A new equity bear market? This one just ended

 

Equity investors suffered in January. Markets never before experienced such a bad start to a year. Stocks in Europe and Japan entered a bear market, while the US is on the brink of one. Some people panicked. Some were pleased, being able to pick up their favorite stocks somewhat cheaper.

Gold equity investors probably shrugged. To them, January was just a blip. They smile faintly when they read all the comments about a hard landing in China. Because slowing growth in China already caused a four year bear market in commodities and gold. This devastating bear took most gold stocks down 80%, 90%, and sometimes more than 95% from the peaks in 2011 to stunning historical lows.

Did commodity producers do stupid things at the top of the cycle? Absolutely. We’ve seen value-destructing debt-financed M&A. We’ve seen billions of CAPEX being thrown into what we now recognize as sinkholes. But companies learned. Managements were replaced. Costs were cut. Humility and the shareholder perspective retook the center stage in a lot of cases.

We also need to remember that mining will always be a margin game. Gold and silver prices have come down. But miners profit from declining input costs. Companies located outside the US also receive a huge boost from depreciating currencies. It is therefore no surprise that we’ve witnessed a nearly commensurate decline in all-in sustaining costs (AISC) at gold miners.

As a result, we’re about to see positive free cash flows at senior gold miners this year, even at $ 1.100 gold. This is obviously a very encouraging prospect after many quarters of cash burn.

With cash flows are looking better, are investors appreciating the operational improvement? Not at all. The bear took its toll. Sentiment is still depressed. Gold miners are now trading at the lowest price-to-cash-flow multiples we have seen in decades, if ever. And remember when gold stocks used to trade comfortably above their NAVs, given their leverage to gold prices and embedded exploration potential? Investors are currently able to buy at large discounts to NAV.

So miners are now lean and profitable, even at current gold prices. Just imagine what would happen if the price of gold would recover. The markets increasingly doubt whether the Fed will raise interest rates three or four times this year. This doubt has been one of the drivers behind higher gold prices in 2016. But did a higher Fed funds rate even correlate with lower gold prices in the past? The answer is: no.

Either way regarding interest rates, we think gold will perform well from here. If things get out of hand in terms of market dislocations, gold would of course do exceptionally well. The monetary experiment might escalate, perhaps starting in Japan. The EU and eurozone might disintegrate. Chinese policy makers might turn to panic mode to avoid a hard landing. The US might not be so decoupled from the economic global order after all.

Choose your pick. There plenty of reasons why the broad equity market could very well resume its January jitters. Smart investors avoid this unfolding bear. They look for the exhausted bear instead. Gold miners witnessed one of the worst price performances in history and now trade at compelling valuation lows. With this near obliteration of the sector, we believe gold stocks will successfully start to battle their way upward. Join the birth of a new bull!