It is a tough time to be a value investor in today’s market. The TSX is up 23% since the start of 2016, recently breaching all-time highs, and is currently trading at around 16.5 times next year’s earnings. According to National Bank economics, this would be the most expensive valuation at this point since 2001.
Canada’s banks are currently sitting at the highest forward price-to-earnings ratios for this time of year since 2007, and many other Canadian sectors have seen big rallies. It is for this reason that gold miners look particularly attractive.
While gold miners have done well so far in 2017 (a key gold miner index is up about 30%), this rally has largely just reversed the massive losses that occurred after Trump’s election victory. The sector still needs to rally over 40% just to hit August 2016 highs, and there is a strong case to be made that the sector could go beyond this.
U.S. dollar strength is not as likely as many think
Gold prices are driven by several factors: stock market volatility, interest rates, inflation, and the strength of the U.S. dollar. Typically, as the U.S. dollar weakens, the value of other currencies increases, which in turn increases the demand for commodities like gold that are denominated in U.S. dollars. The inverse is true when the dollar increases in value, and after the election of Donald Trump, the U.S. dollar surged on expectations of more U.S. economic growth.
The dollar’s strength has stalled recently (which coincided with gold’s recent strength), and there is good reason to think this will continue. The U.S. government currently owes nearly $20 trillion in debt, and Trump’s economic agenda is set to grow this number substantially. Trump’s plan features massive tax cuts and a $1 trillion spending plan, and experts see the plan increasing the debt by between $2.6 trillion and $13 trillion over 10 years.
This problem is made worse by the fact that U.S. interest rates are rising (three interest rate hikes are currently expected in 2017). This means that U.S. interest payments will rise, which will mean more deficits and higher debt levels. A simple 2% increase in interest rates will add over $400 billion in interest expenses.
The end result of all of this is that many more U.S. dollars will need to be issued to fund these deficits, which means a weaker dollar and higher gold prices.
Stocks are overvalued
The current bull market cannot last forever (it is already one of the longest in history), and when it ends, gold prices are set to benefit. Currently, the P/E ratio for U.S. stocks is 26.5, which is much higher than the long-term average of 15. Every time stocks have reached these levels, a major correction has occurred.
These expensive valuations have been supported by low interest rates, and as interest rates begin to normalize, it is likely that stocks will eventually return to levels closer to long-term averages (as they always have). Investors have greatly reduced gold holdings during the current bull market (which began in 2009), as constantly rising stocks have led investors to abandon usual diversification to an extent.
A correction in stocks should lead investors to re-diversify as they usually do, which should lead to further strength in gold prices. The correction in the U.S. stock market at the start of 2016 resulted in gold prices rising.
How should investors play the coming strength in gold miners? Barrick Gold Corp. (TSX:ABX)(NYSE:ABX) is a smart option, since it is the world’s largest and most stable miner and has an improving balance sheet. Eldorado Gold Corp. (TSX:ELD)(NYSE:EGO) is also a smart pick for investors looking for good production growth and more upside potential.
Motley Fool Canada's market-beating team has just released a brand-new FREE report revealing 5 "dirt cheap" stocks that you can buy today for under $49 a share. Our team thinks these 5 stocks are critically undervalued, but more importantly, could potentially make Canadian investors who act quickly a fortune. Don't miss out! Simply click the link below to grab your free copy and discover all 5 of these stocks now.
Fool contributor Adam Mancini has no position in any stocks mentioned.