets overseas and in certain sectors such as commodity-related financing).
Anyway, the upshot is that it will become increasingly difficult to keep all the bubble plates in the air, so to speak.
A lot more was discussed during the meeting - below is the download link for the transcript. Enjoy!
Incrementum Advisory Board CC, Q2 2018 - Markets Underestimate QT (PDF)
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