There are a number of reasons why gold stocks are set to break out in 2018.
1. There are few sellers left
There were very few sellers left in January 2016 when the devastating “forever bear” was about to end. Six months later and a 150% rebound in the large caps and 200% rise in the juniors (via VanEck Vectors Junior Gold Miners (NYSE:GDXJ)) provided sellers an opportunity. They drove the miners and juniors down by 40% to 45% in less than five months. However, both VanEck Vectors Gold Miners (NYSE:GDX) and GDXJ have been able to hold above that low multiple times. GDX has held $21 four times! GDXJ has held $29.50 twice in solid fashion.
The bears had multiple opportunities in 2017 to push the miners lower but the miners held above their December 2016 lows and maintained the 62% retracement of the 2016 surge. The miners did not break out in 2017 but they held key support multiple times and the latest rebound suggests selling power has dried up.
2. The recovery pattern following a mega-bear market bodes well for gold stocks in the second half of 2018
In November we wrote about this history and the potential implication for gold stocks in 2018 and beyond. The mega bear markets that compare to gold stocks from 2011-2016 with respect to price (+80% decline) and time (+2 years) follow a distinct pattern. The initial rebound is sizeable in price but not so much in time. That gives way to a correction and consolidation that lasts a minimum of 18 months. Then the market surges higher in third-wave like fashion.
The gold stocks are nearly 17 months through their consolidation. We do not know if the consolidation is ending soon or if it will last another three, six or even nine months. We do know that history argues the correction and consolidation should end sometime in 2018.
3. Gold is not too far away from breaking out
Gold is much closer to breaking its 2016 high than the miners but the miners could begin to sniff that potential breakout in gold before or as it happens. Gold recently bottomed around $1240 with sentiment indicators at encouraging levels. In the chart below we plot gold along with its net speculative position as a percentage of open interest (CoT) and the SPDR Gold Shares (NYSE:GLD) put-call ratio. The CoT recently touched 27% which although not a bearish extreme is fairly low relative to most readings since February 2016. The GLD put-call ratio recently touched the highest level in more than two years. With current sentiment relatively muted, gold has a chance to rally up to trendline resistance. That would put it in position to breakout sometime in 2018.
4. Gold stocks are one of the few sectors that offer compelling value
As we discussed last week, the gold stocks continue to offer historic value. The value is not quite as historic as in January 2016 when it was absolutely historic but it remains exceptional. Outside of the commodity sector there is nothing in a value sense that compares with the gold stocks. Even within the commodity sector, there is little that compares to gold stocks. Heading into 2018 traders and investors have to be intrigued at the deep value opportunity in the gold stocks in nominal and especially relative terms.
5. Increasing inflation expectations
Commodities typically outperform at the end of an expansion and into the beginning of a recession. This is accompanied by rising inflation. Some commodity sectors have performed well but the commodity sector as a whole (CRB or CCI) has yet to make new highs. One thing that could trigger a sharp rise in inflation expectations would be a breakdown in long-term bond prices.
In the chart below we plot the 5-year bond price, the 10-year bond price and the 30-year bond price. The 5-year bond has already broken to a 7-year low while the 10-year bond is not far behind. The 30-year bond continues to hold above its 2015-2016 lows but does not have much wiggle room. A breakdown in the 10-year and 30-year bonds may not be immediately bullish for precious metals but a continued decline or acceleration to the downside would be.
The strength of the current rebound in gold stocks has definitely surpassed our expectations and the December lows should hold moving forward. If that is the case then a breakout move for the gold stocks this year is more likely than not. More backing and filling may be ahead but if GDX and GDXJ can surpass their September highs it would be a very good sign for 2018. The miners have plenty of work to do before a true breakout move can begin but traders and investors would be wise to keep a close eye on the sector. We prefer companies with strong fundamentals that are trading at reasonable values and have upcoming catalysts that will drive buying.