Italian election results expose eurozone inadequacy

Until prosperity is better distributed, Europe will remain vulnerable to upheaval

Martin Wolf



The election results in Italy are a lesson to Europe. Italians were once among the most enthusiastic supporters of the European project. This is true no longer. The combination of economic malaise with political impotence has discredited not only Italy’s political and policymaking elite, but even the country’s engagement with the EU.

This does not mean Italy will leave; the costs would be too great. It means instead that the threat of both friction between Italy and the European establishment and further financial and economic disruption is now far greater.

The election results are quite as shocking as the Brexit referendum and the election of Donald Trump in the US: 55 per cent of the voters chose Eurosceptic and anti-establishment parties.



The Five Star Movement — an amorphous party of protest — gained 32 per cent of the vote and the League — a rightwing nationalist party — gained 18 per cent. The share of the centre-left Democratic party, in which the European establishment had put its trust, tumbled from 41 per cent four years ago to 19 per cent. The share of Silvio Berlusconi’s Forza Italia fell to 14 per cent. The populist revolution devours its parent.

Why are Italian voters so disenchanted? The obvious answers are that economic performance has been so dismal, while established Italian policymakers appear so ineffective. This is certainly not only — probably not even mainly — due to Italy’s participation in the euro. But the eurozone has made things worse. Not least, it offers an external scapegoat, which unscrupulous politicians are happy to exploit. Blaming foreigners is always an attractive strategy. In a failing country with a frustrated population, it is irresistible.



One aspect of the eurozone has been the inadequacy of its overall macroeconomic policy. In January 2018, the consumer price index of the eurozone (excluding erratic items) was 7.2 per cent lower than it would have been had it risen at an annual rate of 1.9 per cent since January 2007 — a rate of inflation that is a reasonable interpretation of the European Central Bank’s objective of “inflation rates below, but close to, 2 per cent over the medium term”.

An alternative assessment of macroeconomic policy is in terms of the growth of nominal gross domestic product. By the third quarter of 2017, eurozone nominal GDP was 11 per cent lower than it would have been had it grown at an annual rate of 3 per cent since early 2007 — a rate that would have been consistent with annual real growth of around 1 per cent and inflation of 2 per cent. Under Mario Draghi, the ECB did act successfully in the end. Yet overall macroeconomic policy has clearly been inadequate. It failed to deliver adequate growth in overall aggregate demand (see charts).




Within this weak macroeconomic environment, huge divergences also opened up among individual member countries. Germany’s nominal GDP rose by 34 per cent between the first quarter of 2007 and the last quarter of 2017 (a compound average annual rate of 2.7 per cent).

Italy’s rose by a mere 9 per cent over the same period (a compound average annual rate of 0.8 per cent).

Not surprisingly, given modest overall growth of nominal GDP, even Germany’s core annual inflation averaged a little over 1 per cent. Such low inflation in the core creditor country made adjustments in competitiveness within the eurozone far more difficult.

If the Italian government had been able to pursue its traditional policy of devaluation and inflation, it could have generated a far stronger rise in nominal GDP. That would surely also have delivered higher levels of real output. Italy’s real GDP in the last quarter of 2017 was, instead, 5 per cent below its level in the first quarter of 2007, while its real GDP per head was still some 9 per cent below the 2007 level a full decade later. No wonder Italians are disillusioned.



No doubt, Italy has huge structural economic problems, which tightly constrain growth, but potential output cannot have fallen this much since 2007. Italy also suffers from chronically deficient demand, a failing that the eurozone, as it is now run, is simply unable to remedy. This is partly because overall demand has been too weak and partly because, within the rules, demand cannot be directed to where it is weakest.

A prolonged recession, with high unemployment and low employment has inescapable political consequences. But the biggest frustration may be that the people Italians vote for have next to no room for manoeuvre. The question has rather been whom to elect (or sometimes not even elect) to carry out the policies decided in Brussels and Berlin.  Why not vote for a clown or a party created by a clown? It might not make much difference to what happens in Italy, but it might at least be more amusing.  Some Italian economists now argue that the country could obtain a degree of macroeconomic policy freedom by issuing what is known as “fiscal money” — a parallel currency that could be used to pay Italian taxes.  




This is technically possible. It would surely create hysteria in northern Europe, since it would eliminate the monetary policy monopoly of the ECB. But the very fact that such a radical idea is being discussed demonstrates the scale of the disenchantment in so large and important a country.

Unless and until the eurozone is able to generate widely-shared prosperity, it remains vulnerable to political upheaval. Weaknesses of the system, plus the impotence of democratic politics at the only level that really counts (the national one) remains a recipe for populism and fragility.

Italy, as many remark, is too big to fail and too big to bail. But its voters have moved from europhilia to scepticism. Like it or not, the risks of further upheaval are big.

Odebrecht strikes again

The short unhappy presidency of Pedro Pablo Kuczynski

After the president’s sudden resignation, the country may calm down for a while



PERU’S president, Pedro Pablo Kuczynski, left office on March 21st much the way he had governed during his 20 months in power. He walked out of the massive doors of the presidential palace and started waving to onlookers before taking a call on his mobile phone and ducking into a car. It was a low-key exit for the former banker, who was elected with one of the slimmest majorities in recent history and had little support in congress or among the 30m Peruvians he governed. Most had little idea how Mr Kuczynski planned to help Peru become a solidly middle-class country with strong institutions, as he had promised. His administration, like his departure, seemed distracted.

What felled him, though, was his connection with Odebrecht, a Brazilian construction firm at the centre of multiple scandals across Latin America. In December congress obtained evidence that Westfield Capital, a company owned by Mr Kuczynski, had worked with Odebrecht while he was finance minister and prime minister in a government that awarded contracts to the company. He had repeatedly denied that he had had any contact with the firm. Congress, in which Mr Kuczynski’s party has just 15 of the 130 seats, started impeachment proceedings.

Mr Kuczynski fought off that assault in December, apparently by striking a cynical deal. Kenji Fujimori, a congressman from the opposition Popular Force party, abstained along with nine others, which scuppered the impeachment. Days later, Mr Kuczynski pardoned Mr Fujimori’s father, Alberto, a former president who was serving a 25-year jail sentence for human-rights violations. The agreement left Mr Kuczynski friendless. He had fought the election as a foe of fujimorismo, against the former president’s daughter (and Kenji’s sister) Keiko, who leads Popular Force. The pardon alienated his anti-Fujimori base without placating Keiko, who still controls the largest faction in congress (and expelled her brother from it).

Calm comes from Canada

Opposition congressmen resumed their attack this month, citing further evidence of questionable dealings with Odebrecht. Wilbert Rozas, from the left-wing Broad Front coalition, said the president “showed zero understanding of the need to separate politics from his business life”. His downfall became inevitable on March 20th, when a video surfaced that showed Kenji Fujimori apparently promising another congressman public-works projects in his constituency in exchange for voting against impeachment. Mr Kuczynski’s allies in congress then abandoned him.

In a seven-minute resignation speech, he blamed the opposition, saying it had undermined him from the day he took office. He accepted no responsibility himself.

With Mr Kuczynski gone, things may calm down. His successor is the vice-president, Martín Vizcarra, who was also serving as ambassador to Canada. As governor of the small southern region of Moquegua, he improved education (pupils in the region get the highest marks in Peru on standardised tests). He also brokered an agreement to develop a big copper mine between Anglo American, a mining company, and nearby communities, no easy task. He will be the first president in decades who has made his career outside the capital, which will appeal to a lot of voters.

Opposition congressmen forced Mr Vizcarra out of his job as transport minister in May as part of their campaign of sabotage against Mr Kuczynski. They are likely to treat Mr Vizcarra more gently now, pundits predict. Few want to face another general election, which could be triggered if the chaos continues.

Mr Vizcarra must show soon that he is different from his ill-fated predecessor. “He will fail quickly if he keeps the same kind of cabinet, with bland ministers who seem more interested in their business deals than governing,” says Eduardo Dargent, a political scientist at the Catholic University in Lima. And he will have to prove that, unlike Mr Kuczynski, he can get things done. “When you ask people what the Kuczynski government did, they stare back at you. They have no response,” says Mr Dargent. An early chance for Mr Vizcarra to shine will come on April 13th-14th, when Peru is due to host a regional summit. Donald Trump says he will attend.

The Odebrecht scandal will test Peruvians’ faith in politicians and institutions. The company’s former director in Peru testified in February that it financed campaigns for the last four presidents, including Mr Kuczynski. Mr Vizcarra must ensure that investigations proceed unimpeded, however painful the results.


Don’t Mistake Market Calm for Being Out of the Woods

Investors should search the past for lessons about where we are in the market cycle. 2005 was an instructive momento 
By Richard Barley

REGIME SHIFT
Change from a day earlier in S&P 500 stock index


Is the fuss all over? February’s sharp fall in stocks has faded, with the S&P 500 only 3% below its January peak and up 4% for the year. The rise in Treasury yields has paused and corporate-bond spreads are still tight.

But now isn’t the time to get comfortable with the apparent calm.


STOCKPILE
Assets on central bank balance sheets
Source: Citigroup



The underlying economic picture in March is muddier than in January. Some survey data, like purchasing-managers indexes, suggest that growth may have peaked, while inflation is likely to pick up. Sure, last week’s U.S. jobs data pointed to continued expansion, but central banks aren’t backing down from reducing stimulus. And for those who believe the flow of central bank asset purchases are what matters for markets, rather than the vast stock accumulated, then the period ahead looks troubling. That flow is diminishing.

Even the apparent lack of spillover from the implosion of stock-market volatility products might not be that reassuring. Investors elsewhere, not directly affected by the financial fallout, may be underplaying the significance of this event.

A worker labors at a construction site in Washington, DC. U.S. jobs data pointed to continued expansion last week. Photo: mari matsuri/Agence France-Presse/Getty Images 


So which is it? There has been lots of guessing about where we are in the cycle and a search for historical parallels. Is this 1994, a bond market bump before a huge leg up in stocks? Or 1998, when Russia’s default sent markets briefly into panic? Or is this 2007, moments before a crash?

A lesser-noticed moment worth studying is the credit correlation blowup of 2005. Markets were shaken then after auto makers Ford Motor Co mpany and General Motors Co mpany were downgraded to “junk,” sending bets made in the credit-derivatives market awry. That too didn’t have immediate consequences for wider markets or the economy: the corporate-bond market bounced back in the second half of 2005. And it wasn’t in the area of the market—housing—that ended up causing the crisis just over two years later. 


EARLY WARNING?
Spread of U.S. investment-grade corporate-bond yields over Treasurys



Source: ICE BofAML index via FactSet,


But it was an early sign in that cycle that investment strategies that rely on conditions persisting can reverse swiftly and unexpectedly. In the 2005 case, rather than betting on volatility remaining low, investors were using complex derivative trades to bet that corporate bond prices would broadly move in sync. When Ford and GM’s ratings were cut, that bet went badly wrong, as the auto makers’ bonds were slammed, while the rest of the market was steadier. The return available suddenly wasn’t sufficient for the risk taken.

The same is the case for investors who were betting this year that volatility would stay low.

Tight corporate-bond spreads and still-lofty stock valuations speak to a persistent belief that the world hasn’t changed, however.

One could read the start to 2018 in a reassuring way: the global growth story may yet win out.

But investors should probably take the turbulence seriously. Markets are changing. Now isn’t the time to hit the snooze button.


Germany’s Dangerous Political Marriage

Helmut K. Anheier

Angela Merkel, Acting Chairman of SPD Olaf Scholz and Chairman of CSU Horst Seehofer


BERLIN – More than five months after Germany’s federal election last September, a new grand coalition government – comprising Chancellor Angela Merkel’s Christian Democratic Union, the CDU’s Bavarian sister party, the Christian Social Union (CSU), and the Social Democratic Party (SPD) – has finally been formed. But there is little reason to celebrate.

Germany has endured nearly six of months under a caretaker government (the longest in the Federal Republic’s history), a failed coalition agreement, weeks of arduous negotiations, painful internal party rumblings, and much politicking. Moreover, a recent national poll dealt yet another blow to the center-left SPD, indicating that if elections were held today, the party would be outperformed by the far-right Alternative for Germany (AfD).

Add to that Europe’s ongoing right-wing backlash (exemplified, most recently, by Italy’s election) and the threat of a trade war with the United States, and Germany’s new grand coalition reeks of desperation. Not surprisingly, reactions to its formation were subdued, with the public and political insiders alike mostly just relieved to have the long ordeal behind them.

Germany’s new grand coalition – the third in Merkel’s long chancellorship – is a marriage of convenience: loveless, largely unloved, and devoid of any overarching vision. It is a good outcome for Germany’s short-term stability, especially with regard to Europe. But it is an uncertain outcome in the longer term, given the coalition’s considerable political baggage, and it is a bad outcome for democracy, especially at a time when populist forces are a growing threat.

One might argue that it is good for democracy that Merkel’s coalition has shrunk. Because the government parties control barely more than half of the Bundestag, they no longer overwhelm the opposition, rendering it irrelevant. The problem is that the largest official opposition party is now the populist AfD.

Moreover, the share of the Bundestag held by opposition parties that are only semi-loyal to liberal democracy – the AfD and its left-wing counterpart Die Linke (the Left) – now approaches one-quarter. Not since the Weimar Republic has a far-right party been the largest opposition force, or have anti-liberal forces controlled such a large share of the Bundestag.

This illiberal result is a direct consequence of the SPD’s participation in Merkel’s government.

Had the SPD remained in opposition, as it vowed to do after its poor election result, it could have spent the next four years renewing its platform and membership, while acting as a strong challenger to both Merkel and the right- and left-wing populists. A Merkel-led CDU/CSU minority government would have meant open debate on all major policy issues and legislative proposals, enlivening the Bundestag and showing the public that political parties matter, and that a grand coalition isn’t essential to progress.

Instead, Germany got a government that will implement a predetermined set of policies, contained in a 170-page agreement hammered out behind closed doors – one that promises more of the same. Its members will engage in all of the same professionally choreographed and well-rehearsed debates, the ritualistic display of legislative process that devalues parliament because the outcome is pre-determined.

For Europe, this means that no significant shift in Germany’s approach – for better or for worse – should be expected. French President Emmanuel Macron will not see a German hand reaching out to work with him on European Union reform, though he might be able to grasp a finger or two.

To be sure, the new grand coalition’s policy approach will be different in some respects from the last. In her determination to form a government, Merkel yielded to the SPD on important issues, including EU policy and labor-market matters. As a result, the overall legislative program outlined in the coalition agreement is more social democratic than that of any previous grand coalition.

But, ultimately, Germany can expect more of the same for the time being. This will keep the government stable in the near term. But it is a feast for populists – and a missed opportunity for democracy.

In fact, whatever stability the CDU/CSU and the SPD think that they have secured, there are plenty of reasons for concern in the medium term. The CDU is increasingly impatient with Merkel and her policy approach. And, though it is the largest party, it has relatively fewer government posts than the SPD, with no CDU cabinet minister hailing from eastern Germany, an AfD stronghold.

Unlike the CDU, whose members will soon feel short-changed, the SPD has rediscovered the virtues of internal democracy, which revealed a significant disconnect between the party’s leadership and its base. Whatever success the SPD has had playing the coalition game, the party’s participation in yet another Merkel-led government stands to cost it growing numbers of lower- and middle-income voters.

Both the CDU and the SPD face a shrinking electoral base and a falling supply of leadership cadres. As a result, both parties and their coalition will become increasingly unstable over time, a trend that would be accelerated by their poor performance in the 2019 European Parliament election, not to mention in Germany’s upcoming state and local elections.

Meanwhile, in the absence of a crisis that demands political attention, all of the problems and risks that Germany’s previous coalition governments have failed to address will continue to be ignored. At a time when German leadership is so badly needed in Europe, the country is set to continue to play a passive role.

Until recently, the SPD seemed to prefer a loss to a half-victory, much as a person might decide that it is better to be alone than in a mediocre relationship. But now the SPD seems to think that being in power, by joining the ruling coalition, is automatically better than being in opposition, no matter the cost. And the cost could be very high indeed. Loveless marriages can last a long time, but they rarely end well.


Helmut K. Anheier is President and Professor of Sociology at the Hertie School of Governance in Berlin.


‘Rolldown’ Shows Why the Bond Market Is an Unfriendly Place to Hide

The absence of a ‘rolldown’ is making the U.S. bond market an unfriendly place for investors

By Richard Barley




HIGHER, FLATTER
U.S. Treasury yields

Source: FactSet



For bond investors, a concept called “rolldown” is like a virtuous form of financial gravity, a force that generates returns without doing much work. A flattening yield curve, however, is threatening the physics that investors rely upon.


Federal Reserve Chairman Jerome Powell speaks at a news conference following the Fed’s decision to raise rates. Photo: aaron p. bernstein/Reuters


The signals sent by the Federal Reserve Wednesday suggests the yield curve could flatten further: Its rate increases will raise short-dated yields, but there is still skepticism that rates in the long term will be materially higher.

When the yield curve is steep, investors benefit from the yield on a long-term bond “rolling down” the curve. As a 10-year bond over time becomes a nine-year bond, all else being equal, its yield falls and its price rises, producing a gain above the initial yield when the bond is purchased. That offers protection for bond investors in a rising-rate environment, notes TwentyFour Asset Management.



ROLLDOWN RETURN
Rolldown means an investor who holds a 10-year Treasury yielding 2.9% for a yearwould achieve higher returns the lower rates are at shorter maturities.


Source: Tradeweb


The U.S. yield curve still slopes upwards, with 10-year Treasurys yielding 0.57 percentage point more than two-year securities. But the further out you go, the flatter the curve gets. There is now only a 0.07 percentage-point gap between seven- and 10-year Treasury yields, a gap that has more than halved from a year ago. The potential for rolldown gains is small.

A similar phenomenon is showing up in U.S. corporate bond markets too, with the gap between short- and long-maturity bonds shrinking in both yield and spread terms. A number of forces are potentially at play here, as with the rise in Libor rates.


SQUEEZE
Yields on ICE BofAML U.S. corporate bond indexes

Source: FactSet



Higher U.S. Treasury bill issuance is competing for investors’ cash. And the pool of funding for short-dated debt may also have shrunk due to corporate cash repatriation, Citigroup suggests: if dollars can be repatriated and spent, they don’t need to be tied up in bond investments.

By contrast, steeper curves in eurozone government and corporate bond markets may make them attractive to investors. The European Central Bank’s negative-rate policy, which it is in no rush to change, is acting as an anchor for yields, reassuring bond investors. Coupled with the cost for foreign investors to hedge dollar-denominated bonds, U.S. bonds lose out despite their higher yields. All of that may lead to tighter U.S. financial conditions.


CURVEBALL
Gap between two-year and 10-year government bond yields


Source: FactSet



The absence of rolldown is just one factor in the investment equation, of course. But piled on top of a Fed that looks set to carry on raising rates and concerns about inflation, it makes the U.S. bond market an unfriendly place for investors.


Are Gold Stocks Preparing For A Rally?

Gold



The small contrarian gold-mining sector remains deeply out of favor, universally ignored.

Thus, the gold stocks are largely drifting listlessly, totally devoid of excitement. But that’s the best time to buy low, when few others care. The gold stocks continue to form strong technical bases, paving the way for massive mean-reversion uplegs. And they remain exceedingly cheap relative to gold prices, which drive their profits.

Being a gold-stock investor feels pretty miserable and hopeless these days. The gold stocks have been consolidating low for 14.2 months now, stuck in a seemingly-endless sideways grind. There are still gains to be won, but they are mostly within that low-trading-range context. We haven’t seen one of the huge uplegs gold stocks are famous for since the first half of 2016. So most traders have given up and moved on.

That’s understandable psychologically, but unfortunate for multiplying wealth. Sometimes it takes a while for gold stocks to catch a bid, but once they get moving they often soar. This sector is so small relative to broader stock markets that even minor shifts in capital flows can drive enormous gains.

While it’s hard waiting for gold stocks to return to favor, the vast upside when they do is well worth the buying-low pain.

The leading gold-stock measure and trading vehicle is the GDX VanEck Vectors Gold Miners ETF.

It was the original gold-stock ETF launched in May 2006, and still maintains a commanding advantage in popularity. This week, GDX’s net assets of $7.7b were 24.0x larger than its next-biggest 1x-long major-gold-stock-ETF competitor! GDX is as big as all the other gold-stock ETFs trading in the U.S. combined.

GDX’s price action shows why gold stocks are such compelling investments when everyone hates them. After gold stocks were universally despised in mid-January 2016, GDX soared 151.2 percent higher in just 6.4 months! After the previous time sentiment turned so overwhelmingly against gold stocks in October 2008, GDX rocketed 307.0 percent higher over the next 2.9 years. Buying gold stocks low has proven very lucrative.

That quadrupling of GDX after 2008’s first-in-a-century stock panic was actually the tail end of a vastly-larger secular gold-stock bull. Many years before GDX was even a twinkle in its creators’ eyes, that gold-stock bull started stealthily marching higher out of total despair. It can’t be measured by GDX since that ETF started too late, but the classic HUI NYSE Arca Gold BUGS Index reveals the magnitude of that bull run.

Over 10.8 years between November 2000 and September 2011, the gold stocks as measured by the HUI skyrocketed an astounding 1664.4 percent higher! And that was during a long bear-market span in the general stock markets, where the flagship S&P 500 drifted 14.2 percent lower. The gains in gold miners’ stocks as they mean revert from out of favor to popular are so epically enormous that they far outweigh any time lost waiting.

Gold stocks are even more attractive today given the exceedingly-overvalued and dangerous US stock markets, which are on the verge of a long-overdue major bear. Market valuations remain deep in literal bubble territory despite early-February’s correction. The simple-average trailing-twelve-month price-to-earnings ratio of the elite S&P 500 stocks was still 31.5x at the end of last month, above the 28x bubble threshold!

The market-darling stocks investors love today are crazy-expensive, portending huge downside in the next bear. The most-popular stock among professional and individual investors alike is Amazon.com, a great company. Yet AMZN stock is now trading at a ludicrous 252.5x earnings!

That means if profits held steady it would take new investors today a quarter millennium just to recoup their stock purchase price.

Meanwhile the world’s largest gold miner in 2017-production terms, Barrick Gold, is now trading at a TTM P/E of 9.5x. That’s dirt-cheap by any standards! And ABX’s profits-growth potential is greater than AMZN’s. Last year Barrick mined 5.32m ounces of gold at all-in sustaining costs of $750 per ounce. That was $508 under gold’s average price of $1258 last year, fueling fat full-year profits over $1.5b on $8.4b in sales.

Every 10 percent increase in prevailing gold prices boosts Barrick’s earnings by 25 percent. And the average gold price so far in 2018 is already up 5.7 percent, so gold miners’ profits are growing fast. I’m not a Barrick Gold investor and am just using this leading major gold miner as an example. There are plenty of smaller mid-tier gold miners with far more upside profits leverage to gold prices. Gold stocks are darned attractive!

They are one of the last bargain sectors remaining in these overheated stock markets. They are one of the only sectors that can rally in major bear markets, because they follow gold which drives their profits. Gold investment demand surges in weak stock markets, which brings investors back to gold stocks. At some point, investors are going to figure out how compelling gold stocks are today and stampede back in.

Despite the apathetic sentiment plaguing them, the gold stocks are still looking fine technically and even better fundamentally. This first chart looks at gold-stock technicals as rendered by their dominant GDX ETF. Given how bearish traders have waxed on gold miners, you’d think they are spiraling relentlessly lower. But they are actually consolidating nicely, establishing a strong base from which to launch their next upleg.


(Click to enlarge)


After plunging to fundamentally-absurd all-time lows in mid-January 2016, GDX soared into a major new bull market. While its 151.2 percent surge in just 6.4 months was undoubtedly extreme, that emerged out of even-more-extreme lows. And it merely catapulted GDX to a 3.3-year high in early-August 2016, nowhere close to secular topping levels. But the gold stocks were very overbought then, and soon corrected hard.

GDX’s enormous 39.4 percent correction in 4.4 months after that initial bull peak was also extreme, the result of a couple major anomalies. First gold-futures stops were run on major gold support failing, which ignited parallel cascading stop-loss selling in the gold miners’ stocks. Then investors fled gold in the wake of Trump’s surprise election victory, which led stock markets to soar on widespread hopes for big tax cuts soon.

Gold-stock selling finally exhausted itself in mid-December 2016, the day after the Fed’s 2nd rate hike of this cycle. Just a couple weeks later, GDX entered its now-14.2-month-old trading range that persists to this day. It is a basing consolidation trend running from $21 support to $25 resistance, which makes for a 19.0 percent trading range. This has held rock solid ever since, which has made gold-stock trading fairly easy.

My strategy has been simple. Given the extreme undervaluations in gold stocks that I’ll discuss shortly, a massive new upleg is likely to ignite anytime. So, I want a full trading book to reap those enormous gains when they inevitably arrive. Thus, every time GDX slumped down into the lower quarter of its consolidation range, between $21 to $22, I’ve been adding positions in great mid-tier gold miners with superior fundamentals.

All this is shared in real-time with our newsletter subscribers, who graciously support our research work. Buying low in the context of this vexing gold-stock consolidation has driven some great trades despite lackluster overall action. One example is Kirkland Lake Gold, an elite mid-tier miner. I added a new position in our popular weekly newsletter in December 2016. A year later I sold it for a hefty 184 percent realized gain!

So, while this gold-stock trading range has sure felt dull, it has still created plenty of trading opportunities. And over the past month or so since that sharp stock-market correction, GDX has largely meandered in that lower quarter of its range near support again. That means it’s an excellent time to deploy capital in the unloved and cheap gold miners’ stocks today. Another surge higher is due, and it could be a big one.

While GDX $21 support has proven strong since the end of 2016, so has GDX $25 resistance.

The gold stocks have tried and failed to break out above $25 four separate times since early 2017. A couple of the attempts were close but weren’t sustainable as gold retreated. Once that $25 breakout finally comes to pass, investors will realize something different is happening and rush to chase gold stocks’ upside momentum.

Before early February’s sharp stock-market plunge that changed everything, I was looking to the release of gold miners’ Q4’17 operating and financial results as a potential catalyst to fuel that $25 breakout. That didn’t happen though, as gold and especially gold stocks were sucked into the fear surrounding the unprecedented stock-market volatility shock a month ago. That dragged GDX back down near support, which held.

This recent support approach is probably a blessing in disguise, offering another chance for investors to deploy capital in cheap gold stocks before they really start moving again. The great and sad paradox of the markets is investors are least willing to buy when stocks are low and out of favor, which is the exact time they should be buying before later selling high. Gold-stock prices can’t and won’t stay this low forever.

With stock-market volatility back, the highly-likely catalyst to ignite that GDX $25 breakout is gold rallying on resurgent investment demand. Gold is largely ignored when stock markets are high, and investors are euphoric, as they feel no need to prudently diversify their portfolios. But once stock markets sell off for long enough to spook investors, they start shifting capital back into gold which often moves counter to stocks.

With the U.S. stock markets still trading deep into bubble territory in late February, and euphoria remaining rampant as evidenced by the blistering bounce rally following that early-month plunge, there’s no way the stock-market selling is over yet. It will have to resume sooner or later with a vengeance to actually start rebalancing away greedy sentiment. When that happens, gold and gold stocks will soon catch major bids.

The fact gold stocks have held strong in their consolidation trading range for well over a year now is a glass-half-full kind of thing. It testifies to relatively-strong investment demand given the terribly-bearish sentiment pervasive in this sector. The longer prices base during bull markets, the greater the upside potential in their next upleg. It likely won’t take much of a gold rally to blast GDX back up through $25 again.

This strong technical picture and an inevitable sentiment mean reversion are reason enough for gold stocks to surge dramatically higher. But supercharging that is the dirt-cheap state of gold stocks today in fundamental terms. That includes current gold-mining profits compared to prevailing gold-stock prices, as well as near-future earnings-growth potential as gold itself continues mean reverting much higher ahead.

I’m well into my quarterly research work analyzing the Q4’17 results from the major gold miners of GDX. Unfortunately, due to the complexities of preparing annual reports, the Q4 reporting season up to 90 days after quarter-ends is double the 45-day deadlines for Q1s through Q3s. So all the data isn’t quite in yet, but I expect to have enough to delve deeply into the major gold miners’ Q4’17 results in next Friday’s essay.

In the meantime, a great fundamental proxy for gold-stock valuations is the HUI/Gold Ratio.

This is as simple as it sounds, dividing the daily close of that classic gold-stock index by the daily gold close and charting the resulting ratio over time. This reveals when gold stocks are expensive or cheap relative to the metal which drives their profits. And this sector has rarely been more undervalued than it is today!


(Click to enlarge)


This week the HGR was way down at 0.131x, meaning the HUI index’s close was running just over 13 percent of gold’s close. That’s incredibly low historically, showing that the gold miners’ stocks have been wildly underperforming gold. The gold stocks are trading at levels today implying gold and their profits were radically lower. This is a colossal fundamentally-absurd disconnect that can’t last forever, it has to unwind.

GDX and the HUI were way down at $21.57 and 173.4 in the middle of this week. The first time the HUI ever hit this level was way back in August 2003, years before GDX was even born. Back then gold was only running $357 and had yet to trade above $380 in its entire young secular bull. Let that sink in for a second. Gold stocks are trading at prices today first seen when gold was in the $350s fully 14.6 years ago!

This week gold was trading near $1325, an enormous 3.7x higher. That should certainly be reflected in gold miners’ stocks. Today’s super-low gold-stock levels aren’t much above the HUI’s stock-panic lows back in October 2008. There was only a week where the HUI traded lower than today at peak fear in the stock markets, and gold averaged $732 during that extreme span. This week it was trading 81 percent higher!

This is incredibly illogical, only explainable by irrational sentiment. If any other stock-market sector was trading at levels from a decade or more earlier despite the selling prices of its products doubling to quadrupling, investors would be beating down the doors to buy. That would rightfully be seen as a huge and unsustainable anomaly, a rare chance to buy deeply-undervalued stocks at decade-plus-old prices.

And it’s not just gold that’s far higher, so are the profit margins for mining it. With the new Q4’17 results from GDX’s major gold miners not all out yet, the latest data we have this week is Q3’17’s. During that previous quarter, the top GDX miners averaged all-in sustaining costs of just $868 per ounce. The costs of mining gold industrywide don’t change much, which is what creates profits’ big upside leverage to gold prices.

My still-incomplete Q4’17 analysis shows AISCs very similar to last quarter’s. That makes sense, as the past year’s quarters ending in Q3’17 had collective GDX AISCs of $875, $878, $867, and $868.

Mining gold costs similar amounts regardless of prevailing gold prices, at least over medium-term multi-year spans too short for new gold mines to be built. So Q4’17 AISCs are likely to remain around these levels.

Assuming $868 carries forward into Q4’17 and Q1’18, gold-mining profits are really growing. Average gold prices surged from $1276 in Q4 to $1330 quarter-to-date in Q1. That’s up 4.2 percent sequentially, really strong. This implies major gold miners’ earnings are surging 13.2 percent QoQ in our current Q1’18 from $408 to $462 per ounce! That would make for strong 3.1x upside profits leverage to gold, which is impressive.

And whether the major gold miners are collectively earning $400, or $450, or even $500 per ounce today, such profits alone are much greater than the $350s prevailing gold price the first time the HUI traded at today’s levels. With fat profits like this heading much higher as this gold bull continues, it’s ridiculous for gold stocks to be priced as if gold was still in the $350s like mid-2003 or the $730s like in 2008’s stock panic.

This extreme anomaly can’t and won’t last. The gold stocks should be priced for today’s prevailing gold prices around $1325. The first-time gold hit $1325 in October 2010, the HUI was trading at 522. That is triple today’s ludicrous levels! The gold stocks more than quadrupled in the years following 2008’s stock panic, another irrational situation where sentiment had battered gold stocks to fundamentally-absurd levels.

Between that first-in-a-century stock panic and extreme central-bank easing that really hit full steam in 2013, the last quasi-normal years in the markets were 2009 to 2012. During that post-panic span the HGR averaged 0.346x. If the HUI would merely mean revert back up to those levels relative to gold, it would have to soar to 458. That’s 164 percent higher than this week’s levels, upside unparalleled in any other sector.

For 5 years before the stock panic, the HGR averaged 0.511x. While gold stocks might not be able to sustain levels so high anymore, they could certainly blast up there in a temporary mean-reversion overshoot. After extremes, prices don’t simply migrate back to the average. Instead they overshoot proportionally to the opposing extreme as sentiment is equalized. That implies a HUI level of 677, 290 percent higher from here.

No one knows how high gold stocks can go, but there is zero doubt they are radically undervalued given today’s gold prices and the gold-mining profits they generate. Whether you expect this battered sector to quadruple again like after the stock panic, or merely double, that dwarfs the potential of the rest of the stock markets. Especially with the S&P 500 trading at bubble valuations after a long central-bank-goosed bull.

The gold stocks are truly a coiled spring today, ready to explode higher soon and trounce everything else. They are deeply out of favor, incredibly undervalued, and one of the only sectors that can rally sharply when general stock markets sell off. If you want to multiply your wealth this year by fighting the crowd to buy low then sell high, this small and forgotten contrarian sector is the place to be. Nothing else rivals it.

While investors and speculators alike can certainly play gold stocks’ coming powerful upleg with the major ETFs like GDX, the best gains by far will be won in individual gold stocks with superior fundamentals. Their upside will far exceed the ETFs, which are burdened by over-diversification and underperforming gold stocks. A carefully-handpicked portfolio of elite gold and silver miners will generate much-greater wealth creation.

The bottom line is gold stocks are basing technically and cheap fundamentally today. While this small contrarian sector has largely been forgotten, its past year’s consolidation trading range continues to hold solid. The longer the basing, the greater the potential up leg when investors return. And despite trading at levels implying vastly-lower gold prices, the major gold miners are actually earning fat profits today.

Those earnings will surge dramatically as gold continues powering higher in its own bull market. It’s only a matter of time until investors see the extreme market-leading value inherent in the gold miners’ stocks. And with stock-market volatility roaring back after long years of central-bank suppression, diversifying portfolios with gold will soon return to favor. The gold stocks will soar as investment buying drives gold higher.