With the stock market treading water on Wednesday and testing 2-month lows, the gold price spiked $20/ounces, once again reclaiming the psychologically significant level of $1,300/ounces. Thus far, the gold price has risen about 8.5 percent this year, beating both the Dow Jones Industrial Average and the S&P 500. However, while the gold price has risen this year, lately it has been flat as investors cannot decide the next direction for the yellow metal. I think this move will be higher even if the price doesn’t climb in a straight line. Here’s why.
First, one of the signs that gold is in favor is when mining stocks outperform the metal. Mining stocks offer leverage to investors. Say the gold price is $1,300/ounces and it costs a mining company $1,000/ounces to mine gold. If the price rises to $1,600, the gold price is up about 23 percent, but the company’s profit margin has doubled: it has increased from $300/ounces to $600/ounces. Thus, in this scenario, a gold stock has increased its profitability about four times faster than the gold price has risen, and that can do wonders for the gold stock in question.
Gold stocks have been acting extremely well this year. In fact, the junior gold miners — which are even more leveraged than the senior gold miners — hit a new high for the year in July, as measured by the Market Vectors Junior Gold Miner ETF (NYSEARCA:GDXJ), even though the gold price did not. This is extremely bullish, and it indicates that those investors who understand the industry the most and who are willing to take the most risk are becoming bullish. This is a good sign.
Second, geopolitical tension continues to escalate on multiple fronts: both in the Middle East and in Eastern Europe. Specifically, with regards to Russia and the Ukraine, we are seeing an escalating trade war as the U.S. and the EU imposed sanctions on Russia and Russia retaliated by restricting imports of agricultural products hitting American food companies such as Sanderson Farms (NASDAQ:SAFM). These sanctions will have a blowback effect and weaken the entire global economy, and in order to protect themselves investors will turn to gold.
Third, while the Federal Reserve is tapering its quantitative easing program, it is setting the stage for a major rally in gold. If it allows interest rates to rise, then bonds as well as dividend paying stocks will lose their relative appeal, and investors will turn to gold to protect themselves from rising interest rates and falling stock and bond prices. This is somewhat counterintuitive, and many investors have argued that rising rates is bearish for gold. But this claim is historically unfounded, and it is based on a false assumption that rising interest rates and high interest rates are the same thing. High interest rates are bad for gold, but gold will rise as interest rates move from low to high. Since interest rates are low now and set to move higher (it is a matter of “if” and not “when”), the gold market is well-positioned to rally as well.
Given these points, I think it is evident that gold has a lot of potential upside. A lot of investors find it difficult psychologically to purchase an asset that has lost so much value as of late and which isn’t commonly accepted as a sound investment by Wall Street. It is especially difficult to buy gold when stocks have been rising so much over the past few years and appear to be an easy trade. But the difficult trades are the ones that are going to make you the most money in the long run because they are the trades that most investors have yet to discover. If you are early, you may see an initial period of losses or stagnation while the stock market keeps rising, but ultimately investors will come around to gold as interest rates rise and stock market earnings can’t rise enough to support current valuations.
Disclosure: Ben Kramer-Miller owns gold coins and shares in select gold mining companies.