Cheap Gold Stocks 3

Gold stocks have recovered sharply following last month's panic-like capitulation plunge. But this embattled sector still remains incredibly cheap relative to prevailing gold levels, which drive gold miners' profits and hence ultimately their stock prices. While it is very challenging psychologically to buy in deeply-out-of-favor sectors, the panic-like gold-stock bargains out there today are simply amazing.

Speculators and investors have long bought gold stocks for one primary reason, to leverage the price of gold. Between the April-2001 dawn of today's secular gold bull and 2008's once-in-a-lifetime stock panic, gold stocks indeed leveraged gold beautifully. When gold rallied in major uplegs, the flagship HUI gold-stock index would generally amplify this metal's gains by at least 2x to 3x. It was wildly profitable.

But unfortunately that epic stock panic, a perfect storm of fear, broke this normal and well-established bull-market relationship. Most of the pre-panic gold-stock traders couldn't handle the extreme stress of the panic, which drove the HUI to plummet 68% in less than 3.5 months. The psychological damage that event wreaked was vast beyond imagining, scaring away an entire generation of gold-stock investors.

But of course the worst time to sell is when you most want to, when things look the bleakest. That is when prices are as low as they're going to get. So I advised our subscribers to buy gold stocks aggressively in the dark heart of the stock panic, when all hope was lost. And indeed they recovered sharply. By September 2011, the HUI hadmore than quadrupled to dazzling new all-time highs!

This performance was mind-boggling by any standard. Over this same 34-month time frame, the general stock markets as reflected by the S&P 500 merely rallied 40%. Commodities as a group measured by the CCI more than doubled this with an 83% gain. And gold's 155% surge dwarfed them all. But all these pale in comparison to the monster 319% HUI run birthed deep in the panic's fear maelstrom.

So the stock panic definitely didn't kill gold stocks, they've shown incredible strength since. But it did frighten away a large fraction, maybe even the majority, of pre-panic gold-stock speculators and investors. And since it takes years for new traders to rise up and replace the fallen, the gold stocks haven't made anywhere near as much headway as they should have given the high prevailing gold prices since.

In the first half of 2008, before that stock panic's epic discontinuities hit, gold averaged $911 on close. By the last half of 2011, this number surged 86% to $1695. But meanwhile the average HUI close only rose from 443 to 559, up 26%. The gold stocks have lagged gold's progress dramatically in this post-panic era, gaining less than 1/6thof their historical minimum baseline leverage of 2x gold's advance.

This great divergence naturally continues to vex traders, who wonder if it is a temporary anomaly or the new normal. The answer likely lies in profits. Universally in the stock markets, profits drive long-term stock prices. The more a stock or sector can earn, the more investors will bid it up to reflect higher earnings streams. Stock ownership is ultimately just a fractional stake in companies' profits.

In gold mining, profits are overwhelmingly dependent on the price of gold. The more these miners can sell their product for, the higher their profits rise. So if today's higher prevailing gold prices are translating into proportionally-higher profits, then gold stocks are radically undervalued relative to the price of gold. And indeed this is the case, as we've extensively researched gold-mining profitability as a whole.

Impressively, between 2008 and 2011 average gold-mining profits soared 108% from $440 per ounce to $915 per ounce! And the actual gross margins grew too, from 50% in that panic year to 58% last year. So while gold-mining costs are indeed rising as gold-stock bears love to point out, profits are growing much faster. Thus the gold stocks will ultimately have to be bid up to reflect higher prevailing gold prices.

Just how cheap are gold stocks today? My favorite metric for exploring this is the venerable HUI/Gold Ratio. The HGR simply divides the daily close of the HUI gold-stock index by gold's own. When charted over time, this basic ratio reveals trends in the relative performances of gold stocks and gold. A rising HGR shows gold stocks outperforming gold, while a falling one shows the miners lagging their metal.

I've updated this chart every few months since the stock panic, because its implications for gold stocks are wildly bullish. In it the blue HGR line is superimposed over the raw HUI in red. Of course the panic's impact on gold stocks was massive beyond belief, so that epic discontinuity abruptly divides gold-stock performance. Normal secular-gold-bull gold-stock behavior was seen for many years before the panic.

Between the middle of 2003 and the middle of 2008, just before the stock panic, the HGR trended sideways in a tight secular trading range between 0.46x and 0.56x. Both upside and downside breakouts were rare and short-lived. The 5-year pre-panic-average HGR weighed in at 0.511x. In other words, gold stocks as measured by the HUI tended to trade around half the prevailing gold price at any time.

While the panic understandably terrified everyone, there was no reason why gold stocks shouldn't have soon recovered to pre-panic levels. And indeed this happened in the raw HUI itself. By December 2009, just 13 months after the panic lows, the HUI was back up near its March 2008 all-time highs. And gold stocks continued powering higher from there on balance, hitting new record highs in 2010 and 2011.

But relative to gold, the product that drives gold miners' profits and hence ultimately stock prices, the gold stocks weren't doing anywhere near as well after the panic. Following an initial fast recovery in 2009, the HGR stalled out and stabilized in 2010. But it was still low relative to its pre-panic average, not even into that secular trading range yet. At the time it looked like the HUI was basing ahead of a catch-up surge.

But unfortunately last spring the HGR started breaking down again. It wasn't because gold stocks were falling, they were holding their own near all-time highs. But the price of gold was surging on US debt-default fears and the gold stocks weren't following. A rare summer rally catapulted gold to huge gains, but the gold stocks failed to leverage them. So the fragile confidence in this sector quickly eroded.

When the overbought gold price corrected last autumn, the gold stocks got sucked in like usual even though they didn't participate in gold's preceding surge. But the HUI soon found major support near 500, and stood strong as gold continued lower. But a sharp commodities selloff in March 2012 on the latest no-QE3 scare was too much to for gold-stock traders to bear psychologically, so they sold aggressively.

This snowballed into a rare full-blown capitulation, which climaxed at extreme levels in mid-May. The sharp plunge in the HUI and collapse in the HGR are readily apparent on this chart. Gold stocks were driven back down to panic levels relative to the price of gold! So naturally sentiment was utterly rotten, nearly as hyper-bearish as it had been in the stock panic's dark heart. It felt like a bloodbath.

On May 15th, the HUI/Gold Ratio actually closed at 0.244x! To give you an idea of how extreme this is, the HGR only closed below 0.25x on 10 separate trading days during the entire stock panic. Last month was only the second time such incredibly-low levels were seen in this entire secular gold-stock bull, which is over 11 years old now. Gold stocks were truly trading at panic levels relative to gold last month!

Of course such valuations for gold stocks were absurd fundamentally. The HUI closed at 376 when the capitulation bottomed. The first time this index hit 375 in this bull was in April 2006 when gold had just exceeded $625. But the HUI couldn't sustain 375 until over a year later in September 2007 when gold first crossed $725. Yet in mid-May 2012 when the HUI fell to 375 again, gold was trading near $1550!

With gold over twice as high and gold-stock profits massively higher, there was zero fundamental justification for this gold-stock capitulation. It was purely a psychological event. The gold-stock traders foolishly allowed themselves to get so scared that they battered down the gold stocks to trade as if gold was in the $700s. Thankfully sentiment-driven extremes never persist, fear quickly burns itself out.

Indeed gold stocks have already started bouncing back sharply, as is evident in both the HUI and HGR. But there is almost certainly a long way to go yet in both absolute terms and relative to gold. After similar extreme lows in the stock panic, the HUI soon regained its pre-panic highs. A comparable recovery today would push the HUI back up to September 2011's 635 within 13 months of May's low, by next spring.

But gold stocks' likely performance relative to gold is far more interesting. Absolute worst case, the HUI should soon mean revert to its post-panic average HGR which ran 0.358x. Assuming gold does nothing, just drifts around $1600 listlessly, this implies a HUI around 573 by autumn. This ultra-conservative assumption yields a projected gain of 28% in the HUI, which smaller gold stocks will greatly leverage.

After such a rare fear extreme as May's capitulation, I suspect a higher-probability rally in HGR terms is back up near the top of its post-panic trading range. Once sentiment gets dragged too far in one direction, it tends to rebound back to the opposite extreme before stabilizing. At September 2009's 0.437x HGR, we would be looking at a 699 HUI if the gold price stayed flatlined. This is a huge 56% gain from today!

But our ongoing research into gold-mining profit levels makes me much more optimistic than merely thinking in post-panic terms. Gold miners are earning money hand over fist, doing incredibly well. So their price-to-earnings ratios are falling like stones, and sooner or later big institutional contrarian value investors will take notice. So I still fully expect to see the pre-panic average HGR of 0.511x regained.

What would gold-stock prices look like in this scenario? This next chart zooms in to see. In addition to the HGR in blue and the raw HUI in red, I added a third series in yellow which is where the HUI would be hypothetically trading at its pre-panic average HGR of 0.511x. While it may seem wildly optimistic given today's rampant gold-stock bearishness, such valuations would not be a stretch at all fundamentally.

As this yellow hypothetical-HUI line reveals, today's $1600ish gold would support a HUI level near 818! This is about 83% higher than today's gold-stock price levels, a mammoth gain by any standard. In addition to the fundamental profit support for this thesis, the post-panic example of the HGR rebounding sharply after lows not much more extreme than May's also argues this is beyond possible to probable.

The recent gold-stock capitulation that drove the HUI/Gold Ratio collapse hammered the actual HUI to its lowest levels relative to the hypothetical HUI since the stock panic. It was merely at 48% of where a 0.511x HGR would have put it, compared to reads at major interim lows and highs since the panic ranging from 61% to 82%. So even by post-panic standards, gold stocks are ridiculously cheap today.

And the recovery rally has already started, just as I predicted it would right after May'scapitulation. As of early June the HUI had surged 21.0% out of those extreme lows over a time frame where gold was only up 4.9%. As this momentum builds and more and more speculators and investors realize how radically undervalued gold stocks are, this rally will only accelerate. It will probably mirror 2009's gigantic surge.

While it may seem like there is no way we'll ever see pre-panic HGR levels again, consider silver's example. It too had a pre-panic relationship with gold that was shattered in the stock panic. And it too looked like it would never return to pre-panic levels relative to gold. But silver eventually won a broad trader following again, and inlate 2010 and early 2011 new capital flooded into this forsaken metal.

So not only did silver regain its pre-panic levels relative to gold, it greatly exceeded them in the spring of 2011! And even this week, with silver almost as out of favor as gold stocks, it is still trading right around its pre-panic average relative to gold again. Sooner or later some catalyst will come along that will explosively reignite interest in the abandoned gold-stock sector, and capital will return with a vengeance.

I suspect it will simply be a rallying gold price. As you know, with the mess in Europe and crucial US elections looming this year, we face an environment riddled with intenseuncertainty. Anxiety is only going to grow into early November, and possibly even into early 2013 as we wait to see how the new Congress will act. Gold is going to look increasingly appealing as the future remains terribly opaque.

And of course a new gold upleg ratchets up the gold-stock price projections based on the HUI/Gold Ratio accordingly. All of them here use the conservative (and unrealistic) assumption that gold will merely drift sideways around today's $1600 level. If it heads up over $2000, which a surprisingly number of elite research houses are predicting for later this year, all the HGR-based HUI projections rise 25% as well.

It's also important to remember that the giant slow-moving gold miners naturally dominate the HUI. A major gold and gold-stock upleg would translate into smaller high-potential gold stocks, both elite junior explorers and small producers, leveraging the HUI's gains by several times or more. So the opportunities in quality smaller gold stocks today for hardened contrarians who can handle the stress are tremendous.

Over the past decade we and our subscribers have earned fortunes trading the best stocks in the vast junior-gold realm. So we are constantly researching the many hundreds of publicly-traded junior golds. Quite fortuitously given how cheap gold stocks are relative to gold today, we just finished our latest deep-research project. We spent several months painstakingly whittling down this pool to our dozen favorites.

They are profiled in depth in a fascinating new 27-page fundamental report we just published this week. Now available on our website for just $95 ($75 for subscribers), it is a steal for the fruits of hundreds of hours of expert world-class research. It documents our favorite junior gold stocks' histories, projects, plans, and incredible future potential.Buy your copy today, take advantage of dirt-cheap gold stocks!

Of course we also publish acclaimed weekly and monthly subscription newsletters loved by speculators and investors worldwide. In them I draw on our vast experience, knowledge, wisdom, and ongoing research to explain what the markets are doing, why, where they are likely heading, and how to trade them with specific stock trades as opportunities arise. Subscribe today and get deployed!

The bottom line is gold stocks are incredibly cheap relative to prevailing gold prices. Last month's capitulation by scared traders hammered gold stocks to their worst levels relative to gold since 2008's once-in-a-lifetime stock panic. After that earlier extreme, gold stocks rocketed higher to regain some fundamental balance with the metal that drives their profits. A similar rebound is now due again.

Even to merely regain post-panic-average levels relative to gold, the major gold stocks would have to surge dramatically higher. But with gold-mining profits hitting new records, fundamentals certainly support the far-more-optimistic pre-panic levels. With this rebound rally so young, brave contrarians have a heck of an opportunity to capitalize on this short-lived anomaly and buy today's cheap gold stocks.

Adam Hamilton, CPA

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