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It's been an extraordinary year to be an investor. In just seven months we've witnessed the worst two-week start to a new year in recorded history, and also the most voracious intraquarter rally in the S&P 500 to finish back in the black since 1933.
But the year really belongs to precious-metal and mining investors, who've turned out to be the surprising winners. After a multiyear downtrend that began in 2010 for silver and 2011 for gold, both metals have made resounding comebacks in 2016. Spot gold prices are higher by approximately 25% year to date, while spot silver is up an even more robust 44%. Silver has a tendency to follow the movement of gold, although it's a more thinly traded metal and tends to be a bit more volatile.
The gains we've witnessed in underlying metals have sent mining stocks soaring. All 22 gold miners with a market valuation of $300 million or more are higher this year by at least 38%, with 16 of those 22 up by more than 100%. The story is the same for silver, with all six mining companies specializing in the lustrous metal up well over 100% for the year.
Secondary reasons why gold and silver are soaring
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A number of catalysts have favored gold and silver mining stocks, as well as the underlying metals they produce. For example, uncertainty seems to be the new norm, with Wall Street and skeptical investors just waiting for the proverbial next shoe to fall. Britain's decision to exit the European Union could be one such event that adversely impacts growth in the U.K. and EU in the upcoming years; no one is exactly sure what will happen, considering that there's no precedent for such a move. Uncertainty has also reared its head domestically, with wild jobs figures and weaker-than-expected GDP growth.
Supply and demand is another reason spot metals prices have rallied. They can always rally for emotional or irrational reasons, such as when they spike during rapid stock market corrections. However, metal prices also tend to be driven by the traditional fundamental metrics of supply and demand. Mining companies have really pared back production in recent years, in favor of prudently expanding only their most profitable, lowest-cost mines. What that has done is slowed production growth, at a time when demand -- for both silver from the solar industry, and gold from central banks and investors -- is soaring. As long as demand remains strong, spot gold and silver should have some form of pricing support.
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Gold and silver miners have done an exceptional job of improving their balance sheets and cutting costs over the past three years, in response to the multiyear downtrend in precious-metal prices. Barrick Gold (ABX 3.84%) wound up repaying more than $3 billion in debt in 2015, and has a goal of reducing debt by another $2 billion this year. After ending 2014 with $13 billion in debt, Barrick looks to be well on its way to hitting its intermediate goal of $5 billion in debt by perhaps 2018. Reducing its debt gives Barrick more flexibility, and it also reduces interest payments, which can subsequently improve profitability. As icing on the cake, Barrick Gold also has the lowest expected all-in sustaining costs (AISC) of any major gold producer in 2016, with the median point of its forecast calling for $785 an ounce in AISC.
The real reason gold and silver should keep rallying
However, the aforementioned catalysts are nothing more than secondary reasons to be bullish about spot gold and silver, as well as the underlying mining companies that produce these metals. The single most important reason to be bullish boils down to opportunity cost and yields.
Opportunity cost is defined as "the loss of potential gain from other alternatives when one alternative is chosen." Historically, interest-based assets, such as U.S. Treasuries, money market accounts, or bank CDs, have been steady sources of nearly guaranteed income for seniors and other risk-averse investors. These were assets that regularly outpaced the rate of inflation, meaning they allowed for real wealth creation with very minimal risk. A decade ago, if you had offered investors a choice between a 5% CD and buying gold, which has no dividend yield, most would have chosen the guaranteed income of the CD that was outpacing the rate of inflation.
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Today, though, interest-bearing assets are, in some cases, not even yielding pennies on the dollar. Bank CDs probably aren't even yielding 1%, and Treasury yields are still bordering their lowest yields in history. A 30-year Treasury bond currently yields nearly 2.3%, which would be ahead of the current rate of inflation; however, locking yourself in at 2.3% for 30 years could prove disastrous if inflation does rise anywhere near its historical norm of 3%. Though you'd be making nominal gains, you'd be losing real money if the inflation rate increased. What this means is that the opportunity cost of a sub-1% yield for CDs and money market accounts, or a near-record low yield for T-bonds, makes owning gold and silver more attractive.
Typically, gold and silver struggle to rally in unison with the stock market. The reason is that a stock market rally is a sign of bullishness, and bullishness is often construed as a feeling of certainty among Wall Street and investors. But I believe we could witness something unique: a gold and silver rally hand-in-hand with the general stock market. Why? Because everything is based on yields and opportunity cost. Low yields are allowing businesses to borrow cheaply and invest for their future, while they're also encouraging investors to buy gold and silver, as opposed to bonds and other interest-based assets.
These two stocks will feel an immediate impact from a gold and silver rally
If you're looking for the smartest way possible to play an ongoing rally in gold and/or silver, my suggestion would not be to buy the spot metals themselves. Instead, I would target royalty and streaming gold and silver stocks that have the most to gain from an increase in underlying precious-metal prices.
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The two industry giants are Royal Gold (RGLD 0.99%) and Silver Wheaton (SLW 2.98%). What makes these "mining companies" so unique is that they aren't involved in traditional mine build-out, expansion, and upkeep. Royal Gold and Silver Wheaton, in exchange for an upfront cash payment or series of payments, gain long-term or life-of-mine contracts for the production of specified precious metals. More important, the production they receive from the mining companies they contract with is paid out at well below current spot gold and silver prices.
Take Silver Wheaton as a perfect example. During the first quarter it paid out an average of $4.14 for each ounce of silver it received and just $389 per ounce of gold. This means Silver Wheaton's gross margin is nearly $16 an ounce on silver, and more than $900 an ounce on gold. Even if gold and silver prices dropped substantially, Silver Wheaton and Royal Gold would remain profitable, which is reassuring for investors.
Royalty mining companies are also more liable to pay a dividend, which can further boost your results. Again, this dividend is going to be based on the price of the underlying metals received. In other words, if spot gold and silver keep rising, the chances of Silver Wheaton or Royal Gold raising their payouts rises as well. Currently, Royal Gold and Silver Wheaton are paying out 1.2% and 0.8%, respectively.
If gold and silver are going to rally further, both of these companies could be worth a serious look.
