Description

GDXJ

Main Points

Gold trades at a historic 50% discount to its long-term value versus the US dollar and has the potential for 100% upside. On top of this, as cheap as gold is above-ground, gold underground in the form of gold miners’ reserves is even cheaper. Gold miners trade at a 30-60% discount to gold. The last time this happened was in 2000, and the HUI Gold Miners Index returned 6x over the next seven years. We’re long GDXJ as well as a basket of gold miners.

The problem with owning individual miners is that absolutely anything can happen--and often does. And there's just no way to predict in advance which projects and which management teams will do well and which will do disastrously. Given this track record, GDXJ may be the cleanest way to get convexity to rising gold.

Gold as a commodity

Before we get to our central thesis, it’s worth pointing out that the supply dynamics of gold are the most attractive in decades. As a commodity, gold is unique because the supply is so fixed. There are 7500 million ounces (“moz”) of above-ground gold in the world (worth $16 trillion). Annual gold production is just 130 moz or 1.5% of above-ground stock. This trickle of supply is what gives gold its much-prized stability. Meanwhile there’s lot of pressure on this trickle. Major gold discoveries have been falling for three decades. There were 180 major discoveries in the 90s, 117 in the 2000s, and just 42 in the 2010s. The effect on total ounces discovered has been dramatic. 1990-1999, new discoveries averaged 157 moz a year. 2000-2009, 85 moz a year. And from 2010 to 2022, new discoveries averaged only 32 moz a year. Gold discoveries halved each decade.

In addition to this, the quality of new discoveries has fallen by half. The 189 producing gold mines in the world have an average grade of 1.06 g/t. By contrast, the world’s undeveloped deposits have an average grade of just .66 g/t. What this means is that double the rock needs to be processed to extract the same amount of gold. And that in turn means mining gold in the future will be more difficult, pressuring supply.

We can already see the effect of three decades of falling discoveries on current production. For the first time perhaps ever, gold production has plateaued.

What does this mean for us as investors? One, as investors once again become interested in gold, tighter supply could amplify any price increases. Two, because underground gold may be the cheapest it’s ever been, there’s a big opportunity in “reserve duration,” i.e. in miners with reserves which won’t go into production until after 2025.

The Great Divergence

Nixon took the US off the gold standard in 1971. From then until 2008, one would expect gold prices to track inflation, which was 4.6% a year. Instead the price of gold did something surprising. It tracked the monetary base. The monetary base grew 7% a year, and gold prices increased 8% a year. This is interesting because, since 1971, the US hasn’t increased its 8134 tonnes in gold reserves. As a result, each additional dollar printed was technically 100% pure debasement. Why is this significant? It means that instead of being the dead asset it’s often dismissed as, gold did exactly what it was supposed to. It kept its value against the dilution of the US dollar. And it kept its value against the true dilution of the US dollar as measured by the monetary base, not by an indirect, managed number like CPI.

This relationship held—with extreme variance—for over four decades. Then in 2008, quantitative easing happened, and everything changed. From 2008 to 2023, the monetary base grew 12% a year. But gold prices appreciated just 5% a year, a substantial annual lag which has led to a historic undervaluation.

Gold now trades at a 50% discount to its 37-year average versus the US dollar (“USD”). Even though the US left the gold standard long ago, the correlation of gold prices to USD isn’t theoretical. Notice how the yellow line always catches up with the green. In the past, gold prices have always caught up to the growth in the monetary base. And in order for gold to catch up today, gold would have to rise from $2300/oz to $4850/oz, an increase of 110%. Miners are massively leveraged to changes in gold prices. But adding to this leverage is the fact that today they’re particularly cheap. From 2011 to the present, gold miners massively underperformed gold, and now they’re 30-60% undervalued versus gold alone.

Their leverage to rising gold + this undervaluation means that if gold revalued to its long-term average, miners would repeat or even exceed the 6x return they earned in the wake of the tech crash.

You might be wondering what I mean when I say gold is undervalued. After all, gold would seem to have no intrinsic value. Think of gold as a stand-alone currency, one that trades against the world’s other currencies. The supply of these other currencies grows 5-15% a year as governments print money and expand their monetary bases. Now what happens exactly when these governments do this? Money printing is just like a company issuing stock and diluting shareholders. The company isn’t increasing its underlying value. It’s simply creating more claims against it underlying value. That in turn dilutes each claim proportionally. Inflation is really dilution.

But in contrast to the world’s monetary bases, the supply of gold grows only 1.5% a year. Thus little “money printing” is taking place which dilutes each ounce of gold’s value. The result: over time, gold stays the same, but currencies devalue. This setup is what gives gold its long-prized status as a store of value. It also reveals what gold prices are a true measure of. Gold price increases aren’t a reflection of gold becoming more valuable. They’re a reflection of the degree to which other currencies have lost value through money printing and dilution.

As an example, say the US prints 100% more dollars. What should happen to the price of gold? If it stays the same, then the US could just print more money and buy all the gold in the world for free. In fact why stop there? It could just print an infinite amount of money and buy all the assets in the world too. But this would never happen. Why? Because people aren’t stupid. Everyone would know the dollars weren’t backed by real wealth.

So what would actually happen? If the US prints 100% more dollars, the price of gold should go up 100%. That’s the only way to keep both currencies—the USD and gold—at rough parity. That’s also the only way to not let the US cheat and start buying gold with diluted, devalued dollars.

The situation I’m describing is exactly what’s taking place today. Gold prices and the monetary base growth tracked each other for 37 years. Then the US printed 110% more dollars without an equivalent increase in gold prices. Now to restore parity, gold needs to go up 110%.

So what would make that happen?

There have been three major gold price increases over the last 100 years. All three share one thing in common, and contrary to popular belief, it isn’t inflation. It’s the popping of a massive financial bubble.

In the 1930s, after reaching the then-highest valuation in its history, the US stock market fell 90%. This was accompanied by deflation, not inflation. Consumer prices fell 20% cumulatively over the decade, and commodities crashed. Gold prices, however, increased 70%, going from $20.67/oz to $35/oz, as FDR devalued the dollar and printed so much money the monetary base grew 2.5x in six years. 

In the 1970s, after reaching the then-second highest valuation in its history, the stock market suffered a 40% crash and then a lost decade. There was also 8% inflation as well as money printing. In violation of Bretton Woods, the US had printed double the USD it had gold reserves for. The result? As soon as the US went off the gold standard, the price of gold quickly went back to parity with USD, increasing 100%. And by the end of the decade, gold had gone up 16x.

In the 2000s, after reaching its highest valuation ever, the stock market suffered a 40% loss and had another lost decade. This time, there wasn’t inflation, devaluation, or large-scale money printing. Instead gold was simply undervalued and traded at a 50% discount to its long-term value versus USD, the same as today. When the tech bubble popped, gold increased 150% by 2007.

Based on these three episodes, what makes gold go up?

1. Inflation is nice but not necessary.

2. Gold has to be extremely undervalued.

3. A generational financial bubble pops.

Today we have all the key ingredients. Gold is 50% undervalued, an undervaluation only seen once before in 2000. Meanwhile the US faces arguably the biggest, broadest financial bubble in its history. In view of this, we think today is one of three times in the last 50 years that gold has become a value investment and not a low-percentage speculation.

Very little out there is priced for substantial—or even positive—returns. Meanwhile gold miners provide both a powerful hedge and the potential to make massive, uncorrelated returns. Today even if gold prices stay the same, many miners are priced for 3x returns. And if gold reaches $2700/oz or more, those payoffs double.

The cleanest example is probably Seabridge Gold. Seabridge has others, but their main project is KSM. KSM has 90 moz of gold resources. Assume that if KSM gets built, 10 moz of this actually winds up going to Seabridge, and the rest is lost to share dilution, the partner who actually builds the mine, non-recoverability of the gold, etc. Also assume gold is $2700/oz and the all-in sustaining cost net of by-products per oz is $1000, a conversative assumption given KSM has a lot of copper, which is itself cheap today. That gives Seabridge’s interest in the project an after-tax NPV of $7 billion, 5x the company’s current market cap*. And bear in mind this quick math gives no credit to the company’s other projects, which are substantial.

Something else to consider: KSM hasn't been built because the initial IRR on the project was low, only 15% or so. But with gold at $2300/oz, the IRR is probably now well above 20%, and the mine is economically worth the risk.

*Note: my discount rate for the NPV is only 3%, not the typical 5%. This is because my usual hurdle rate is 10%, and gold historically returns 7% a year. The 3% discount rate reflects what gold has to earn net of its store of value factor (7%) to equal 10%.

Don’t fight the Fed

Gold’s use as money has been attacked as a relic. But gold is money. How do we know? Because 15-20% of above-ground gold is held by central banks, the very people who, we’re told, made gold obsolete. So why do they own the thing they’re competing with?

As a matter of survival.

With respect to bitcoin, gold is the greatest opt-out in the history of finance. Central bankers hoard gold, not out of nostalgia but because it’s the only escape from one another’s machinations. Anything someone does over and over that’s completely at odds with his stated beliefs is a behavior worth paying attention to.

For the last 15 years, “Don’t fight the Fed” has been sound advice. So what are central banks doing? They’re buying gold, the most record.

DISCLAIMER: This work is the opinion of the author and nothing but that. The author may make mistakes, including when it comes to his assertions of fact. He’s made them before. Please do your own research. And note the author undertakes no duty to update or correct anything.

Catalyst

Simple undervaluation. The popping of a financial bubble.