Stocks’ Last Cheap Sector

The lofty stock markets suffered a sharp selloff this week that may prove a major inflection point.  There was one lone sector that bucked the heavy selling to surge in the carnage, the gold miners’ stocks.  They are the last cheap sector in these bubble-valued stock markets, long overlooked and neglected.  Wildly undervalued today, the gold stocks have great potential to soar dramatically even if stock markets keep weakening.

Just several weeks ago, the US stock markets hit new all-time record highs stoking universal euphoria.  The flagship S&P500 broad-market stock index (SPX) closed at 2930.8 in late September, extending its monstrous bull to 333.2% over 9.5 years.  That made for the 2nd-largest and 1st-longest in US stock-market history!  It also left these markets dangerously overvalued, literally trading at bubble valuations.

Exiting September, the elite stocks of the SPX sported an average trailing-twelve-month price-to-earnings ratio way up at 31.4x.  Weighted by market capitalization, that was even more extreme at 34.9x.  Over the past century and a quarter or so, bubble valuations start at 28x earnings.  So the stock markets were ripe for a fall, and the catalyst would prove surging 10-year Treasury yields along with a hawkish Fed chairman.

While the SPX started weakening last week as 10y yields blasted to a 7.3-year high, the serious selling finally erupted this Wednesday.  The SPX plunged 3.3% to 2785.7, taking its total pullback from the peak to 4.9%.  Leading the way down were the market-darling mega tech stocks, which have valuations much more expensive than the general markets.  Everything was sucked into that frenzied selling, with one exception.

The gold miners’ stocks were an island of green in that roiling blood-red sea, their leading sector benchmark actually rallying 1.3%!  That is the GDX VanEck Vectors Gold Miners ETF.  That seemingly-impossible divergence is exceedingly important for investors to understand.  It is the key to generating great wealth when everything else burns in what will likely snowball into the long-overdue next bear market in stocks.

The gold stocks are a unique sector because stock-market fortunes aren’t their primary driver.  Instead they mirror and amplify the trends in gold, which directly drives their profitability in leveraged fashion.  Gold rallied 0.3% to $1194 Wednesday as investors finally started to return.  The major gold miners of GDX surged 3.9x that much, despite the flaring stock-market fears.  Such contrary action is nothing new.

Weakening stock markets motivate investors to prudently diversify their bleeding stock-heavy portfolios with gold.  Their buying bids gold higher, which eventually fuels monster gold-stock bulls.  Within and after the last secular stock bear, the gold stocks skyrocketed.  GDX was born in the middle of that epic run in May 2006, so we need to use an older benchmark to remember why gold stocks are compelling in stock bears.

Between November 2000 and September 2011, the HUI NYSE Arca Gold BUGS Index soared a truly-astounding 1664.4% higher.  You read that right, the world’s most-hated sector today multiplied wealth by nearly 18x across those 10.8 years!  The SPX actually slumped 14.2% in that span, but was down as much as 56.8% at worst when a mid-secular-bear cyclical bear climaxed.  So investors returned to gold in a big way.

In roughly the same span, it powered 638.2% higher in a massive secular bull.  The HUI leveraged those gains by 2.6x, right in line with the usual 2x to 3x it has seen historically.  If the stock markets are finally on the verge of another bear driven by record Fed tightening, this gold-stocks-to-the-moon cycle is going to repeat.  Gold will be bid for years as investors slowly rebuild normal portfolio allocations, so gold stocks will fly.

This leveraged relationship between gold miners’ stocks and gold prices is deeply fundamental and easy to understand.  While the major gold miners of GDX will report their Q3’18 financial results over the next month or so, their latest-available data is still Q2’s.  That quarter their average gold production cost was $856 per ounce in all-in-sustaining-cost terms, which is way under even Q3’s low average gold price of $1211.

For easier calculations, let’s round these to $850 AISCs at $1200 gold, which yields profits of $350 per ounce.  If gold rallies 10% to $1320, the major gold miners’ profits surge 34% to $470.  A 20% gold upleg to $1440 boosts these earnings to $590, a big 69% gain.  And a little 30% gold bull to $1560 catapults the industry profits 103% higher to $710!  Gold-mining earnings have big leverage to prevailing gold prices.

The costs of gold mining are largely fixed during mine-planning stages, when engineers and geologists decide which ore to mine, how to dig to it, and how to process it.  The actual mining generally requires the same levels of infrastructure, equipment, and employees quarter after quarter with little changing in throughput terms.  Thus average AISCs don’t move around much even when gold prices climb far higher.

Gold-mining profits and thus gold-stock prices would double with a mere 30% gold bull!  And that’s not a stretch at all.  Back in early 2016 gold investment returned to favor in a major way after back-to-back SPX corrections spooked stock investors.  American stock investors in particular buying shares in the leading GLD SPDR Gold Shares gold ETF drove gold 29.9% higher in just 6.7 months in essentially the first half of 2016!

The major gold miners of GDX reacted with a massive 151.2% bull upleg in that ETF’s share price in just 6.4 months in roughly that same span.  That made for outstanding 5.1x upside leverage to gold.  So the idea that gold stocks soar when weakening stock markets spur gold investment demand is based on historical precedent.  This week’s gold-stock rally on an SPX selloff is just a small foretaste of the feast to come.

If gold stocks were already super-expensive like mega tech stocks, the psychology of rising gold prices would still drive them higher.  But this small contrarian sector has been forsaken and left for dead for the last couple years or so.  Investors wanted nothing to do with gold and its miners’ stocks as the general stock markets levitated on Republicans’ massive corporate tax cuts.  So gold stocks are swirling in the gutter.

Their valuations relative to gold are exceedingly low today, an extreme anomaly.  Because they are so deeply out of favor, their stock prices are radically disconnected from their underlying profitability even at $1200 gold.  That means their coming upside as investors return to gold is much greater than it would be normally.  Gold stocks need to mean revert far higher to merely reflect today’s gold prices, let alone future ones.

Gold-stock valuation trends can be understood and gamed through a simple proxy, the ratio between their stock prices and the underlying metal which drives their profits.  Since American stock investors prefer to deploy capital in GDX for gold-stock exposure and GLD for gold, we can construct a GDX/GLD Ratio to analyze this key fundamental relationship.  This GGR reveals gold-stock prices are ridiculously low today.

This GDX/GLD Ratio rendered in blue simply divides the daily closes in GDX and GLD.  Charted over time, this reveals whether gold stocks are relatively cheap or relatively expensive compared to the metal they mine.  This Wednesday even after gold stocks’ counter-market surge, the GGR was still only running 0.165x.  That’s very low in secular terms, highlighting how undervalued gold stocks are relative to gold.

Gold itself remains in that bull market ignited in mid-December 2015 immediately after the Fed’s first rate hike of this cycle.  Gold soared in the first half of 2016 after American stock investors returned to GLD with a vengeance following the first stock-market corrections in years.  Once these guys remember stock markets can’t rally indefinitely because they are forever cyclical, they shift some capital back into gold to diversify.

Gold started falling out of favor again after the SPX started climbing to new record highs in mid-2016.  And all that accelerated dramatically after Trump’s surprise election victory late that year.  Republicans controlled both sides of Congress, so stock markets soared on hopes for big tax cuts soon.  While gold fell in a huge correction, it didn’t exceed the -20% new-bear threshold.  Gold’s bull has consolidated since.

Because gold-stock fortunes are overwhelmingly dominated by gold’s own, this sector is still considered to be in a bull market because gold is.  During the past 2.8 years of gold’s bull, the GGR averaged just 0.187x.  GDX’s share price tended to close at just under a fifth of GLD’s share price since gold’s current bull was born.  That is exceedingly low historically, not normal at all.  The GGR needs to mean revert far higher.

Again GDX was launched back in May 2006, when gold stocks were really in favor after rocketing higher in their young secular bull.  Over the next 2 years, the GDX/GLD Ratio averaged 0.591x.  If the gold stocks fully mean reverted back up to those levels relative to today’s gold prices, GDX would have to soar 258% higher from here!  But late 2008’s first stock panic in a century torpedoed this core fundamental relationship.

Gold stocks plummeted in that stock panic, with GDX collapsing 71.0% in just 7.5 months!  That’s a major exception to the rule that gold stocks tend to thrive during stock weakness.  While episodes of epic extreme fear are mercifully brief, free-falling general stock markets can suck in gold stocks and even gold for a spell.  The baby gets thrown out with the bathwater when investors’ fear reaches blinding peak levels.

At worst in October 2008 after the SPX had plummeted 30.0% in a single month, the GGR bottomed at 0.227x.  That highlights the sheer absurdity of recent years’ gold-stock prices.  Even in the most-extreme stock-market fear event we’ll likely witness in our entire lifetimes, the gold stocks were trading over a fifth higher relative to gold than their average over the past few years!  They rebounded powerfully from that anomaly.

Over the next 2.9 years after that epic stock panic, GDX more than quadrupled with a 307.0% gain!  In the first couple years of that post-stock-panic mean reversion, the GGR averaged 0.422x.  Restoring that fundamental relationship between gold miners’ stocks and gold prices would require a 156% GDX rally from here.  In the 4 years after that panic, the GGR averaged 0.381x which is 131% higher than this week’s levels!

But effectively starting in 2013, the Fed began radically distorting the markets with its third quantitative-easing campaign.  That led to soaring stock markets which mirrored the Fed’s ballooning balance sheet as it bought massive amounts of bonds with money newly conjured out of thin air.  So gold fell deeply out of favor as stock markets rocketed higher on epic Fed QE, suffering a multi-year bear which crushed gold stocks.

That ultimately culminated in mid-December 2015 on the Fed’s first rate hike of this cycle ending 7 years of its stock-panic-spawned zero-interest-rate policy.  The GGR hit an all-time low of 0.120x about a month later as gold stocks bottomed before soaring in their new bull.  Just like after the stock panic, gold-stock upside was explosive after being pummeled to unsustainable lows relative to the metal which drives their profits.

GDX again skyrocketed 151.2% higher over the next half-year or so in early 2016, but its young bull was still tiny.  Ever since gold stocks have languished, grinding sideways to lower as investors forgot about them.  There was little demand for contrarian investments while the SPX surged dramatically on taxphoria since late 2016.  But this week’s action warns those stocks-higher gold-lower trends may be starting to reverse.

There are several key takeaways from this long-term fundamental relationship between gold-stock prices and gold levels.  First, in the past the gold stocks have surged sharply in strong bulls after their prices fell too low compared to gold.  Gold-stock prices as measured by GDX have doubled to quadrupled in recent years’ mean reversions out of anomalous extremes.  Similar gains at least should be expected in the next one.

Second, gold-stock prices can’t fall relative to gold forever.  While this small contrarian sector can lapse out of favor at times, investors flood back in once the stock markets weaken and investors return to gold.  Between 2008 to 2015, the GGR’s trend was sharply lower.  It stabilized and consolidated low from 2016 to 2018.  Now gold stocks are due for a secular reversal where their gains outpace gold’s on balance for years.

No markets or relationships between markets move in one direction forever!  American stock investors are being shocked into remembering this core reality this week.  Everything is forever cyclical.  The longer any market is stuck in any particular trend, the bigger and longer its proportional mean reversion will last.  Gold and especially gold stocks are likely to experience years of plenty after suffering years of lean demand.

Third, all this GGR analysis so far makes the unlikely assumption that gold prices don’t rally too.  But gold is likely to enjoy a powerful bull in the coming years as stock investors re-diversify small fractions of their stock-dominated portfolios into counter-moving gold.  As gold prices are bid higher, the upside in gold stocks will leverage and amplify gold’s gains.  The higher GLD is bid, the higher GDX’s mean reversion will go.

As an example, assume the most-conservative mean reversion of the GGR back to that 4-year post-panic average of 0.381x.  At today’s gold levels, that implies GDX has to more than double from here with a 131% gain.  But if GLD is bid 10%, 20%, or 30% higher, the necessary GDX upside to regain that normal gold-stock pricing relative to gold climbs to 154%, 177%, or 200%.  And that’s actually quite conservative too.

After anomalous price extremes, mean reversions don’t simply stop at the averages but tend to overshoot proportionally in the opposite direction.  So gold stocks are due for a period where they outperform gold so greatly that the GGR soars to the high side instead of mere normal levels!  That portends far-larger gold-stock gains than anything discussed.  Run the numbers with a GGR mean-reversion overshoot and be amazed!

This last chart zooms in to the past few years or so, essentially the current gold and gold-stock bulls.  The GGR was recently driven to a 2.6-year low by the forced capitulation in gold stocks in August and the echo capitulation in early September.  So even in the context of recent years alone, the gold stocks are way too low relative to prevailing gold prices.  The GGR is due for a sharp surge back above that meager mean.

At worst in mid-September, the GGR plunged to 0.155x.  That was a breakdown from its downtrend of recent years, and 0.032x under its past-few-years average of 0.187x.  A full proportional mean-reversion overshoot out of this latest anomaly would drive the GGR back to 0.219x.  Just to normalize relative to gold in even that little way would require another 33% rally from this Wednesday’s close to $24.73 in GDX!

With gold stocks so wildly undervalued relative to the metal which drives their profits, their upside is huge no matter how you slice it.  The gold miners are truly the last cheap sector in these entire lofty, euphoric stock markets!  And since their earnings are totally dependent on gold prices which tend to rally on big investment buying when stock markets weaken, gold stocks have the unique ability to climb during stock bears.

We got a small preview of that this week, when GDX rallied 1.3% on Wednesday despite that sharp 3.3% SPX plunge.  Given the bubble general-stock-market valuations and the Fed’s unprecedented now-full-steam quantitative-tightening campaign to destroy QE money, every investor needs to make portfolio allocations to gold and the stocks of its miners.  They tend to power enormously higher when little else will.

And even if the stock markets again evade the hangman’s noose and somehow continue grinding higher still, gold investment demand could still climb.  Once stock investors are spooked, they usually add gold for a long time after to get some semblance of portfolio diversification.  So gold and gold stocks still soared from 2009 to 2011 and in the first half of 2016 even as the SPX recovered from a panic and corrections.

Wall Street has long hated gold because it thrives when stock markets weaken.  So it’s essential for all speculators and investors to cultivate excellent contrarian intelligence sources.  That’s been our specialty at Zeal for decades now, we’ve long published acclaimed weekly and monthly newsletters.  They offer a unique and essential contrarian perspective to help offset and neutralize the endless stock-market cheerleading.

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The bottom line is the gold miners’ stocks are the last cheap sector in these entire lofty stock markets.  They’ve languished deeply out of favor for years as investors forgot the wisdom of prudently diversifying their stock-heavy portfolios with gold.  But once stock markets weaken enough to spook them, traders start returning to gold and gold stocks.  This classical behavior started to play out again with this week’s selloff.

As capital flows back into this forsaken sector, the gold-stock upside is truly extreme.  These gold miners’ stock prices are wildly undervalued relative to the metal which drives their profits.  So they are overdue for a massive mean reversion and eventually overshoot.  When this dynamic of gold stocks returning to favor after a long exile has played out in the past, contrarians who bought in early and low really multiplied their wealth.

Adam Hamilton, CPA

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