How to prosper in stocks during a downturn

At Formula Stocks, our specialty is Artificial Intelligence-based stock analysis. Using this quantitative bottom-up approach to stock selection often yields interesting results. Upon entering 2021 we found that over 30% of our AI-based portfolio is in precious metals-related stocks, a clearly unusual concentration for a generalist approach.

We found this interesting to look into through a human analytical prism as well and would like to share the results. Since the complete analysis would fill a book, please forgive us for skipping straight to the conclusion for the sake of brevity.

But first a bit of background. Both the business cycle and the larger credit cycle will be coming to an end in the coming years. This will result in downward pressure on the economy. Once some asset values go down, there is going to be a rush to safe havens which are becoming unusually difficult to find this time.

Usually, the dollar is a candidate, but this time structural problems (too much debt, deficits, and a balance sheet at the FED with a very long duration) may likely reduce the value of the dollar going forward making it a more risky proposition. Plus there is an ongoing de-dollarization at work throughout many parts of the world due to too many sanctions applied. This decreases foreign appetite for holding large dollar reserves. Do not be surprised if the dollar in a few years buys 30% less goods than now. Also, do not be surprised if a devaluation (by either market forces or government actions) would later ramp the US economy into a higher gear. The US needs a lower dollar, even if it has not yet fully realized to which extent.

Bonds are also at risk. While usually considered a safe haven, the bond bubble might burst after a three decade long bull market, even if it is highly uncertain if and when. If not, the currency component still represents risk. A possible crisis might be lurking beneath the surface in corporate bonds, and should it ignite, it may lead to a larger revaluation of the real risks in bonds, which are currently conveniently overlooked by the market. In particular small cap equities have seen a large increase in leverage in recent years, which increases risk. As for currencies elsewhere, they generally have their own structural problems.

So what is left as a safe haven that will maintain purchasing power, remain liquid, and entail little or no counterparty risk? Precious metals and commodities in their physical (non-derivative) form as well as ownership of gold ounces in the ground.

Since gold peaked in 2011, gold mining equities have dropped 70% in a move that is already beginning to reverse. This leaves this sector as one of the most unwanted and underappreciated sectors out there. Where else can you find cash flow-producing businesses with great growth prospects trading at only 50% of the book value? Okay, we can think of a few other niches too, but in the bigger picture, gold mining equities have tremendous upside, once the gold price recovers, which it will, and in time this 70% drop will be fully retracted.

This sector is one of the few that has not participated in the “everything bubble”. And as for gold, the backdrop seems close to perfect for it to start appreciating soon enough. Gold is money and the only kind of money that has survived for thousands of years, due to its nature of being unencumbered by the repetitive mistakes of politicians and sovereigns throughout history.

Gold is going to go up in the long run. Many of these reasons are related to structural, macro, and monetary issues, and an overwhelming large culturally based buying interest from an increasingly affluent Asian population. At the same time, the gold sector is among the most undervalued, when taking into account that gold itself is undervalued, and will rise in the future. This leads us to the conclusion that a future bull market is extremely likely in precious metal equities. These equities generally offer a factor 2 to 3 upside during a bull market, relative to the price of physical gold, as they represent ownership of existing gold assets in the ground that are becoming more economical to extract.

History is replete with examples of downturns which, while reducing values of procyclical assets, have increased the value of gold mining equities simultaneously. The classic example is 1929–1935, a period in which the Dow Jones Industrial Average dropped -64%, while the largest US gold miner at the time, Homestead Mining, rose no less than +520%. This was a deflationary crash, and while we do not expect this particular type of crash scenario in the future, rather an inflationary or stagflationary period, it is just one example of many that illuminate the often counter-cyclical nature of gold miners.

Another interesting example is that of the transition from a low-interest period to a higher-interest period. Effectively a bear market in bonds. Between 1960 and 1980 gold mining equities soared nearly 40-fold.

Returning to our core area of analysis: Artificial Intelligence. Whereas a human-based analysis is seconding an investment in gold equities, it is notable that our AI system invests in this area for different analytical reasons. Its logic is centered around value and growth, which, as Warren Buffett likes to say, “is joined at the hip,” and this as well as a margin of safety are guiding principles of our AI. Along with projecting a probable non-linear future, It identifies interesting value and growth opportunities which are typically not available anywhere else.

What we have here are two different types of analyses yielding the very same result, both in terms of top-down macro and bottom-up micro perspectives, human and AI viewpoints, value, and growth. We believe that we are well prepared to beat the market again in 2019, even if it is going to be a generally somewhat difficult environment for stocks. Even under adverse conditions, there are pockets of winners simply if you know where to look. These can offer a solid cornerstone in how to prosper through a coming downturn.

See which mid-to-large cap precious metals stocks we rate as having the best risk-reward ratio via a free trial membership of www.formulastocks.com.