The gold rally is far from over

The performance of gold during 2016 has caught many investors by surprise, outperforming all major asset classes.

Given the strong performance of gold and gold equities so far in 2016, it is instructive to examine factors contributing to this strength and assess their likelihood to continue in the future. With respect to the performance of gold bullion, during the past two-and-a-half years, staunch global physical demand has been carving out a durable price floor for gold in the general vicinity of $1,100 to $1,200 per ounce.

Gold bullion bars and coins.
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Gold bullion bars and coins.

The only ingredient missing from a sustained advance in the price of gold has been weak western investment demand, in an environment of persistent strength in U.S. financial assets. In essence, when the S&P 500 index sets ever increasing highs on a monthly basis, gold's allure will diminish reflexively to consensus. However, mounting concern that U.S. financial asset prices may be a bit extended, just as breadth and liquidity are receding, has opened the door to reevaluation of gold's role as an effective portfolio-diversifying asset.

Most recently, investor concern over negative interest rates appears to have lent some urgency to western investment demand—inflows to bullion ETF's have exploded in recent weeks.

During the first 10 weeks of 2016, gold ETFs have expanded their bullion holdings by about 9 million ounces (about 19 percent year-to-date growth), or twice as much as the 4.5 million ounces shed during all of 2015. Expanding our lens to include published bullion holdings for all ETF's, mutual funds and repositories (such as COMEX and TOCOM), bullion holdings have jumped about 18 percent year-to-date.

We have long suggested that the single greatest factor determining gold price is the relative rate of capital migration between the global stock of financial assets (we estimate roughly $280 trillion) and the global stock of investable gold (ex-jewelry and central banks, we estimate roughly $2.5 trillion).

While a myriad of economic, monetary and geopolitical factors are always influencing individual investment decisions, which in turn compose the aggregate migration rate between gold and financial assets, it is important to recognize that it is always the total migration rate which sets the gold price.

In other words, individual bits of economic data or central bank policy decisions are generally overrated in terms of their lasting impact on the gold price. Meaningful moves in price are always tied to a shift (at the margin) in general confidence in global financial assets. Because the stock of global financial assets is so large relative to the available gold stock, shifts in relative confidence can have significant impact on the price of gold.

Our expectations for gold shares over the next 18-24 months are especially optimistic. Gold equity indices have all declined more than 80 percent from their September 2011 highs to their January 2016 lows. While there is no predictive value in the calculation, even after year-to-date gains over 40 percent, gold equity indices still remain well below their respective highs (any reversion to the mean should have far further to go).

Second, the relative performance of gold equities versus bullion has proved similarly disconcerting during recent years. After trading at a ratio of 0.25 times for 25 years through 2007, the current ratio of the venerable XAU index (of gold miners) to spot gold has declined all the way to 0.05 times today.

Virtually all contributing factors (inherent leverage of gold miners, poor corporate stewardship during the past decade, and the powerful feedback loop of fluctuating long-term gold price assumptions on current project valuations) have reversed in favor of gold shares. The sheer magnitude of the past three cycles of gold-share advance, generally during periods of recalibration in reigning U.S. financial asset prices, lends interesting perspective to year-to-date gains for gold shares.

Gold can play a portfolio-diversifying role during periods in which faith in U.S. financial assets is being challenged. Historically, the performance of the S&P 500 index and gold shares displays strong inverse correlation. One of these periods was during 1996-2003. Following the Internet craze in March 2000, investors displayed incorrigible enthusiasm for broad equity averages and left gold stocks virtually for dead.

Then, the S&P 500 Index fell by 52 percent and gold stocks roughly quadrupled after the March 2000 peak. A similar period of virtual tick-for-tick inverse correlation has unfolded since September 2012 between the S&P 500 index (incorrigible enthusiasm) and gold shares (left for dead). To us, a modest portfolio reallocation from the S&P 500 index to gold shares at this juncture seems an investment decision with extremely compelling logic. Once the "jaws of life" divergence between broad equities and gold shares starts to close, mean reversion suggests gold shares may be in for an extended period of outperformance versus the S&P 500 Index.

We believe compelling fundamentals have underpinned the strong performance of the gold complex so far in 2016. There has clearly been an uptick in general investor concern about the eroding effectiveness and potential overreach of global central bank policies. We expect this concern to remain an important component of the investment landscape in coming quarters, with positive implications for gold and gold shares.

Commentary by Trey Reik, a senior portfolio manager and precious metals strategist at Sprott Asset Management USA, a division of SprottInc., a Toronto-based alternative asset manager. Reik is also the author of The Sprott PreciousMetals Watch, a monthly newsletter produced by Sprott Asset Management LP.

Disclosures: Neither the author nor his family owns any shares of individual gold companies. He does own, but doesn't actively trade, physical gold. Sprott Asset Management as a firm does manage active and passive strategies that may own or trade gold or gold securities. Sprott Asset Management LP is the investment manager to the Sprott Physical Bullion Trusts (the "Trusts").

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