MW Stocks and gold are both at record highs. Only one will be right on inflation.

By Michael Brush

Gold's gain is warning the stock market that higher inflation could return

'Gold is telling us that either we are going to have a recession or inflation will be sticky. Or both.'Christopher Mancini, co-manager of the Gabelli Gold Fund

U.S. stocks are approaching lofty valuations not seen since right before the 2022 bear market, so gold also hitting all-time highs is a problem - because only one of them can be right.

Gold (GC00) is considered a safe haven in times of economic and political distress. The yellow metal's surge signals investors' caution about the economy and the U.S. Federal Reserve's ability to contain inflation, says one of the gold sector's top experts.

"The action in gold tells us the market is becoming increasingly skeptical that the Fed is going to be able to engineer a soft landing" for the U.S. economy, according to Christopher Mancini, co-manager of the Gabelli Gold Fund GOLDX. "Gold is telling us that either we are going to have a recession or inflation will be sticky. Or both."

Recession and inflation are bad for stocks. And that last option, known as stagflation, is a big negative for stocks, too. Stagflation contributed to extended stock market malaise during the 1970s. "Gold is pricing in a high probability of one of these three not-so-great scenarios playing out," Mancini says.

Mancini is a good source on the meaning of the high price of gold because his fund performs so well. Gabelli Gold Fund beats both its Morningstar precious-metals fund category and benchmark index nicely over the past three years, says Morningstar Direct.

Gold goes higher from here

If you are nervous about stocks, consider putting some money into gold. Gold reached an all-time high of $2,685 an ounce in September, but it has room to move higher, say gold experts. Here are three reasons why:

1. Central banks around the world will continue to buy gold: China's central bank has taken a break on buying, but it will be back, predicts Shree Kargutkar, a co-portfolio manager of the Sprott Gold Equity Fund SGDLX, which also has outperformed its Morningstar precious metals category and index over the past three years.

Says Kargutkar: "If China is trying to be a more dominant player economically, it would be very surprising if it did not have a much bigger central bank position in gold." China is the world's second-largest economy but its central-bank gold holdings do not even rank among the top five. Besides China, central banks in Russia, India, Poland and Turkey, among others, have been buying gold.

2. Central banks are cutting interest rates: Besides the Fed, central banks in Canada, the U.K. and Europe have been reducing interest rates. As rates come down, the opportunity cost of owning gold (the foregone interest earnings) is lowered, which supports demand. "This will be the next big tailwind for gold," says Kargutkar.

3. Retail buying is strong worldwide: Consumers in India are picking up the slack from China because India has reduced import taxes on gold, thereby lowering the price. "As a result, the appetite for gold imports has increased over past few months," says Kargutkar.

Of course, the wild card for gold is that it turns out to be right on its ominous forecast for the U.S. economy. Any trouble on the economic front could push gold prices higher. "If the Fed does not engineer a soft landing or it doesn't seem likely to happen, then gold is going to do well," Mancini says.

Go with gold stocks

Gold-mining companies are making a lot more money on each ounce produced.

If you are interested in exposure to gold, it makes sense to own shares of the gold miners as well as the metal itself. So far this year, gold stocks and gold are up by about the same amount. But this makes no sense, because of the favorable operating leverage for gold companies. "I think gold stocks should be up more than gold year to date," Mancini says.

Here's what he means by operating leverage in gold companies: The average cost to mine an ounce of gold is the same as it was last January. Yet the price of gold is up more than 28%. So gold-mining companies are making a lot more money on each ounce produced.

At the beginning of the year, the average gold mining company paid $1,400 an ounce to mine gold, and the price of gold was around $2,100. Gold companies (on average) earned $700 an ounce of gold mined.

Now, with gold near $2,800, profits per ounce have about doubled. The increased profitability is reflected in gold mining companies' free cash flow. "But it hasn't really been reflected in gold mining stock prices," Mancini says. Gold mining companies are putting the extra cash to good use to buy back stock, pay down debt, and pay shareholder dividends.

Here are five gold mining companies Mancini singles out from his mutual fund holdings. They were chosen in part because they are low-cost producers with long-lived assets that generate lots of cash being used to buy back stock and pay down debt.

1. Kinross Gold: Based in Canada, Kinross $(KGC)$ is developing an expansive mining asset called Great Bear. Mancini thinks the investment will pay off for shareholders by producing high profit margins and plenty of free cash flow.

2. Eldorado Gold: El Dorado $(EGO)$( )has mines in Turkey and Canada, and is developing a large operation in Greece.

3. Northern Star Resources: A large gold mining company in Australia, Northern Star (AU:NST) also has a mine in Alaska. Geopolitical risk for the company is low. Northern Star is developing a large mine in Western Australia that will be one of the biggest, and lowest-cost mines in the world, Mancini says.

4. Endeavour Mining: Endeavour (UK:EDV) has mines in West Africa, and faces the risks of nationalization or political instability that could impact production. The company also recently fired its CEO. Both of these factors have depressed the stock price. Yet the company boasts a free-cash-flow yield of 25%, compared to 8% at Kinross. "It is worth the risk to own the stock because it is so cheap," Mancini says.

5. Artemis Gold: Artemis Gold (CA:ARTG) is developing a big mine in Canada's British Columbia, which means geopolitical risk is low. Called Blackwater Mine, it will be one of the largest, lowest-cost mines in the world.

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush publishes a stock newsletter called Brush Up on Stocks. Follow him on X @mbrushstocks

More: Gold may not reach a price ceiling anytime soon. Here's why.

Also read: Silver's scarcity factor is helping it catch up to gold's record run

-Michael Brush

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October 26, 2024 13:29 ET (17:29 GMT)

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