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Markets
Monday
Jan302017

Gold Mining Stocks Could Halve In 2017

Fed Hikes and Their Impact on Gold

When the first hike was delivered, along with the intention to deliver 3-4 more, gold prices were hovering above $1000. Gold now sits over $100 higher than it was at the time of the first hike, having rallied to $1375 when hikes were taken off the table. In our view one hike will see gold test $1000, two will see $1000 break, and three hikes would see $720 tested.

A slide in the yellow metal back to $1000 would put significant pressure on the mining stocks, which enjoyed a spectacular bounce over 2016. The HUI index was around 100 when gold was around $1000. Perhaps it was oversold at those levels, but that just proves how oversold miners can become, if they have done that before they can do it again. $1000 gold should certainly pressure the HUI index below 150, and if gold slides further below $1000 then gold miners will likely break the support at 100 on the HUI – therefore halving in value from current levels.

When the first hike was delivered, along with the intention to deliver 3-4 more, gold prices were hovering above $1000. Gold now sits over $100 higher than it was at the time of the first hike, having rallied to $1375 when hikes were taken off the table. In our view one hike will see gold test $1000, two will see $1000 break, and three hikes would see $720 tested.

The Miner’s Relationship with Gold and Equities

A slide in the yellow metal back to $1000 would put significant pressure on the mining stocks, which enjoyed a spectacular bounce over 2016. The HUI index was around 100 when gold was around $1000. Perhaps it was oversold at those levels, but that just proves how oversold miners can become, if they have done that before they can do it again. $1000 gold should certainly pressure the HUI index below 150, and if gold slides further below $1000 then gold miners will likely break the support at 100 on the HUI – therefore halving in value from current levels.

There is an argument that gold mining stocks will outperform gold this year as the stock market in general rallies. However, there are two key points to consider here. Firstly, when the stock market plummeted in January last year, gold miners enjoyed strong gains as gold prices rallied. Therefore, miners are more tied to the price of gold than the level of the S&P 500. Secondly if the Fed delivers multiple hikes this year, this will cap the stock market rally. The better the condition of the economy, the stock market and financial conditions, the more likely more hikes are. Therefore the hikes will cool the stock market rally, and could even reverse it. That would create yet more downside pressure on gold miners.

Our Trading Plan

As with any trade, the most important aspect is timing. Being too early is the same as being wrong. We are not shorting gold miners at this stage. Our plan is to wait out Q1 (just another couple of months) before beginning to layer into a core short position on the sector. As we approach the June FOMC, if multiple hikes are still looking likely, we will be aggressively short the gold mining sector into the second half of 2017. This also coincides with a seasonally weak period for mining stocks, from May through the European summer.

We would express our view and execute our short exposure via options. Even at current levels, the risk reward is attractive. For example, the low in GLD was around $100. One can speculate on gold making new lows by say $50 by the end of the year, by using options on GLD. Buying GLD December $100 puts and selling $95 puts against them costs $0.70 with a maximum upside of $5.00, a potential return of 600%. The risk-reward dynamics on gold miners appeal even more, despite a fall in liquidity for options on GDX. The low in GDX was around $12.50. On can speculate on GDX making new lows by purchasing January 2018 puts with a strike of $13, and selling $11 puts against them, for a net cost of 18 cents. This spread could be worth $2.00 if GDX was $11 or lower by this time next year, a return of over 1000%.

In summary, the gold mining stocks is extremely vulnerable to a wave of selling as a result of multiple Fed hikes this year. Whilst perhaps not a trade for right now, the risk-reward offered in long dated, far out of the money puts both on gold and gold miners is a standout. To see what trades we are making and when, please visit subscribe via either of the buttons below. We intend to pull the trigger on these types of strategies over the coming month or so. Unless one holds the view that the Fed is not going to hike in 2017, then buying downside protection on gold miners, as a standalone trade or as a hedge against existing holdings in the sector, could be the trade of the year.

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Monday
Dec122016

Buying Gold Into A Fed Hike: As Dumb As It Sounds?

The Fed will hike rates this week. The US Dollar is strengthening. Fiscal policy is about to ignite economic growth. The ECB has reduced rate of QE purchases. It doesn’t sound like now is the time to be buying gold does it? And yet, the setup is remarkably similar to this time last year, before the yellow metal put in a near 30% rally. What matters most is not what will happen, but what will happen relative to expectations. It is fair to say that the market has some lofty expectations built in at present, which is why it could be a case of buying the rumour and selling the fact over coming months.

+0.25% This Week Is 95% Done

 According to the CME’s FedWatch Tool, a 25bp hike this week from the Fed is 95% priced in, which is near enough 100%. So when the Fed hikes rates, how will the market react?

The hike has been so well signalled, and is so well priced into financial markets, that when it is confirmed it will have little impact whatsoever. So those arguing against being long gold this week as “the Fed will hike” are perhaps not fully considering the extent to which this hike is expected. What matters more is the tone surrounding the hike and the dot plot projection of future rate expectations.

The Fed has been emphasising its extremely cautious, data dependent stance for years now. Stability is one of their key concerns. They have not hiked through all of 2016, so are not about to signal a rapid series of hikes given economic data has been relatively stable. In fact, when the Fed hiked in December last year, the dot plot was lowered from the September projection. Whilst we are not expecting the Fed to lower the dots this time around, we see a very limited chance that the dots are higher. The markets on the other hand have aggressively increased their expectations for future hikes in the last month or so, meaning that no change in the plot could see them bitterly disappointed.

Greenback Rally Dependent On Hawkish Yellen

Gold prices exhibit and inverse relationship with the US dollar, particularly against the Japanese Yen. In order to the USD rally to continue it will take a hawkish Fed that signals further tightening over and above the markets current expectations. If the dot plot is unchanged, this could see the USD weaken and take gold prices higher.

The relationship between gold and USDJPY has become more apparent recently due to the widening interest rate differential between the two. The BoJ has pledged to keep its 10year bond yield near 0%, but US bond yields have risen significantly as the market bets on aggressive tightening from the Fed in response to inflationary fiscal policy next year.

Fiscal Policy Is Not A Light Switch

The market has grown increasingly confident of a sustained uptick in economic data, driven by upcoming “borrow and build” policies from the new administration. However, the market is placing little chance of anything derailing the programs and their impacts. Trump cannot simple flip a switch when he takes office.

Whilst aggressive US fiscal policy can be inflationary, the effects of such policies take time to feed through. Of course such policy still has to be proposed, agreed upon, and implemented. When the Hoover Dam project was announced during The Great Depression, thousands of unemployed Americans flocked to Nevada looking for work, shovels at the ready. They were bitterly disappointed when they learned that it would be years before any labour was required, since the dam still needed to be designed, construction planned, and materials sourced.

There is then yet another lag between the implementation of such projects and their impact being seen in economic data, then the Fed reacting to that data. Yet, the market expects a couple of Fed hikes to come next year – despite the Fed only just getting to its second hike eight years after the GFC.

It’s not about the end result. It’s about the result relative to expectations. Expectations are lofty, and markets are impatient. The market will react poorly to any delays in fiscal and monetary policy changes, but gold will respond positively to them.

Buy The Rumour, Sell The Fact

Last year the December FOMC marked the low point for gold prices. It was a classic case of where “buying the rumour and selling the fact” was the optimal trading strategy. We cannot help but feel this will be the case again. Every time the Fed hikes, the hurdle for the next hike is higher. The level of economic strength required for the first hike is minimal compared to what the Fed will need to see for the third and fourth hikes.

In our view gold is sitting on a key support zone around $1175-$1150 and from this base it is primed for a $150-$200 rally over the coming month or two. To see what trades we are placing to take advantage of this move please subscribe via either of the buttons below.

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Monday
Nov142016

Gold Prices Have Overreacted To The US Election

To say it has been a turbulent week in markets would be a dramatic understatement. The moves around the US election were nothing short of incredible. We wrote last week about fading a risk off move over the election, and whilst we expected market nerves to calm after an initial period of uncertainty, we were completely blindsided by the pace and magnitude of the reversal. Nowhere are we more surprised than in the yellow metal’s reaction to the result. Not only do we view it as an overreaction, but actually view the gold prices as significantly undervalued in the current environment.

Inflationary Fiscal Policy

The market appears to have taken the view that a Trump presidency will be inflationary. Bonds have been sold, interest rates have risen, and the market has stepped up its expectations of Fed tightening. Given a December hike as a given, then market now has over 100bp of hikes priced in over 2017-2019.

It is important not to confuse this inflationary reaction as “risk on”. Although the S&P 500 has rallied, this is again a symptom of the inflationary reaction. Emerging markets have been crushed.

We are cautious about the reaction. Whilst aggressive US fiscal policy can be inflationary, the effects of such policies take time to feed through. Of course such policy still has to be proposed, agreed upon, and implemented.

When the Hoover Dam project was announced during The Great Depression, thousands of unemployed Americans flocked to Nevada looking for work, shovels at the ready. They were bitterly disappointed when they learned that it would be years before any labour was required, since the dam still needed to be designed, construction planned, and materials sourced.

The story that inflation is coming has been repeated numerous times since the Global Financial Crisis, yet it has yet to really make an entrance. Treat rhetoric along the lines of “this time it’s different” with a large grain of salt.

Gold Drops Back To Support Zone

We saw a big drop in the yellow metal this week as it fell right back to the $1225 support zone. This was in line with the fall in bond prices and USD strength, with the move turbo charged by the realisation that a Fed hike is now just a month away and 85% priced in.

Despite the price action, we find ourselves turning increasingly bullish on gold prices. When we consider the macro economic factors at play and how they have changed over the week, we struggle to come to any other conclusion than that gold could go through a major rally over the next year.

Consider Foreign Policy, Not Just Fiscal

 We have mentioned the potential for US fiscal policy to be inflationary, but haven’t touched on foreign policy. There are two major changes to note there. Firstly the geo-political risk premium should increase given the change in government and its more aggressive stance on numerous issues in the Middle East.

Secondly the change in government is likely to result in more protectionist policies, tariffs, import duties and similar measures to protect domestic industries against foreign competition with the aim of increasing domestic growth and employment. This is undoubtedly a policy path that leads to USD weakness in our view.

FOMC Will Maintain Cautious Stance

 The Fed is going to struggle to deliver what the market now expects in terms of tightening. We are nearly seven years into the economic recovery and we are only just approaching the second hike. Yet the market expects another three hikes over the next two years.

Yellen has said that the Fed would be happy to see inflation overshoot their targets, rather than tighten prematurely. Not only will the inflationary impacts of US fiscal policy take time to be reflected in the data that the Fed has made monetary policy dependent on, but the Fed would be content to see inflation tick higher without tightening, to ensure the economy is running hot enough to take some cooling from higher rates. Of course, this all presumes that such projects do go ahead, and quickly.

Mispriced Risks Creates Opportunities

 Bringing this back to gold, given the balance of risks and the current level of gold prices, we see an asymmetric risk of a major rally. The market is counting on a Republican government to rapidly put into place aggressive fiscal spending, which will flow through to inflation and lead the Fed to aggressively hike, seeing gold prices fall $75 this week.

However we believe the market is nearly fully discounting the following risks;

 

  • Government spending is delayed or doesn’t come at all
  • Said spending does not lead to inflation due to slack in the US economy
  • The Fed lets inflation run higher without hiking aggressively
  • Protectionist policies see the USD weaken
  • Increased geo-political uncertainty in the Middle East
  • Large systemic risks from Brexit
  • US economic data turns after seven years of improvement

 

Risk-Reward Dynamics In Favour Of Gold

Therefore when we look at the risk-reward dynamics in long term options on gold they are very compelling. We will likely begin to execute some of these strategies in the coming weeks and layer into a significant medium term long position in gold.

The next $25 or $50 move in gold prices could be either way given the current volatility. However the next $250 move is far more likely to be higher than lower in our view. Therefore we intend to position accordingly and use options to tailor our trades to fit our view, whilst optimising risk-reward dynamics.

Since our inception in mid-2009, SK Options Trading we were bullish on long and aggressively so until the end of 2012. We turned aggressively bearish the yellow metal at the start of 2013 until the start of this year, when we went more neutral. It’s now time for us to put the bull horns back on.

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Monday
Nov072016

The US Presidential Election Is Not A Brexit Moment

There have been a number of comparisons drawn from the event risk around the upcoming US presidential election and the Brexit referendum earlier this year. There are a number of similarities, most notably in the market reaction to changing poll numbers prior to the vote, but also a significant number of crucial differences which make trading strategies around the US election different from those around Brexit. 

 

Trump Victory Triggers Risk Off 

The reactions of financial markets to polls that suggest an increased probability of a Trump victory have seen traditional “Risk Off” moves; sell stocks, buy bonds, higher implied volatility, buy gold. We are not going to discuss if these moves are reasonable, the pattern has been consistent and therefore it is reasonable to presume that in the short term this is highly likely to be the reaction we will see on Election Day as the results trickle in. 

This is similar to the reaction caused by increased probabilities of a “Leave” vote into Brexit, with risk assets also under pressure. As the votes came in with a significant bias towards “Leave”, risk assets were heavily sold, and this increased as the result became clearer. To put the move into context, interest rate futures began to price in a chance of a cut from the FOMC, when just days before there were calls for a hike at the next meeting. 

Black Swan Event

We have been asked a number of times, “How can we prepare and protect against a Black Swan event like a Trump victory?” It is not a Black Swan event. A Black Swan cannot be predicted. The very fact that one is discussing how to deal with a Trump victory means it is not a Black Swan. 

It is not even a “tail risk”. A tail risk is the risk of a very unlikely event according to a probability distribution. For example, the stock market moving 10% in a single trading session, since most observations have movements lower than 10%.

 

 

However, we are discussing an election with two parties in a race that’s perhaps 65-35. That is hardly a tail risk. The chance of some outlandish extreme policies from the candidates once they take office is perhaps a tail event, but this is at a minimum many months away. So this is not a tail event, and certainly not a Black Swan. Rather it is merely a period of volatility in markets that needs to be treated with the appropriate level of respect, but not undue scaremongering with respect to the consequences.

Reduced Consequences

A major difference in the dynamics of Brexit compared with the election is the potential consequences. This week we could see a change of government in the USA. Brexit was a complete change in how the UK would be governed for years to come. It signalled the exit of a major country from one of the largest political and economic unions ever seen. Most importantly, the process after the vote around how this would occur was (and perhaps still is) largely unknown. More than anything markets fear uncertainty.

Whilst there may be uncertainty around what the future may hold for the US if either Clinton or Trump wins, this uncertainty pales in comparison to the questions being asked in the Brexit aftermath. This arguably reduces the potential downside scenario and at the margin leaves us more inclined to “buy risk” on the dip.

Tougher Numbers

Whilst the “Leave” campaign only required >50% of the vote to trigger Brexit, the hurdle is much larger in the US. Even if Trump takes the “must win” states such as Florida and North Carolina, mathematically the Republicans still need to turn a Democrat state red in order to realistically be in with a chance of victory. Some polls have put the candidates very close to 50-50, but there is so much more at work than simply the popular vote.

Most predictions have something like a 35% chance of a Trump victory. This may appear low but is close enough to have the market jittery. The average margin of error is enough to make the result to close for comfort, as seen in the price action in equities this last week.

How To Trade On The Day

In our view the market will get increasingly concerned if Trump wins Florida and North Carolina. At the margin he is expected to win these states, but a Clinton victory in either effectively sinks his chances completely. Therefore the market will likely become concerned as the election is kept live. 

If there is a traditional risk off move on these results then we would fade it. A combination of the following would be our vehicles; Selling gold above $1350, buying the S&P 500 below 2050, or short selling VIX above 25 (VIX December futures above 22). 

 The right trade post Brexit was to fade the move, therefore even if a Trump victory does follow, the move is likely to reverse as markets realise the consequences are not as dire as they initially feared.

Conclusion

With respect to the prior bias of skews around the election, as well as other factors, we have been running small short positions on the S&P 500 and long positions in gold. These have performed well, however the next opportunity is to fade any risk off move this week, particularly intraday as the results come in. We are looking at entering short equity volatility trades prior to the election should volatility spike. The trade has merits on a standalone basis as well as complementing our current positions. For more information on the trades we are making please susbcribe via either of the buttons below. It is important to remember that despite the wave of media coverage and sensationalism, there are more factors at play for markets than this election. The FOMC and ECB meetings next month will likely be far more critical for markets than this week’s events, which as we hope to have demonstrated above, are not in the same ball park as Brexit or even tail risks, and certainly not Black Swans.

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Thursday
Feb182016

What is the Best Trade on the Gold Mining Sector?

Gold prices soared last week when market pricing went to extremes, with bond prices indicating that there was next to no chance of a rate hike in the next twelve months. We have covered the cause of this irregular pricing, which was the stopping out of 2016 consensus macro trades, in a previous article, so we will not repeat ourselves here. For the purpose of this analysis it suffices to say that gold prices were heavily overbought when they challenged $1250 and that the currently high levels are unsustainable.

As gold spiked to one year highs the precious metals mining sector followed suit and tore ahead. The HUI increased more than 60% in value from its January lows to triple the performance of gold. With this strength many have been calling to load up on precious metals miners while they are "cheap".

However, we are not so hasty to jump on the band wagon due to the historic underperformance of the gold mining sector and the underlying fundamentals for gold, which remain bearish over the long term. Therefore in this article we analyse the risk reward dynamics involved with the precious metals mining sector.

The mining sector faces increasing costs

The significant decline in oil prices have led some to believe that the costs of production for mining companies will also fall. While energy costs are likely to be lower, these are far from the only cost facing mining companies. One of the most significant and threatening to the mining industry is the increase in debt costs.

In 2013 Hecla Mining raised capital to fund the takeover of Aurizon Mines, selling bonds with a coupon rate of 6.875%. In 2015 the yield on these bonds had risen to around 9%. Today these bonds offer a yield of over 17%. Hecla Mining is not the only company facing extremely high borrowing costs, Coeur d'Alene is another miner whose debt offers close to a 20% yield. While the bonds for much larger miners, such as Barrick, offer lower yields, the fact remains that borrowing costs are high and increasing for the mining industry.

Of course, these companies may not need to borrow and the high yield on their current debt may not be an issue as the pay the lower coupon rate. However, any miner looks to borrow in the next five years will almost certainly be subjected to higher costs. This means that miners will struggle to expand into new projects, as the increased cost of borrowing will makes these financially inviable. This means that any undeveloped assets in the ground are unlikely to be greenlit, and therefore any expected increase in earnings from those projects are unlikely to eventuate.

Perhaps more importantly is the cost of rolling over debt. If Hecla Mining needs to roll over their current debts, then they would have to do so at almost three times their current borrowing rate. This means if Hecla Mining wishes to refinance any of their debt in the next five years, it will almost certainly be at a higher rate. This means that they are locked in to their current rate, as are many of the mining companies.

Borrowing is just one of the many costs that face the mining industry. One can make the argument that these are unlikely to flow over to some of the larger miners, but this holds little water. Newmont Mining, one of the largest and best performing mining stocks in 2015, had an all-in sustaining cost (AISC) of $999 per gold ounce in Q4 2015, compared to $927 the previous quarter. The numbers do not lie. Oil and commodity prices may be in a rout, but the miners costs are still going up.

Take a look at the earnings

In terms of earnings per share, last year Newmont Mining Corp was one of the best performers in the gold mining sector. In fact, of the top 10 largest holdings in the GDX fund, Newmont was the best performer with earnings per share of 3.83% its current stock price. By taking a closer look at the figures, we can paint a rough picture of how the company will be likely to perform going forward.

The first figure that stands out here is that of their 2015 gold reserves, which were calculated at a gold price of $1,200. However, the average realised gold price was $1084, which means that the estimation for the value of reserves is based on figure more than 10% over the price achieved. Of course, the price of gold fluctuates and the metal has been off to a roaring start in 2016, so it is not impossible that the average realised gold price could be $1200 in the first quarter this year.

However, it is highly unlikely that such a level can be sustained in 2016, and over the next five years it would be close to impossible to secure an average realised gold price of $1200. Gold has only closed above $1200 four times this year and is likely to continue falling back as market pricing returns to more normal levels. This means that going forward the value of reserves is likely to fall, which means that earnings over the long term will be lesser.

There is also the matter of production costs to consider here as well. As mentioned above, Newmont had an AISC of $999 per gold ounce last quarter, which means they made a profit of $85 per ounce. A crude deduction from this means that if the average gold price, not the spot, for this quarter drops $86, then Newmont will be lose money.

Admittedly, the currently high gold price means that this is unlikely to happen this quarter, perhaps not even this year. However, it is likely that over the second half of 2016 and beyond we will see the Fed hiking rates and this will almost certainly drive gold into the triple figures, which means that unless costs somehow fall Newmont Mining could be facing losses.

Now, recall that Newmont Mining was the best EPS performer in 2015 out of the top 10 GDX holdings. If a titan of the gold mining industry, that faces much lower borrowing costs than many, will be near certain to lose money if gold falls into the triple figures, then how vulnerable is the rest of the sector?

With long term gold prices likely to be lower than expected and costs rising across the industry, we believe that the gold miners are heavily overbought at current levels. Further to this, it is likely that they were in fact overvalued before gold prices rallied. This means that once the short term spike in gold passes, the gold miners are likely to fall to new lows.

Trading arguments against holding gold stocks

The recent spike in gold and its miners, along with the calls from the bulls to back up the truck on "cheap" gold stocks, may tempt some into getting long the mining sector. We are not so easily convinced. These companies face increasing costs against falling revenue and downward revisions in the value of their assets. This means that the trade is not buying gold miners.

Even if one were bullish on gold, the trade would not be to buy gold mining companies. There exist a number of varied ETFs that offer direct long positions on gold that can be easily traded. GLD is single long gold, DGP is double long, and UGLD is triple long. This means that if one wanted a position that outperformed a gold long by triple, as miners did in the recent spike, then one could easily get that by buying UGLD. This trade would achieve the desired returns if the bullish view is correct without any of the risks involved with gold mining companies.

Suppose that one insisted on having long exposure to the gold mining sector. Buying gold stocks would still not be the best way to go in terms or risk reward dynamics. Consider Hecla Mining, whose debt yields over 17% a year. For a long position on the company's shares to outperform their bonds over a 5 year period, HL would have to more than double in value. Even in one of the best 5 year periods for gold, 2007 - 2011, gold mining stocks did little more than double. How can one reasonably expect them to perform better than this in an environment where gold is a third lower and more likely to fall than rally?

This is not to mention that in the case that one's bullish view on gold stocks is wrong and the company starts to lose money. In this situation, the debt has first call on the company's assets. This means that your downside risks are much higher when holding the stock versus holding that same company's debt. Given that long debt exposure offers a considerably higher expected return and much lower potential losses, holding gold stocks has poor risk reward dynamics even if one insists on having long exposure.

Therefore, we recommend not holding any long exposure to shares of gold mining companies. It is our view that there is no reasonable situation in which long trades on these companies can offer positive risk reward dynamics. Long trades are simply not compensated well enough for the risks being taken.

What is the trade?

If not long, is the trade to get short? We believe the answer is yes, and that one can do so in an exceptionally attractive way. Double or triple short ETFs, such as DUST, are not our favoured vehicle here. The way these inverse vehicles move does not make them suitable for longer term investment in our view.

We also do not believe the right trade is to short the miners, or a long gold miners ETF such as GDX, outright. This type of trade involves unlimited potential risks, and although we believe the probability of these risks being realised is low, we would not be achieving our top goal of prudent risk management if we took on such a position.

It is our view that the best risk reward dynamics for any trade on the gold mining sector come via options. The versatility of options allow one to take a low and limited risk position with significant upside potential. We have used options to tailor positions to exactly fit our views on gold mining stocks and have issued these trades to our subscribers. If you wish to find out the exact details of these trades, please subscribe via either of the buttons below.

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