During 2016, gold markets shook off three consecutive years of price weakness. Spot gold posted an 8.56% annual increase, rising from $1,061.42 to $1,152.27. Gold equities were among the best performing global assets, with the Sprott Gold Miners ETF (SGDM) rising 48.15% and the Sprott Junior Gold Miners ETF (SGDJ) surging 64.99%. By way of context, the S&P 500 Index posted 2016 total return of 11.95%, with roughly 40% of the gain occurring in the seven weeks following the U.S. presidential election. Despite strong relative performance during 2016, various gold sentiment measures registered year-end readings among the lowest in three decades. In mid-December, the Bernstein Daily Sentiment Index actually tolled its lowest 21-day moving average for bullish gold sentiment since inception of the index in 1987.
What accounts for the dispersion between gold’s 2016 market-leading performance and year-end bearish sentiment? As is frequently the case in the gold sector, short-term sentiment is generally more reflective of recent price action than underlying fundamentals. After consolidating sharp first-half gains during the third quarter (in constructive sideways fashion), gold and gold equities suffered meaningful corrections in Q4. We attribute gold’s fourth quarter weakness to a combination of three factors, each of which we view as temporary. First, the Fed’s second rate hike in the current tightening “cycle” has unleashed a new round of forecasts for multiple rate increases in each of the next several years. Of course, this will be the eighth straight year of consensus confidence in Fed tightening, a record so far unblemished by success. Second, the Trump victory has unleashed powerful expression of latent longing for normalcy in business and economic conditions. While we are sympathetic to the frustrations of consumers and business leaders from the distortions of eight years of QE and ZIRP, we suspect recent sentiment highs will soon be tested by harsh realities of excessive debt levels and legacy malinvestment. And third, gold’s inability to sustain sharp first-half gains has reignited debate as to whether 2016 strength was merely a bear-market rally. In our view, fourth quarter weakness amounted to fairly textbook retesting of gold’s January 2016 breakout from a three-year downtrend.
If our analysis is correct, the investment opportunities afforded by gold’s fourth quarter correction are compelling, and, in our view, likely to prove short-lived. We recognize that bullion’s inherent volatility makes an investment in gold notoriously difficult to “time.” When gold is appreciating rapidly, it is natural for investors to feel an entry point may have been missed. Conversely, because gold corrections can be sharp and swift, investors can find buying dips a bit daunting. Finally, during occasional instances when gold trades flat for an extended period, investment urgency can be lost. In our experience, the most logical juncture for a significant commitment to gold is immediately following a bull-market correction. As long as underlying fundamentals remain intact, such corrections can help harness gold’s volatility within favorable risk/reward parameters, especially over the short run.
At Sprott, we do not view ourselves as gold bugs. To us, a gold bug is a congenital pessimist who sees risk behind every corner and who has become closed-minded to the possibility that good things can occur in the world, even in uncertain times. We recognize that gold’s relative investment merits can shift over time. Still, we believe strongly that careful and honest appraisal of economic, financial and monetary variables can identify certain periods during which gold serves an invaluable role as portfolio-diversifying asset. In this report, we hope to establish beyond reasonable doubt that the current investment landscape is among the most supportive of the gold investment thesis we have ever witnessed. We have organized our report in three sections. In the first two sections, we present brief reviews of our investment case for gold and 2016 developments in gold markets (frequent readers may skip). In the body of our report, we present our outlook for gold’s prospects in 2017 and beyond.