The year has just begun and there has not been a dull moment. The frightening volatility of early January resulted in relentless selling and panicked calls for lower lows from commodity and market generalist analysts alike. But the value waves in precious metals prices seem to have already been forgotten. Instead, a new, perhaps unfamiliar, emotion has emerged: hope.
As of Friday’s close on February 26th, gold in US dollars was up 15% (the strongest first quarter rally since 1980) , the Market Vectors Junior Gold Miners ETF (GDXJ) was up 29% and the Market Vectors Gold Miner ETF (GDX) was up a whopping 36% year to date.
The mood has also begun to change in the mining landscape. Companies that were reluctant to raise equity due to beaten down share prices are beginning to come up for air. Franco Nevada, after having announced a bought deal financing for $550 million in mid-February to support the purchase of additional streaming contracts, saw its share price break a pattern: the stock rose after the announcement. Noting greater demand, this prompted the company to increase the total financing round to $800 million. 
Mergers and acquisitions have also begun to pick up steam. Tahoe Resources kicked off the year by announcing a $650 million all-share deal for Lake Shore Gold and Sumitomo spent $1 billion to purchase a larger stake in Freeport’s Morenci mine . Signs of health are in the air and many of the same analysts that predicted that 2016 would be the same as previous years have begun to change course. With gold on the rise, valuations of miners finally showing some strength, and five years of a bear market behind us, have we finally hit bottom? Or is this just a seasonal rally?
If past is prologue, previous years have shown a particular pattern that is similar to what we are seeing in today’s markets. Looking at the past four years (including the first part of this quarter), both gold and the miners have exhibited strength in the first quarter of the year.
One can see that, despite gold and miners ending the year considerably lower than where they started, the first quarter of each year showed signs of a seasonal rally. Four of the five last years saw gold peak above 10% and three out of five saw the GDX climb over 20%.
So is this year any different? For one thing, the magnitude of the performance far exceeds what we’ve seen in years past. Gold has had its strongest first quarter rise since 1980, and there are some stark differences to previous years.
Within the context of the broader market, one clear distinction between 2016 and others is that the broader bull market rally clearly is losing steam. The Dow and S&P are off over 4% since the beginning of the year. The Second Tech Bubble seems to have finally burst, with shares of hot tech stocks like LinkedIn, Fitbit and Yelp all having plunged more than 40% within the first six weeks of 2016.  In return, gold has begun to act as a perfect hedge against this volatility.
Sprott Analyst Trey Reik recently broke down other macro factors which are affecting gold prices. You can read his full report here. The below graph shows the YTD performance of gold compared to the Dow.
With all this volatility on the broader markets, investors are looking for places to park their cash in an effort to preserve wealth.
We cannot discuss gold or the equity markets without a discussion on the US dollar.
Over the last five years, the Dollar Index (DXY) has been on a strong run, culminating in an unprecedented rally in the later part of 2014.
Last year the dollar wiped out most other developed world currencies, including the yen, the euro, the pound, the Canadian and Aussie dollars. Many investors believe the dollar’s rally is over, and are looking to take their currency trade elsewhere in search of the next gains.
After five strong years, why the change in sentiment now? Dovish comments from the Fed, including Janet Yellen’s statement of using negative interest rates as a potential tool, have been one of the leading contributors spooking dollar bulls. The Fed’s anticipated interest rate hike in March, which even in the beginning of the year seemed to have been set in stone, now looks to be increasing unlikely, thanks to a weakening economy and equity market, which has caused yields on treasuries to fall. Further contributing to the dollar ‘s decline, the Chinese central bank (PBOC), which holds a massive foreign currency reserve of $3.2 trillion, has sought to diversify outside of the dollar by selling USD after its recent run, and buying cheaper euros and yen instead. 
But the dollar run may not yet be over. While these pressures may be strong enough to weaken the USD in the mid-term, the countervailing tailwinds which boosted the USD are still in effect. Central banks around the world are still desperately attempting to depreciate their own currencies in an effort to boost their economy, meaning the USD could continue to rise on a relative basis. The most notable example of this includes the ECB and BOJ experiments of entering into an era of negative interest rates: there is a real possibility that depositors will be charged a fee for depositing their cash. Sweden, Denmark and Switzerland have all followed suit in an attempt to punish banks that hoard their cash and force them instead to lend out capital as a means of spurring growth.  Whether central banks want to admit it or not, they are engaged in a very real currency war. They face the threat of stagflation, a falling velocity of capital and their only real weapon against it is continued currency devaluations, the ramifications of which could have drastic and prolonged unintended consequences.
With the fate of the dollar and the Federal Reserve’s plans unknown, combined with the apparent slowdown to the third longest bull market in history, the market’s appetites toward gold in the first part of the year may be something very different than a seasonal fluctuation. I am not yet prepared to venture out on a limb and say there is a certainty that we have hit bottom in gold prices, but I will state that there is a strong possibility.
Assuming we have, and this is indeed a start to a real run in the gold price, what do we as inventors do to take advantage of the situation?
For gold investors pondering the early 2016 gold rally, there are two schools of thought. Either the recent run is a temporary one which will last for a few weeks, sparked by a flight to safety as other asset classes start to come down, or this is the start to another long run bull market in gold, as the market begins to recognize that the asset is undervalued at current prices.
In a recent Sprott’s Thoughts article, Rick Rule spoke about optionality. Rick suggests buying producers or companies that are either in production or near production. These projects may not be profitable at current gold prices, but will be if gold goes higher and therefore provide immense leverage. Note this is an aggressive strategy that does not necessarily require investors to buy quality, high margin producers or projects that are already economic at today’s or even lower gold prices. One who chooses to follow such a strategy has to be cognizant of the risks involved.
Remember that leverage works both ways. If this market instead takes a turn for the worse and gold goes lower, the optionality plays will underperform their higher-quality peers. One can see the big gainers year-to-date have been senior producers that have high leverage and narrow margins:
Another important factor to note is the flow of funds in the start of a bull market. Typically, when generalist investors begin to see the price of gold rise, they first allocate capital to the most commonly followed ETFs (e.g. GLD, and GDXJ). Thereafter, they move towards senior producers. As the bull market moves forward and the ETFs and senior producers become fully valued, investors seek to boost their returns and allocate capital to higher risk and reward small cap junior producers and explorers. Indeed, we have seen this pattern this time around with capital flowing towards GDX (the components of which are large cap gold producers) more so than GDXJ (the components of which are small and mid-cap producers and exploration companies:
This shows the money moving into the sector is typically going to larger, more liquid names, since the beginning of 2016.
Therefore, for those investors that are looking to boost returns, and willing to risk a short-term, “fake” rally, should focus on senior, narrow margin producers or development stage companies.
For the other set of investors that are looking to play the more cautious approach, the best approach is sticking with higher quality companies that are either developing economic projects or producing with high margins.
As a rule of thumb, whether you are buying into a bull or bear market, the best results are always to take advantage of market corrections.
On a final note, for those readers who have made mistakes in the past that they sorely regret, this market has provided an ideal opportunity to sell the losers and reallocate. Remember, if you wouldn’t personally buy a position you hold today, you should not continue owning it.
If you have any questions about this article, please contact your Sprott Global broker or the author, Mishka vom Dorp at 760-444-5254 or through email at MVomDorp@sprottg lobal.com
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