gaineswood market transformation (may 2012)
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CreditMarketTransitions:AnHistoricalTemplate(May2012)
Contents
Overview ............................................................................................................................. 1
The Great Transition to Lower Corporate Profitability ..................................................... 4
Gold & Gold Mining Equities: The Precursor Stage ....................................................... 12
The Adjustment Period: Rejecting the Null Hypothesis .................................................... 19
The Aftermath: Returning to a New Normal.................................................................... 35Conclusion ........................................................................................................................ 37
Disclaimer......................................................................................................................... 37
Overview
There is an old saying among economists: the cure for high prices is high prices. What they
mean is that if the price of something used in the economy is too high, then this elicits acorrective response. Either people will rush to compete and supply more of it, or buyers will
substitute other things for it, reducing demand. This maxim is also a forecasting tool. What it
tells us now is that corporate profit margins are probably peaking. This would at best place a
ceiling on stock prices for many years ahead, or cause a decline.
Gaineswoods model of long-term trends in corporate profit margins would be in equilibrium if
S&P 500 inflation-adjusted per share earnings drifted from the present Wall Street consensus
forecast of over $100 to less than $75 over the next decade. If inflation continued at its present
rate, the nominal outcome would be flat earnings. Note that in the 1980s, which were relatively
good economic conditions, real earnings for the S&P 500 fell 30% from the 1979 peak by 1987,
and increased rapidly after the stock market crashed that year.
Corporate profits are now more than two standard deviations above a multi-decade mean,
specifically higher than about 99% of other observations. Because of the extreme divergence,
our degree of confidence in forecasting a drop in margins is high. We reviewed nearly a century
of data, and found two earlier periods when this was also the case: the 1930s and the 1970s.
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In revisiting this data, we found there was one thing that was common to these two eras and
the present time, which did not occur in other times. These periods began with low gold prices,
and concluded with a gold price that went shockingly higher. In both past instances, the price of
either bullion or companies that produce it corrected some after these eras were over, since
they overshot. But even after this, the dollar and other currencies were permanently devalued
or you could say gold was revalued by a lot.
Gold is therefore the one exception to the cure for high prices adage. Why? Because the
cumulative supply of gold mined since the beginning of mankind is rather constant. Currencies
and credit expand often rapidly thus stretching their number of units relative to ounces of
gold, setting the stage for periods when gold catches up. One corrective response to this
situation can be reduced supply of credit and currency (deflation, austerity, and default), which
reduces the volume of these tokens of value to their old ratio relative to gold bullion. Another is
a rise in the gold price that pushes the aggregate value of the yellow metal to its former level
relative to currency and credit. Its just like the cure for high prices example, but due to golds
inability to be synthetically manufactured, its price is the thing that adjusts, not its volume.
We note that gold can be fabricated in the futures market, and these paper ounces couldchannel demand into derivative liabilities. This creates the potential for a short squeeze later in
the cycle. The Hunt brothers established a derivative asset this way in the 1980s by being long
silver futures. They attempted to squeeze the physical market by demanding physical delivery,
but were foiled by regulators in 1980. Regulators have been investigating a large short position
in silver futures by J.P. Morgan for several years, but to date no action has been taken. The
bank claims this is a hedge, but it may simply be a derivative liability. Excitement over the
potential for a squeeze was probably the main cause for the silver price to spike to $50/ounce in
April 2011.
Some believe in conspiracy theories that the Fed or the BIS are acting behind the scenes to
suppress the price of gold during the entirety of the present adjustment cycle. Suppose weconcede they may have a point. Then the significance of our research would be that it
establishes a linkage between corporate profits and gold. Maybe a small and arcane gold
market can be suppressed, but a financial ecosystem containing reflexive relationships would
overwhelm interventionists, just as the London Gold Pool failed spectacularly. To this list one
might add the gold standard itself, for governments could no longer suppress the price in the
early 1930s or the early 1970s, no matter how proficient they were at printing money.
For those interested in long-term ratio analysis of gold relative to the money supply and Fed
balance sheet accounts, see The Case Against the Fed(Rothbard, Mises Institute 1994) and
updated calculations in Endless Money(Baker, Wiley 2009), or many internet sources. These
typically place the value of bullion at over $10,000/ounce assuming gold were to only to provide
20% backing of credit dollars.
Apparent in reviewing the data is that gold mining equities are sensitive indicators in their own
right, because they incorporate not only the gold price in their valuation, but also the cost of
economically sensitive materials and other inputs.1 They can provide intelligence on where we
1For nearly all of our charts we have used the Barrons Gold Mining Index, which was started in 1938, initially with
two companies in the composite: Alaska Juneau Mining and Homestake. We credit Mark Lundeen for providing data
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might be in these peculiar cycles marked by abnormal readings in corporate profitability or the
price of gold, or both. For this reason, gold mining equities can enter prolonged periods when
they are not well correlated with the stock market, or are even negatively correlated. But they
can just as easily enter into years when their correlation is high. These phase changes are good
markers as well as the actual movement in gold mining equities or of bullion.
If we are correct about our thesis that the 1930s and the 1970s provide a template for the
present, then we believe that gold and gold miners would soon begin to appreciate again,
ending a severe correction that began over a year ago. However, if this decline matched the
most severe downturns of these previous eras, potentially another 45% to 50% of downside risk
remains. (Note they are down over 40% through mid-May, and the greatest stumble of the
template eras was 69%). Once the upturn commences, we think the miners will outperform
bullion handily. The upside is unknowable, but in the 1970s the total move for gold and its
miners was about 20x (depending how you measure it). Based upon what we think we know of
monetary and credit conditions in the present era, we would rate it a coin toss as to whether
the present era logs less or more of a gain than the 1970s.
that incorporates price research of these two stocks going back to 1920, thus permitting us to make a full cycle
analysis of the 1930s economic adjustment period and its precursor time. Generally charts in this essay index the
Dow Industrials and the mining stocks at a common starting value of 1 in 1920. Recall that funding of World War I
had caused inflation to be strongly in the double digits each year from 1917 through 1920, so there is a little
distortion from using 1920 as a jumping off point. Hyperinflation would surge in Europe, especially in the Weimar
from 1921-1923, but in the U.S. deflation started in 1921. This long indexation permits the reader to glean insights
into the valuation of gold miners during normal economic times in between the crisis periods of the 1930s, 1970s,
and the present. For example, inflation expectations remained high in the 1980s, and the Barrons Gold Mining Index
vacillated between 50x and 100x its 1920 value, whereas the Dow ascended from 9x to 24x during the 1980s. This
difference has been completely worked off at the present time, but because of unknowable issues surrounding the
choice of 1920 as a starting point for indexation, no one can precisely say whether equivalence having been reached
proves the miners are fairly priced presently. We would rather use DCF analyses of cash flows as a reference for that,
which indicates there are substantial discounts to be realized through buying productive, profitable mines, even
assuming lower gold prices than in the spot market today.
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TheGreatTransitiontoLowerCorporateProfitability
Many Wall Street analysts and strategists maintain that stocks are attractive now based upon
valuation. Valuation in turn is a function of underlying corporate profit. Most observers think
profits will grow in line with recent upward trends. We find that corporate profit margins are in
the upper 99% of historical observations of our present era. Moreover, going back to 1920 wehave identified other times when this was the case and noted the outcome for stocks and also
for gold mining and bullion. The common deduction is that the foundation for the stock
markets current heights could erode surprisingly and persistently. In this section, we show
three periods where corporate profit margins had expanded to levels similar to the 99% reading
today, and what the outcome was.
The theory that the price of a commodity would rise and fall to induce the right amount of
production also applies to corporate profits. When companies are extraordinarily profitable,
there is a powerful incentive for competitors to seek a bigger piece of the profit pie. They may
do it by hiring away key talent, which might bid up the cost of labor. New products could be
devised that would tempt customers to change brand loyalty, often prompting a marketing war
that would erode profitability. Competitors could deploy new business models that would
disrupt mature businesses. Or, they could do it the old fashioned way by expanding capacity
or cutting prices.
Managements dont always slit their own throats. When money and credit is flowing, demand
for their products or services can outstrip supply, fostering wider margins. Somehow corporate
profit margins expand to high points, a process that can take years. But then it similarly takes
years to unwind, and we dub these usually decade-long periods transition eras.
It is not easy to assemble historic data that extends back into the interwar era of nearly a
century ago. What we have done is to use profit data from the S&P 500 as far back as the
1920s, and compare that to gross domestic product as a proxy for sales. Therefore dontconclude the ratio calculated is exactly the same as corporate profit margins, but it should be
somewhat proportionate. (In some of our charts we have utilized Federal Reserve corporate
profit data).
Period #1: The 1930s
The first period when high corporate profitability was corrected back to a mean value was the
Great Depression. In the graph below, one can see that at the start in 1929 profits were more
than two standard deviations above the average of the following two decades. Interestingly,
profitability actually fell as the United States came out of the Depression, because of wartime
rationing and price controls.
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Source: Bloomberg/S&P and St. Louis Fed, Gaineswood
Another fascinating aspect of the period is that before the Fed committed the Mistake of 1937
by raising reserve requirements, corporate profit margins had returned within hailing distance
of the late 1920s. But unemployment remained irritatingly high, and the stock market could not
regain all its froth. Unlike earlier decades or the postwar years, Roosevelt jawboned and strictly
regulated pricing, especially for labor. For instance, Jack Magid, a New Jersey tailor, was jailed
for pressing a suit for 35 cents when the NRA had fixed the price at 40 cents. Price controls
would not be seen again until the next anomalous era in our study, the 1970s.
Period #2: The 1970s
Below we present the next similar transition period, the 1970s, which also saw a permanent
resetting of the gold price through the breaking apart of Bretton Woods, and a parallel erosion
of corporate profit margins as measured through the same set of statistics:
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Ratio:S&PProfitto
GDP
Profit Margin ProxyPrewar Era
Profit Margin Indicator +/- 2 Std Deviations
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Source: Bloomberg/S&P and St. Louis Fed, Gaineswood
Nixon placed wage and price controls on American businessmen to fight off the effects of too
many dollars and too much credit having been extended relative to the worlds gold supply
during the baby boom era after World War II. Ultimately that fight would be futile. After an
initial shock associated with the oil embargo of 1973, there was a tepid economic recovery.
Similar to the 1930s, this would be cut short by an aftershock, which happened in 1979
coincident with the Iranian hostage crisis.
Before the 1970s, economists were confident most economic questions had been settled. But
soon Keynesians had to share the limelight with Milton Friedmans monetarists. Even then they
could not easily resolve the breakdown of the inflation and unemployment tradeoff (PhillipsCurve). The infamous misery index was conceived just as the well-meaning President Carter
gave up and declared malaise was a permanent condition.
The decade of the 1970s was not good for stocks, despite inflation of nominal earnings, because
cost-push inflation and supply constraints eroded margins. We entered the era with profitability
at over two standard deviations above the norm, and exited in the opposite condition, over two
standard deviations below it. The stock market had the nifty fifty in the late 1960s and early
1970s: companies like Xerox, Polaroid, Avon, or IBM. These were juggernauts with new
paradigms impervious to competition. But they would crumble as Japanese imports, Wal-Mart,
and mid-sized computers and minicomputers stole their markets away.
Period #3: The Present Era (2008-Onwards)
The present era has its own competitive steamrollers, Apple being the epitome. But there are
Facebook, Google, Visa, Disney, Nike, Goldman Sachs, and others. Companies today make use
of inexpensive Chinese labor, Indian software engineers, or Taiwanese semiconductors but
maintain command of their American and Eurozone distribution systems. They arbitrage third
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Ratio:S&PProfitto
GDP
Profit Margin ProxyVietnam-Malaise Era
Profit Margin Indicator +/- 2 Std Deviations
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world costs against their ability to set pricing at developed world levels. Never have these cheap
imports been available in such quantity relative to total economic output, and the spread
between costs and revenues may have achieved a generational maximum of wideness.
Source: Schiller, Yale University
S&P earnings have been on a tear. The late 1990s experienced rapid earnings growth, similar to
the 1960s, but on steroids. The 2008 meltdown creates an air pocket that was quickly filled, for
the 10-year calculation plotted in the above chart compares earnings of the current year to the
same time 10-years ago, and 2009 saw earnings collapse.
Now in 2012 it doesnt matter much what your forecast is, for if you think the S&P earnings will
flatten out at $105 a share or rise to $120 per share, the 10-year growth rate only varies fromalmost 11% up to a bit over 12%. Both are hugely positive, being unmatched by an order of
magnitude compared to over fifty years of data on the chart. Similarly, you might argue that 10
years ago marked a recession, so the denominator might be artificially depressed for 2012.
However, if we normalize the denominator then the 10-year earnings growth would soften to
just below 9%, which is still an outlier.
Perhaps globalization of input costs has caused the surge, but Fed policy may have spiked the
punchbowl, to borrow a phrase from former Chairman William McChesney Martin. Make no
mistake: the Greenspan and Bernanke eras have been inflationary for corporate profits as well
as the prices of stocks and bonds, and 2009 was a very brief hiatus.
Equity risk premium models are popular for determining if stocks are attractive relative to other
investments. We believe they have a flaw which becomes relevant only when corporate profit
margins are high as they are today. Essentially they are two-dimensional. They take a snapshot
of the valuation of assets today and make a conclusion, without reflecting any statistical wisdom
of what inputs are going into the model. In Gaineswoods investment process of looking at
individual companies, we think of this phenomenon as bad GARP.
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10YrAnnualizedChange(%)
S&P 500 Real 10-Yr EPS Growth
10-Year Real EPS Growth
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Think about it. What is GARP (growth at a reasonable price)? There are two components. One
is growth. Most portfolio managers tell you a stock has earnings growth by observing earnings
over the last five years or so. It must be proven by this rear-view mirror test. How is a
reasonable price defined? Usually by looking at a price-earnings ratio, which typically uses next
years earnings as its input. Heres the weakness. If a company has proven its earnings should
grow and analysts have not learned there is something on the horizon to derail this, then it
almost never would see its price-earnings multiple compress. So if such a stock gets cheap or
reasonably priced, it means some of its shareholders have put selling pressure on the stock,
but expectations for the majority of holders (and especially the analyst community) have yet to
be reset lower. So you might think you are paying a reasonable price of, say, 13x earnings, but
once earnings weaken, you will find out you paid maybe 20x earnings.
For the market as a whole, we think of this as the Lake Wobegon effect. At the mythical
community of Lake Wobegon, all the children were above average. There are so many good
companies in the S&P 500 that its aggregate profitability cannot be attributable to Apple or
Nike. Nope. They are all pretty much well managed, have extraordinary growth, and have the
financial flexibility to think about raising dividends or buying back stock, at least looking at the
data for the index as a whole.
Equity risk premium models generally utilize inputs that reflect analyst expectations, and weve
just shown you that with profitability so high now, weve lost the sensitivity of measuring GARP
properly. Presently the S&P 500 looks inexpensive or reasonably priced, and earnings
projections are consistent with rear-view mirror extrapolations, which are as robust as ever over
50 years. So there must have been sellers who have put pressure on the market without
factoring in what analysts think is reasonable today. If statistics revert to mean values, we may
have paid up dearly for future earnings that wont materialize or would be lackluster at best.
Source: St. Louis Fed, Gaineswood
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Jan-53 Jan-63 Jan-73 Jan-83 Jan-93 Jan-03 Jan-13
Ratio:CorpProfittoGNP
Profit Margin ProxyBaby Boom to Present
+/- 2 Std Deviations
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Not to state the obvious, but the graph above of present times differs from the two for the
previous transition eras, because the present era has just begun. So the surge of profitability
that christens what we have observed is the start of another anomalous era appears at the end
and not the beginning of the charts time frame. Also notable is the greater sweep of time
chosen to depict the present era. Without doing so, in isolation the past five years would look
normal, like we had always been in a new era of permanently higher profitability.
Such a conclusion was once drawn in 1929 by famous stock market commentators such as
economist Irving Fisher who, upon observing reasonable price-earnings multiples at the time,
said, Stock prices have reached what looks like a permanently high plateau. The S&P 500
index closed at a value of 26 at the end of June 1929, and then-current earnings were about
$1.50 per hypothetical index share. Enthusiasm was reinforced by rapidly growing innovators
like RCA that exhibited market leadership. Forty years later at the start of the next decade of
adjustment, analysts would write glowing recommendations to buy one-decision stocks in the
Nifty-Fifty when valuations as well as earnings were stretched. T. Rowe Price would start its
New Era fund in 1969. In todays Wobegon market, all companies are nifty, and companies
like Apple and Facebook are the niftiest.
Phenomenal profitability would have arisen for cyclical reasons, but it may have been preserved
for longer than usual by super-accommodative monetary policy. In the graph below, through a
regression we fitted the expected value of corporate profit that corresponds to a level of GDP.
Prior to the Greenspan-Bernanke heavy hand in setting interest rates and printing money,
expansion of the economy from year-to-year would produce a moderate increase in profit,
depicted below the red trend line. The function steps up as soon as the new Fed policies are
enacted to save the economy.
4Q 2001
Q4 2008
Q4 2011
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CorporateProfit(1947=1)
GDP (1947=1)
Regression: Corporate Profit & GDP
Postwar Period (1947-2011)
Corporate Profit Predicted Corporate Profit
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Source: St. Louis Fed, Gaineswood
This brings us to yet another similarity of the present era with the 1930s and the 1970s. In our
time, perhaps the most important driver of the capital investment, savings, the budget deficit,
and retirement income the interest rate is regulated by price controls. The maintenance of
interest rates at zero percent may be a many times greater distortion than Nixons wage and
price controls, which were easily circumvented by changing job titles, developing new and
improved consumer products, or substituting new oil for old oil. Imagine if something asimportant as interest rates say gasoline was decreed to be free until 2014 at the earliest.
Poor Mr. Jack Magids distortion of the price of steaming a suit by a nickel seems picayune.
Note that in the mid-1930s, it was possible to temporarily maintain high profitability in the
midst of an economic disaster, so the unusual profit margins recorded thanks to the stimulus of
Bernanke and Greenspan may not be as incongruous with bad times as we think ought to be the
case. Imagine if a newly appointed Fed chairman spurns quantitative easing, as rightly must
occur someday. Would not another Mistake of 1937 be in the making?
To put the price control on interest rates into perspective, the chart below depicts how the 10-
year U.S. Treasury bond yield is approaching its 60-year lower boundary of 95% of observations:
Source: St. Louis Fed, Gaineswood
The precursor stage of eras of financial adjustment starts with corporate profits being about two
standard deviations above a very long term average. Our observation of the 1930s and 1970s
revealed that corporate profit margins weaken, and usually overshoot to be two standard
deviations below the mean.
In this essay, we will break down the progress of stocks, gold, and gold miners as we move
through three distinct stages within long periods of financial adjustment, making the case that
the present is following in the footsteps of these two earlier periods. The next section describes
what we call the precursor stage of these eras, a period of years when gold miners awaken from
a multi-decade slumber to warn us of the events that transpire once the adjustment begins to
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In
terestRate(%)
10-Year Bond Yield
+/- 2 Standard Deviations
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take place. Later we will cover the other two stages, the adjustment period, which can last a
decade or longer, and the aftermath.
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Gold&GoldMiningEquities:ThePrecursorStage
The last section established a fundamental basis for a long corporate earnings cycle. In the past,
part of the cure for high prices in this case high profitability was the action of the capital
markets to stop allocating capital to businesses for expansion. This launched two infamous
periods when stock prices performed poorly for an extended time, the 1930s and the 1970s.The present adjustment era may drag on longer than these did, because intervention has put
economic transition on hold. No one ever wants to believe that there could be too much capital
available, so there are few who advocate for less. The present era is unique since for the first
time authorities have possessed powerful tools to accommodate the equity and debt markets
with bulk production of money out of thin air.
Truly horrendous episodes of printing paper tokens exchangeable for gold or silver recurred in
bursts during the two centuries leading up to the establishment of the Federal Reserve System
in 1913. These were difficult moments, so bankers worked to establish a central bank that
would emulate those of Europe. Compared to clearing house operations used to stem bank
runs that occurred after too much credit had been extended, the new Fed had more expansive
power.
Modern finance traces its origin to the establishment of the Fed, and its foundation is the logic
of having an elastic supply of funding in order to permit business expansion and avoid crises.
But since 1913 the character of capital profoundly changed, and the crises became prolonged
affairs such as the eras we have identified in our analysis of corporate profit cycles. We have
witnessed a steady expansion of capital, and with it devaluation of the dollars purchasing
power by about 98%.
As a repository of value that expands only very gradually, gold ounces historically thought of as
base money cant be more or less, just the same. Gold may have been outlawed or fixed by
government in price, but this could not alter its attributes ideal for use as money (durability,portability, divisibility, rarity, anonymity, recognizability, inability to be counterfeited, and most
importantly its innate appeal as an element). Therefore, whether or not you side with Warren
Buffett in thinking gold is a barbarous relic, the hard cold fact is that it remains a barometer of
financial cycles, and it generally increases in value in fits and staggers proportionate to the
supply of money. Somebody holds it. Perhaps 75% to 80% is in private hands, and the central
banks and treasuries that own the rest are buying gold in size for the first time in many decades.
China may be establishing gold reserves, a daunting task since its currency has been fiat based
since it dropped the silver standard in 1935. During the Second Sino-Japanese War (1937-1945),
the Empire of Japan plundered gold and other wealth from China, Korea, and other Asian
neighbors, so there is a void to be filled. A fascinating account of this pillaging is documented by
Sterling and Peggy Seagrave in Gold Warriors: Americas Secret Recovery of Yamashitas Gold(Bowstring 2005).
Changeover in the investment climate from normal expansion to eras of extreme adjustment
such as the 1930s or 1970s was completely unanticipated by investors. Probably because of
this, our study of gold bullion and gold equities shows that perhaps one of the easiest tradable
pattern recognition opportunities for investors is the period of time prior to one of these eras,
which we call the precursor stage.
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What happened in these adjustment eras, in short, is that after decades of dormancy, shares of
miners started to rise for several years. Their advance was inexplicable because the price of
gold was fixed (1920s and 1960s) or trading in a sideways pattern in a market where it is allowed
to float (late 1990s). The movement of the miners offered a signal that the price of gold was
also about to rise and usher in an adjustment era when the supply of capital to the economy
(business, government, or both) gets constrained. In the 1930s and 1970s, this lead to lower
profit margins for companies and a persistently unhealthy stock market. Lets take a look at
each of the three precursors to a gold revaluation, starting with the 1920s.
Period #1: Precursor to the 1930s
Source: Barrons, Mark Lundeen, Gaineswood
Above we see how gold miners (really Homestake and Alaska Juneau) cycled from being
somewhat correlated with stocks to having negative correlation during the period prior to the
severe devaluation of the U.S. dollar in 1934.
The interplay with corporate earnings and long-term interest rates is evident in the graph below.
Notice how once corporate earnings weakened, gold mining stocks got a boost.
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StockIndicies(1920=1)
Gold Miners & Dow IndustrialsPre-1934 Devaluation
Gold Miners Dow Jones Industrials Correlation
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Source: Schiller, Yale University
Basically, as in the 1950s/1960s and the 1980s, gold stocks were in hibernation during the bull
market of the 1920s. Recall that during the 1920s the price of gold was mandated by
government to be $20.67 per ounce. As a miner, all you could do to grow earnings was manage
your costs or increase volumes, something that was quite difficult to do in the 1920s under price
controls for your product. The rise in the miners must have been difficult if not impossible to
explain with fundamental data. But they began to appreciate beginning in 1927, a process that
picked up steam by 1932, two years before Roosevelt devalued the dollar. Gold mining stocks
were invulnerable to the 1929 onslaught, and continued to appreciate despite the severe equity
bear market of the early depression years.
Period #2: Precursor to the 1970s
The next period in our study that anticipates the topping of corporate profitability and the
revaluation of gold is depicted below. The graph covers the 1950s through the first break in the
fixing of the gold price in dollars. This occurred in March 1968 when the London Gold Pool, a
secret endeavor of the U.S. and its major trading partners, collapsed because it could no longer
suppress the gold price at $35/ounce.
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3.0
4.0
5.0
6.0
0.00
1.00
2.00
3.004.00
5.00
InterestRate(%
)
S&PEarnings/Gold1920=1
S&P Earnings & Gold MiningPre-1934 Devaluation
Earnings Gold Miners LT Interest Rates
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Source: Barrons, Mark Lundeen, Gaineswood
The 1940s (not shown) and the 1950s were uneventful, and gold stocks failed to work off much
of their overvaluation left from the 1930s. The stock market entered the Go-Go years in the
mid-1960s, ultimately reaching an important secular top in February 1966, followed by a
double top in 1969, and finally a triple top in 1972. (Note these moments are hard to
discern on the graph because the action in the gold mining shares overwhelms that of the Dow
Industrials, a phenomenon that would continue into the 1970s).
When the secular top for the Dow (especially as measured on an inflation-adjusted basis) was
achieved in 1966, gold miners awakened from a period of hibernation, just as they had in the
late 1920s. Probably most thought this sectors own private bubble party was to end
convincingly by 1969 on cue with the second peak in the Dow Industrials, when gold bullionreestablished its $35/ounce value. Certainly the nearly 60% plunge in the Barrons Gold Mining
Index (BGMI) from March 1969 to January 1970 seemed to confirm this. However, the setback
would set the stage for the real fireworks, a roughly 14-fold advance in the following decade.
The year 1971 was quite eventful. Like today, central banks were swapping out dollars for gold
in their central bank reserves. The demands on the U.S. Treasury became unbearable, so Nixon
cancelled gold redemptions in April 1971 and slapped wide-ranging wage and price controls on
the economy by August of the same year. The elimination of the convertibility of dollars for
gold in 1971 may be the defining economic moment of our lifetime, for which we may just be
feeling the primary ramifications. Nixons actions call to mind the eighteenth century perils of
the assignat or John Laws break with gold. With the new economic order established by him soinadequately understood, gold merely crawled into the low $40s/ounce range by December.
Meanwhile, mining stocks imploded, suffering a heartbreaking setback of 35% from April
through December, culminating the 60%, two and a half year-long clipping we just mentioned.
Making matters worse for those measured by performance relative to conventional equity
indices, the Dow steadfastly held its ground near its old high. In our opinion, the 60% decline for
the miners may have been logical to those living at that time, because no one could envision
(1.0)
(0.5)
0.0
0.5
1.0
1.5
0
5
10
15
20
25
30
Jan-50
Jan-51
Jan-52
Jan-53
Jan-54
Jan-55
Jan-56
Jan-57
Jan-58
Jan-59
Jan-60
Jan-61
Jan-62
Jan-63
Jan-64
Jan-65
Jan-66
Jan-67
Jan-68
Jan-69
Jan-70
Correlation
StockIndices(192
0=1)
Gold Miners & Dow IndustrialsBaby Boom to Gold Pool Failure (1950-1969)
Gold Miners Dow Jones Industrials Correlation
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how these companies could make much money at $35/ounce. But in hindsight many years
later, this steep correction seems completely irrational. The selloff happening in 2011-2012 may
have similar characteristics, but we think it better fits with dips that occur in the middle of the
customary 10+ year periods when corporate profit margins erode and gold revalues relative to
the dollar.
Source: Schiller, Yale University
Inflation made its debut in the 1970s in response to Nixons closing the gold window, because it
meant that loan volume could expand unchecked and the price of tangible assets would be
exuberantly bid up. Tangible assets attracted global capital flows more than equities, because
inflation-adjusted profits for the S&P 500 were listless, as seen in the chart above. The huge
rally in gold mining stocks that took place in the late 1960s coincides with the weakening of realearnings for the S&P 500 during the first three years of the chart above. In the next two years
real earnings descended sharply, and along with this was the 60% retracement spoken of earlier.
Period #3: Precursor to the Present (2008-Onwards)
We believe the present time shares a lot in common with the 1930s and the 1970s. Below we
display the data on gold mining stocks leading up to the 2008 meltdown.
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
0
10
20
30
40
50
1966
1966
1967
1968
1969
1970
1971
1971
1972
1973
1974
1975
1976
1976
1977
1978
1979
1980
1981
1981
1982
1983
1984
InterestRate
S&PEarnings
S&P Earnings & LT Interest Rate
Earnings Real Earnings (2012$) LT Interest Rate
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Source: Barrons, Mark Lundeen, Gaineswood
In the graph above, once again we see the familiar pattern of gold mining equities being in a
deep slumber during decades of normal economic expansion. Of note is that in this chart,
twenty years before the present era begins, they start out at well over 100 times their 1920
value. At that point, the Dow Industrials had only gone up about 9-fold. (Note: Both the DJIA
and the BGMI are indexed to start in 1920 at a value of 1).
While the decade of the 1980s was good for stocks, it was the feel-good 1990s that saw the
greatest and most consistent appreciation of stocks for any decade of the last century. The Dow
Industrials roughly quadrupled in 10 years, whereas the 1950s had achieved only a triple.
Positive psychology was primed by the birth of the internet in 1992. Microsoft and Intel had
wrested control of the technology sector from IBM, while enterprise software firms and Cisco
routers made it all work together and drive productivity. Banks gobbled up other banks, and the
government finished its cleanup of the savings and loan crisis.
There were plenty of good investment opportunities in the economy at large, but few in gold
mining due to margin pressure from a falling gold price and cost inflation. Nevertheless,
commercialization of large scale low grade heap leaching technology in the Carlin trend in
Nevada was a major advance. This enabled industry leader Newmont to experience dramatic
production growth from 1986 to 1989, and sustain a high level of output afterwards. However,
its per share earnings would be only slightly lower in 1990 than a decade before, despite its
realized gold price falling from $615 an ounce to about $385 per ounce.
(1.0)
(0.5)
0.0
0.5
1.0
1.5
0
50
100
150
200
Correlation
Indices(1920=
1)
Gold Miners & Dow IndustrialsVolcker Rate Hike to Lehman Meltdown (1980-2007)
Gold Miners Dow Industrials Correlation
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Source: Barrons, Mark Lundeen, Gaineswood
Gold prices started an uptrend in the middle of 2002, about two years after the miners had hit
bottom. Both the miners and gold continued to advance through March 2008, presaging the
credit crisis by half a decade or more. This loosely fits the pattern established in the late 1920s
and the late 1960s, which telegraphed a secular peaking of the stock market and corporate
profit margins. As in those cases, the awakening of the gold mining stocks, if noticed, was a
powerful early warning to major economic structural change that would shock the financial
system and society at large.
Our next section covers what we call the transitional eras, when gold prices rise dramatically
and corporate profit margins erode substantially, a persistent trend that equally lasts about a
decade. In hindsight what happened in the 1930s and 1970s is obvious. But we will focus onhow investors dealt with these changes. What we find may surprise you. It seems they
steadfastly deny the change is occurring. This attitude successfully held back the tide in the
financial markets for a year or two periodically during these long transition periods. However,
eventually those who choose to lean against the wind become overwhelmed by the necessity to
remove capital from the overly profitable corporate sector and its associated stocks and bonds,
and to restore gold value in historical proportion to the pool of invested dollars and other
currencies.
(0.6)
(0.4)
(0.2)
0.0
0.2
0.4
0.6
0.8
1.0
1.2
0
50
100
150
200
1995 1997 1999 2001 2003 2005 2007 2009 2011
Correlation
Index(1920=1
)
Gold Miners & Bullion
Gold Miners Gold Correlation
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TheAdjustmentPeriod:RejectingtheNullHypothesis
In the statistical analysis of experiments, the burden of proof is that your concept of whatever it
is you are testing is sufficiently different from the status quo. For example, a new drug must
affect a meaningful number of patients andproduce a measurable effect in a sampled
population for one to conclude it is better than the null hypothesis of taking a placebo.
We believe the investment community and for that matter the population overall gets quite
accustomed to normal conditions of economic expansion that take place when the financial
system is not in transition periods like the 1930s and 1970s. Then, once in an adjustment
period, it takes a great deal of evidence before anyone feels confident in rejecting the null
hypothesis that conditions wont revert back to normal relatively soon. For this reason, when
gold and gold miners rise going in to establish a prolonged period of economic adjustment, it is
regarded as an oddity.
By the end of a decade or so, corporate profit margins erode substantially and gold prices
ascend beyond what was thought possible going into the long transition, give or take some
gyrations in between. Towards the end of this transition period the phenomenon has been
explained ad nauseum and the harsh conditions of the transition become accepted as the new
normal. A depression can be named Great, America can suffer from malaise, but names
such as these would not have been conjured up just a few years into the process of adjustment. 2
We mentioned that the precursor to these adjustment periods may be among the most easily
recognizable patterns useful for forecasting and trading. Once the adjustment period begins,
gold mining shares have displayed superior investment characteristics. In the 1930s and 1970s,
returns for gold miners exceeded the Dow, and correlation was often low or negative. However,
our read of the data is that the easy part of achieving good investment results with this sector
comes in advance of the transition period having started, because disbelief is near total.
Essentially you are both a value and a growth investor, who is buying in at an early discoverydiscount. Here in 2012, we are perhaps 4-5 years beyond that point.
In our study, we define the transition starting point at about the time the dollar surprises the
world by taking a large reduction in value relative to gold bullion, and when corporate
profitability peaks. From that point forward, the process begins when investor convictions
change. We observe that they gyrate tremendously between accepting the null hypothesis that
the world will return to the old normal or that it would go through a marked transition into a
new set of market clearing prices. Those who might be prescient enough to identify the new
trend can be foiled by a year or two of market action that harkens back to the old normal. A
sizeable and prolonged retracement of the move into a transition, which eventually saw equities
rally strongly and gold miners decline, happened in the 1930s. It happened three times in the
1970s, like a tug-of-war contest. It has happened four times already in the present era!
Here is a table that summarizes the action in gold, gold miners, commodities, and corporate
profits during each of the transition eras:
2Note: We cant go back and sample opinions of market participants to draw the conclusions we do about the
psychology of market participants. Our conclusions are based upon the movement of securities prices, which tell the
story of where capital was flowing.
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Transition
Era
Commodities Gold Gold Miners Major Mining Stock
Corrections
Corp Profit
1930s Collapsed
initially, rose
from lowlevel post
revaluation
Government-
set price raised
from$20.67/oz to
$35/oz in
February 1934
Anticipated 1934
turning point from
May 1925 bottom.Peaked in March
1939.
14x increase to top
35% Mar-36 to Oct-37 1929 > 2 SD from
average
1932-34 average1937 near 2 SD >
average
1944-1946 near < 2
SD from average
1970s Explosive
upside from
beginning to
end
Government-
set price of $35
abandoned in
April 1971
20x increase
overall
Slow rise in 60s
accelerated in
1965, made over
17x advance by
1980.
61% May-68 to Jan 70
35% May-71 to Dec-71
68% Aug 74 to Aug-76
1966 > 2 SD from
average
1971-81 average
1982 2 SD from
average. 4Q08 wasaverage.
Many think of the 1930s as a period of extreme turmoil and volatility. Being only about twodecades after the formation of the Federal Reserve, the set of prices necessary to make the
market clear in the 1930s had not varied too much from normal times. Clearly the 1970s and
the present times exhibit a greater range in the value of gold and the miners. We think an even
wider range of outcomes is possible now. Investors should develop some imagination of how
different prices could be for stocks, bonds, gold, and gold miners. Knowing such vision is never
perfect, they should also develop some tolerance for misjudging the swings.
Period #1: The 1930s
Lets look a little closer at the 1930s. What we see is that after the huge move up for mining
stocks prior to the 1934 revaluation in the U.S. of gold (and against other global currencies
during the early-to-mid 1930s), gold mining stocks generally did well up until the outbreak of
World War II. However, there was a 35% correction from March 1936 to October 1937. This
happened during the second half of a bull market in equities when industrial production
recovered sharply from the depths of the depression.
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Source: Barrons, Mark Lundeen, Schiller / Yale University
Despite persistently high unemployment and an undercurrent of financial system instability, the
stock market had rallied from its bottom in 1932, and people thought the recession was over.
Seeking to cool things off and establish a firm foundation for the banking system, the Fed
doubled reserve requirements in 1937. This caused commodities prices to tank (except gold,
which was fixed at $35), and the stock market started a nosedive that only saw a modest
recovery occur in 1938, followed by meandering for another two years. It appears the bulk of
the outperformance of gold mining shares occurred prior to 1934, because by then they had
nearly doubled off their 1920 value while the Dow had given back all of its increase over the
same time span. But through their apex in 1939, the gold miners had appreciated 445% from
1920, far in excess of the 40% profit in the Dow (excluding dividends).
Even going on through the end of 1942, well after credit markets had cleared, the gold miners
would be 149% above their 1920 level, compared to just a 10% gain for the Dow. This is quite
surprising, because as a business proposition they had become quite shaky again. World War II
totally remade the gold mining landscape. The government continued to cap gold prices, but
since it printed up a storm to pay for the war effort, costs inflated. The Treasury cut back on its
aggressive gold purchases of the 1930s, and it began to ration supplies of rubber, steel, andother vital commodities so critical to getting ore out of the ground.
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
0.00
0.50
1.00
1.50
2.00
2.50
3.00
1934
1934
1934
1935
1935
1936
1936
1936
1937
1937
1938
1938
1939
1939
1939
1940
1940
1941
1941
1941
1942
1942
InterestRate(%)
S&PEarnings/GoldMiners
Index
S&P Earnings & Gold MinersPost-1934 Revaluation
S&P Earnings Gold Miners LT Interest Rate
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Source: Barrons, Mark Lundeen, Gaineswood
The correlation between action in the mining sector and the Dow was negative during the gold
miner price decline phases, and not very strong otherwise. However, when correlation became
stronger (roughly 40% to 60%), it signaled either a bottom or a top in the gold miners (spring
1936 top, summer 1937 bottom, summer 1939 top).
All told, the 1930s were a transition period for the economy. It saw the gold price unexpectedly
reset from $20.67 to $35, an elevated price that would be smashed apart to the upside a few
decades later. The gold miners suffered a major setback that lasted 18 months in the middle of
the decade. However, a financial aftershock was felt in 1937 that would seal the sectors
reputation as a low or negatively correlated asset that could appreciate, especially when there
was pressure on corporate profit and stock prices. The setback of the 1936-1937 period mightbe a parallel to the present post 2008 meltdown time, when earnings have recovered strongly
and gold stocks stopped participating in the equity rally in the late stage of the move up.
Period #2: The 1970s
Turning to the 1970s, we see another slightly different template. An apex of American
technological achievement was the landing of astronauts on the moon in July 1969, which
occurred pretty much right at the secular peak of the stock market and also for real earnings per
share of the S&P 500. During this adjustment period, the Dow Industrials appeared to be
constrained by a glass ceiling fixed at 1,000, which it approached or exceeded many times: in
1966, 1969, 1972, 1976, and 1980-1981.
Inflation-adjusted profits seen in 1966 would only be marginally matched or surpassed
occasionally during the 1970s. The S&P 500 had essentially the same peak inflation-adjusted
earnings in 1966, 1974, and 1977. In 1979 oil producers experienced a profit windfall, elevating
real earnings of the S&P 500 a mere 15% over what they had been in 1966. By 1987, well into a
robust economic recovery and prior to the stock market crash of that year, real earnings for the
(1.0)
(0.5)
0.0
0.5
1.0
1.5
0.0
1.0
2.0
3.0
4.0
5.0
6.0
Jan-34 Jan-35 Jan-36 Jan-37 Jan-38 Jan-39 Jan-40 Jan-41
Correlation
StockIndices(1920
=1)
Gold Miners & Dow IndustrialsPost-1934 Devaluation
Gold Miners Dow Industrials Correlation
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S&P 500 were 23% lower than they had been in 1966! Once knocked down from their perch at
two standard deviations over average, S&P 500 profit margins hovered at the center of the
channel of profitability discussed at the beginning of this essay through 1979. By the early
1980s, profitability would reside two standard deviations below its two decade norm. (Two
graphical depictions, one of earnings and other of margins, are presented in earlier sections of
this essay).
Source: Barrons, Mark Lundeen, Gaineswood
The chart above shows how the gold mining stocks reacted during the economic transition of
the 1970s. While it is important to see the entire transition era in one sweeping view, the
magnitude of the changes during the 1970s requires splitting the era in two.
The first half we present below, with an ending point of August 1976. In that month gold bullion
and the gold mining stocks bottomed out simultaneously. Gold then was $104/ounce, nearly
20% below where it peaked in mid-1973 and 40% under its April 1974 top.
(1.0)
(0.5)
0.0
0.5
1.0
1.5
020
40
60
80
100
120
140
160
Correlation
StockIndices(1920=1)
Gold Miners & Dow IndustrialsMoon Landing to Malaise+ (1969-1984)
Gold Miners Dow Industrials Correlation
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Source: Barrons, Mark Lundeen, Gaineswood
We already mentioned how the miners gave back 60% of their roughly three-fold advance from
1965-1968 that presaged the collapse of the London gold pool in 1968 and how irrational it was.
Like the three mystic apes who see no evil, hear no evil, speak no evil, once again in the early
1970s gold mining investors steadfastly refused to recognize what was happening right under
their nose in the bullion market. The casting off of the U.S. dollar from its anchoring at
$35/ounce by 1971 (its free market price was $39.10) would be greeted by a yawn. The gold
price would climb almost 70% from the 1971 free market value to January 1973, a point where
the Barrons Gold Mining Index would not have advanced at all.
Compared to the eight fold increase to come for gold miners through the peak in 1980, this
price action in the first three years of the 1970s seems unbelievable. A parallel may be in themaking today, where the gold price has ascended mightily, but gold miners have by and large
ignored the massive move up by bullion. Well share more insight on this in a series of charts
later.
Finally in 1973 and early 1974 the gold mining stocks could not wallow in the mud while gold
made a another baby step along its march to a 20-fold increase, this time from just over
$100/ounce to about $150/ounce. 1973 was the first year Americans waited in lines to get
gasoline, driving home the point that there was an imbalance in the global monetary order.
Nixons severing the dollars linkage with gold may have been an esoteric point to most
Americans, but when oil followed suit the monetary origin of the crisis became painfully real.
Spiro Agnew, the nations Vice President, would exit the scene in 1973 after being charged with
accepting bribes, presaging Nixons demise.
Throughout 1973 and 1974 the stock market eroded gradually after having touched 1,000 in
1972. Then, like the Titanic, it took on water and headed for the bottom in August and
September of 1974. During 1973 the gold miners had grabbed the bullish baton from the Dow,
nearly quadrupling through the first two months of 1974. They would ultimately hit a high in
August 1974. This was the month when the Dow submerged definitively, and unfortunately it
(1.0)
(0.5)
0.0
0.5
1.0
0
10
20
30
40
50
60
70
80
Jan-70 Jan-71 Jan-72 Jan-73 Jan-74 Jan-75 Jan-76
Correlation
StockIndices(1920
=1)
Gold Miners & Dow IndustrialsEarly 1970s Gold Cycle (1970-1976)
Gold Miners Dow Industrials Correlation
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beckoned from the deep and soon pulled the gold miners down there with it. Mr. Dow Jones
might have well changed his name to Davy.
The Dow would bottom in October 1974 at the start of the Watergate trial, two months after
Nixon had resigned. This would start yet another period of delusion counter to the primary
trend that favored gold in its best decade ever, since the Dow would rally back to over 1,000 by
the second half of 1976, but the gold miners would suffer their biggest collapse ever, a 68%
free-fall that ceased in August 1976. Concurrently, gold bullion fell 30%. Strangely, the
restoration in confidence for the stock market and the correction in gold witnessed two major
bearish milestones. Saigon would fall to the Vietcong in April 1975 and New York City would
brush with bankruptcy later in October. Correlation between the Dow and the gold miners was
negative once the stock market got a head of steam, an interesting flip side to its having also
been negative when gold stocks made their huge advance in 1973 during the equity bear
market.
This correction in the miners and the rally of the Dow was a countermove back to the old
normal. Large as it was, it set the stage for an even more pronounced repricing of stocks, bonds,
oil, and especially gold and the gold miners by the end of the decade. By 1979, President Carterand most Americans concluded America had descended into what he described as malaise.
Gold miners would climb 554% from their August 1976 bottom, making the dreadful 68%
decrease in the 1974-1976 period seem small by comparison.
The late 1970s finally saw the economic adjustments of that decade reach completion. While
gold miners surged 554% in their final leg up of that decade, gold bullion would go from
$104/ounce to almost $700/ounce using weekly closes, or an intraday high of $850/ounce. We
would exit these years at a climactic peak marked in 1980 by the Iranian hostage crisis and the
attempt by the Hunt brothers to corner the silver market. The speculative juices were so
exaggerated that the Barrons Gold Miners Index would be nearly 140 times as valuable as it
was in 1920, while gold would only have advanced by a factor of about 33 and the DowIndustrials would register about a 9-fold gain over that same 60 year span.
Precisely sticking to the decade, gold bullion handily outperformed the miners, but in reality the
full cycle saw no differential in appreciation because bullion was handicapped by being under a
price control during the late 1960s, when the miners got a head start on beginning the dramatic
advance.
The chart below starts with the simultaneous bottom seen for both gold and the miners in
August 1976, a point when we believe the two assets had worked off their differences. Our
proof of this theory is that from 1976 through the peak in 1980 the two achieved an equal gain.
If we are right, then the lagging behind seen in the present time wherein the miners have not
shared about two-thirds of bullions ascent since the 1980 peak might be restored. Note that
well after the long adjustment period of the 1970s was over, gold miners and gold would
maintain a permanently higher plateau. But by then malaise was gone and there would be
morning in America, at least through the next normal period.
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Source: Barrons, Mark Lundeen, Gaineswood
Period #3: The Present
Our thesis in this section has been that in the middle of the eras of the 1930s and the 1970s, we
were well into an adjustment period for corporate earnings and for gold. We further claim that
at these midpoints, investors foolishly accept the null hypothesis, that the world has not really
changed much and in fact will revert to its old normal. During these countermoves, gold
mining stocks have declined anywhere from 30% to nearly 70%, which certainly is a large move.
However, we observe there were much more powerful forces at work during these decades of
adjustment. The main trend is that corporate profit margins to go back to their mean or eventwo standard deviations below this in the fullness of time. It may simply be coincidence that
gold and gold miners feed on this erosion of corporate profitability. But it is far more plausible
that capital is compelled to flow to the logical alternative to credit.
Capital flees the equity and debt instruments of corporations in order to rationalize their undue
expansion. If the price of gold and its miners is low relative to the aggregate pool of debt and
equity in circulation, which is the case by definition after long periods of dormancy or big
corrections, then flows into it and out of conventional corporate securities have a powerful
effect.
The value of all publicly traded stocks in the world was over $50 trillion at the end of March
2012, and the value of all traded bonds was about $100 trillion. This compares to perhaps $10
trillion for gold bullion (which allows for about $2 trillion of gold unaccounted for in official
statistics), and only $350 billion for all precious metals miners.
When money flows out of gold into the public securities markets, not much impact is felt. When
it moves the other direction, the price is greatly affected. Think of how a large reservoir of
water behaves once someone opens a sluice gate on a dam. The outflow is raw energy, and the
(1.0)
(0.5)
0.0
0.5
1.0
1.5
0
20
40
60
80
100
120
140
160
Aug-76 Aug-77 Aug-78 Aug-79 Aug-80 Aug-81 Aug-82 Aug-83
Correlation
StockIndices(1920
=1)
Gold Miners & Dow IndustrialsMalaise & Recovery (1976-1984)
Gold Miners Dow Industrials Correlation
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funneling effect hydraulically magnifies price movement in gold, and especially for the miners,
which are only a miniscule safety valve that can slightly increase the capacity of the lesser vessel
of wealth.
In the 1930s we saw that the gold price was fixed, being raised once by only about 70%. With
the deflation of that era, gold miners benefitted on both the cost and revenue parts of the
income statement, and the stocks did better than the bullion. In the 1970s, we saw both bullion
and miners do well, but with a staggered performance wherein the stocks raced ahead prior to
the 1971 devaluation because the gold price was still fixed. In the present, the value of bullion
has been the star, with gold miners left at the altar, as the chart below dramatically attests.
Source: Bloomberg
The present cycle has been odd indeed. Gold mining stocks are down over 13% (through May
15) since their last cyclical peak, which was in September of 1980, while gold bullion is 2.3x
more dear. In contrast, from that peak the S&P 500 has multiplied by almost 11-fold, and debt
in the U.S. has grown by about 11x as well. So it is very clear that the financial water behind
the dam has swelled immensely, while gold and gold stocks have not changed much. If there
will be an aftershock in our present period of adjustment as we foresee, it could open the sluice
gate, and the force of the capital flowing into bullion and mining stocks could be a sight to
behold. If we are correct that the template of the 1930s and the 1970s applies to the present
time, then gold stocks are likely to make a massive move up, well in excess of bullion. Althoughmany commentators are currently offering explanations as to why precious metals miners
should almost perpetually underperform the yellow metal, we observe that in the 1970s
investors went through similar phases when bullion beat stocks only to see that situation
powerfully reverse.
While it is interesting to make a comparison from the prior peak, of more fundamental value is
what has happened to these three indices since the dollar became purely fiat based, i.e. not
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exchangeable for gold internationally, which takes you back to the far left of our graph above.
You can see that gold began to part ways with stocks quite dramatically in late 2006, which
marks the peak of the leveraging of the financial system that fueled the denouement of a
multigenerational boom in real estate.
This behavior poses a question that has been dogging the goldbug community for about five
years, because there appears to be no fundamental reason for gold to appreciate mightily andfor gold mining stocks to trade as if they are no different than IBM, Coca-Cola, Pfizer, or
ExxonMobil. To be fair, gold mining stocks did extremely well from the internet bubble peak
through the 2008 meltdown, so one might expect some underperformance relative to bullion.
Particularly strange has been the behavior in the last six months, where a slight hesitation in
golds ascent has clobbered the already lackluster gold stocks.
One reason offered by observers for this difference in performance is that the profitability of
extracting gold has not expanded as much as one would have thought from the strengthened
gold price. The two charts that follow show a key cost driver (particularly in West Africa): oil.
Source: Bloomberg
Here we can see that even though oil has been one of the best performing commodities that
affect the cost of gold mining, in the time period since gold began to take off and leave the
mining stocks in the lurch, gold and oil have traced out about the same appreciation over time,
with the meltdown a temporary interlude.
So might oils progress prior to 2006 account explain the anomaly?
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Source: Bloomberg
Perhaps. But it is doubtful that oils rise relative to gold way back in 1999 would still be on
everyones minds. The industrys cash margin has tripled in the last four years (see chart
below), so another theory is that companies have been investing too much of this windfall into
the ground. Maybe.
Source: ABN AMRO, Gaineswood estimates
Finally, those who would accept as logical that mining stocks would decline since 1980 while
bullion would be up substantially point out that governments can be hostile to companies that
extract precious metals in their country. Recently Argentina imposed capital controls and
nationalized its largest oil company, YPF. Peru blocked a silver project in the province of Puno.
A civil war nearly broke out in the Ivory Coast, disrupting neighbors. Mali recently raised its
royalty, but that placed it near that of other countries. While these are all obstacles, we would
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note that governments and companies have become more sophisticated and have begun to
draft regional mining codes such as the Union Economique et Monitaire Ouest Africaine
(UEMOA). UEMOA has been promoted through the 15-member Economic Community of West
African States (ECOWAS), which sets standards for state participation, royalties, and taxes. Such
pacts have been helpful in reducing sweetheart deals, corruption, and in presenting a unified
stance when negotiating with Chinese mining interests.
Gaineswood invests in long-term growth, so we actually want management to expand, provided
the return on capital is high. We monitor the internal rates of return of major projects, and the
ones that are getting funded usually do have high returns even with a $1,250/ounce gold price,
which is about the 3-year average through 2011.
With the decline in gold miners relative to bullion, now we are finding many established small-
to-mid tier producers are trading at 25% to 50% discounts to corporate wide valuations that
discount cash flows at 5% or more. In theory if you paid par for the present value of a gold
project calculated with a 5% interest rate, you would earn a 5% return that is backed by a hard
asset. If you buy in during a big correction as is the case in early 2012, your compounded rate of
return should be far higher, presuming our template is correct and we have done our homeworkon project cash flows.
However, since you are buying a stock and not making a loan, there is the risk of cash flows
drying up under a lower gold price scenario or unrecovered cost inflation. The market seems to
be discounting margins dreadful enough to put a serious crimp on maintaining industry
production levels, much less funding exploration and development. But if our template from
the 1930s and 1970s is correct, then these projects would generate significantly higher earnings
if the gold price takes a quantum leap up and at the same time corporate earnings weaken.
Well return to the conundrum of the present times a little bit later. In the meantime, lets
review what has been happening during the present era, and how the templates of the 1930s
and 1970s may be setting a precedent.
Source: Barrons, Mark Lundeen, Schiller, Yale University
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What about corporate earnings and the economy? In the chart above the performance of the
gold miners is shown to be similar to the early stages of the 1970s period of adjustment. Recall
in the 1970s there was an initial move up in the miners prior to the big 1974 bear market, which
also saw the miners eventually succumb. Similar to that is the meltdown in 2008, which we
think marks the start of the present era of financial adjustment. In late 2008, S&P earnings were
nearly wiped out (using Schillers data), and the collapse in gold stocks edged out the previous
record correction of 68% set from August 1974 to August 1976 by a point. Among chaotic
kickoffs that started transition eras, we believe the 2008 meltdown has earned a spot aside
1929 and 1974.
The 1970s are also providing a better template for today than the 1930s, because of the
seesawing of gold miners in the middle of the adjustment era is a shared element with the
present situation. We think the 2011-2012 sell-off is continuing to follow the template of the
middle of both adjustment periods. Back in the mid-1970s, corporate earnings recovered from
the 1974 debacle as did the Dow Industrials. But the return to the old normal caused capital
to abandon the gold miners in favor of the equity markets other sectors. Similarly this is what
has happened in the 2011-2012 period, when corporate earnings looked good and seemed to be
accelerating, perhaps due to unusual seasonal adjustments.
In March and April sporadic employment and other reports suggested that we may be in danger
of entering a recession. This episode has not yet concluded, but we think when it does, the
twist could be that gold miners bottom out before the Dow does. Our reasoning is that this time
miners led on the way down, and the Dow will need a long time to digest what we think will be
serving after serving of unpalatable quarterly earnings reports.
If we are anywhere near correct about corporate profits being stretched at a multi-decade high
above two standard deviations of observations, this would suggest the surge in the Dow and the
collapse of the miners in late 2011 to early 2012 is a recalcitrant countermove. We think it most
closely resembles 1936-1937 and 1974-1976 among the seven deep corrections in mining stocksof those two transition eras. Like these two, corporate earnings were in a strong uptrend, luring
capital out of gold and back into corporate securities. Recall that in the mid-1930s, profit
margins nearly returned to two standard deviations above average. Inflation pushed corporate
profit margins close to their upper boundary in 1974 as well. But it was the last hurrah for visits
to the stratosphere of corporate profitability until 2005, save for an unsatisfying oil-inebriated
fling in 1979.
We believe that the credit markets have not cleared adequately. The cure, which is higher
interest rates or forced debasement of all global currencies, has been indefinitely deferred by
quantitative easing. Without clearing, intense pressures have rebuilt at shorter intervals
between interventions (it took just one month to burn through $1 trillion from the ECB).
Sovereigns and banks have access to new money from central bank purchases of notes and
bonds when the funding window is opened, but the minute funds are consumed, the system has
a very limited capability to organically service debts. The political shift from austerity to growth
may further destabilize the sovereign debt market.
Europe may turn out to be more important to market psychology than has been the case
through early 2012. The shrugging off of the unexpected scare of late 2011 indicates
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complacency may be stoked by rising corporate earnings, a factor that for now is having the
upper hand. However, growth in earnings is clearly decelerating. Europe might graduate from
being a mere psychological influence to become a fundamental cause of weaker earnings.
To date, what has preserved earnings in so challenging an environment? For one, the U.S. dollar
has lost one-third of its value from the 2000 peak, despite its recent rally. About 35% of
corporate profit comes from abroad, and these earnings have surged from the translation
benefit. We dont see this happening again without setting off a trade war. Spain, Portugal,
Greece, Italy, and now the United Kingdom are in recession. China claims merely to have slower
economic growth, but enviously its high single digit GDP expansion has remained faster than
almost every other nations on the planet. However, some dont believe the statistics. In China
real things like electric power growth slowed to less than one percent in April, and oil demand
purportedly was flat and perhaps negative in that month. Europe is a big customer of Chinese
exports.
Asia has been regarded as an engine of earnings growth, but it might become a drag on
corporate profitability. The Federal Reserve has exported inflation to countries that have trade
imbalances with us, because more than a few important developing nations peg their currencyto the dollar. This means that their authorities print local currency that they provide within their
borders in exchange for dollars, which they keep to invest as exchange reserves. Credit growth
remains high in China, which may explain why retail sales climbed 14% in April when output
measured by electricity or oil barely changed. Wages in China and other developing nations
have risen, which might negatively impact margins. For example, earnings at Wal-Mart, a major
importer of Asian goods, have fallen slightly short of analyst expectations in the last two
quarters, and projections for the coming year have been shaved by a few percent.
There are also hazards approaching that could shove U.S. corporate earnings down the stairs,
such as tax increases looming in 2013, the cost of implementing healthcare reform, the effect of
state and local austerity programs, or enacting a U.S. debt ceiling.
We dont want to overstate what is only a slight change so far. But you have to ask, why should
there be any slowing at all, and what is it about this point in the recovery that contributed to the
change in tone that started late in 2011, and which has resurfaced just half a year later? Each
period, the 1930s, the 1970s, and the present era, have their own rhythm. No one can predict
which ball players will score runs or in which specific innings they will do so, but we might have
a better than even shot at figuring out what team will prevail over time by using our template.
While there is a certain amount of randomness in the short-term, through solid statistical
analysis we may not be completely blind to forces at play now compared to the 1930s and the
1970s. If we have the template right for the present (and there is no guarantee that we do), we
could be nearing another inflection point where gold miners and gold resume their uptrend and
have low or even negative correlation with the stock market. The path of corporate profits,
credit markets, and then by extension gold miners might be known in general terms over the
balance of the adjustment era, especially once the present countertrend has exhausted itself. If
we are right, fundamental news from Europe and from corporations will begin to cast a larger
shadow over the U.S. stock market, which appears somewhat detached from downturns on the
bourses of Europe, Japan, and developing nations like China and Brazil.
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The chart below shows how correlation between the Dow and gold miners has dropped to no
greater than 50% since about a year ago. While unpleasant to gold mining shareholders, it could
indicate that gold has begun to break free from the risk on risk off trading pattern just as
was the case in 1973 and 1978-1979 just before the sector catapulted upward (see charts similar
to the one below presented in the beginning of this section).
Source: Barrons, Mark Lundeen, Gaineswood
One risk is that like in the 1970s we see gold miners extend their loss to match the greatest
corrections on record. But once that has happened, what then are the odds that the fragile
state of affairs cannot be preserved longer?
Another risk is that the template more closely matches the 1930s. However, then gold prices
were kept under wraps and held constant, with the economy bearing the brunt of adjustment
through the mechanism of default. The 1970s coincided with shortages of oil and other key
commodities, as well as a banking system that had the ability to take on additional leverage.
Finally, the present era is decidedly different, and that presents unknown risks. Commodities
may have already had a bull market cycle, and their descent could be a part of weakening
nominal corporate earnings. The 1970s saw corporate earnings rise in nominal terms, but in
real terms they only went sideways in serpentine fashion. Our best guess is that unless tens of
trillions of dollars and Euros are printed, the present cycle will see earnings and commodity
prices move sideways cyclically in nominal terms, somewhat like the 1930s, but not as bad since
there is a predilection to print Euros, dollars, Yuan, and other currencies. A major difference is
gold bullion is no longer pegged. So, it can float upward, which is what happened in nominal
terms in the 1970s and in one mandated step in the 1930s. In the 1970s, shares of gold miners
followed in grand fashion, which we believe is the probable outcome once the countermove in
the present era runs its course. It could happen in spades considering the underperformance of
mining shares and the hefty discounts to project net present values.
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If you extrapolate the large declines in the Barrons Gold Mining index seen in the 1970s to the
present period, then the correction that began in April 2011 might take the shares of gold
miners down another 45% to 50% from where they were in mid-May 2012. But if they
bottomed here, they would have declined by over 40%, which would exceed three out of the
seven major corrections that happened in the 1930s, the 1970s, and in 2008. In other words, as
far as corrections go, the present one already ranks up there among the worst.
When the dust settles, the 1970s may keep their title of producing the wildest ride for gold and
the miners ever. During that episode, recall that the gold price advanced 20-fold from 1971 and
the miners went up by 15-fold (starting from 1965). The present era, although seemingly
formed by fantastic speculative bubbles, has had gold and its miners only jump 7-fold. Even
the staid 1930s which had the government capping the gold price increase to 69