Cheap Gold Stocks Breaking Out

Gold stocks have surged dramatically in recent weeks, defying the odds to catch a serious bid.  Extreme bearishness still plagues this sector, which is certainly the most despised in all the stock markets.  So why are investors returning?  The universally-hated gold stocks are absurdly cheap, easily the greatest bargains anywhere.  And after a long year of basing, they are finally breaking out relative to the gold price.

It’s easy to understand why everyone hates the precious-metals sector these days.  During the first half of 2013 when the mighty S&P 500 general-stock index powered 12.6% higher, gold plunged 26.4%.  Thanks to the Fed’s stock-market levitation, American stock traders dumped the dominant GLD gold ETF at epic record rates, flooding the gold market with excess supply.  The resulting gold drop obliterated gold stocks.

Their primary index, the HUI gold-stock index, plummeted by 48.7% over that span!  So this entire sector was abandoned, left for dead by existing investors and avoided like the Black Death by new investors.  Bearishness was off the charts, with widespread predictions gold and its miners’ stocks were doomed to spiral lower forever.  Yet like nearly all popular forecasts at market extremes, that one was dead wrong.

The precious-metals sector instead stabilized over this past year, drawing a line in the sand and basing.  As of this week, gold is up 3.4% and the HUI merely off 0.9% since the end of last June.  Not the worst sector sentiment seen in decades, not stupendous record gold and silver futures shorting, not even the Fed’s ongoing stock-market levitation could force the precious metals lower.  New buying absorbed all the selling.

And that brings us to today, where the precious metals are surging to break out of this year-long base.  And this is happening in the midst of the dreaded summer doldrums no less, the weakest time of the year seasonally for this sector totally devoid of recurring investment-demand spikes.  So much strength now is a harbinger of a sea-change shift in capital flows back into gold stocks, which are exceedingly undervalued.

The vast majority of investors have woefully short memories, forgetting the past to delude themselves into believing the last year-and-a-half were normal for precious metals.  Nothing could be farther from the truth!  Between November 2000 and September 2011 when the S&P 500 retreated 14.2% in a brutal secular bear, the HUI skyrocketed 1664.4% higher!  When gold stocks are moving, great fortunes are won.

Fundamentally, few sectors are simpler and easier to understand than gold miners.  These companies wrest the shiny yellow metal from the bowels of the earth, and then sell it at market prices.  Thus their overall profitability, and resulting earnings-per-share measures that drive future stock prices, are utterly dominated by the gold price.  When gold rises, gold-mining profits leverage these gains to soar higher.

So the best way to view gold-stock price levels from an investing standpoint is through the lens of their relationship with gold.  For nearly a decade now, I’ve done extensive research into trading this sector using the HUI/Gold Ratio.  The daily close in that leading gold-stock index is simply divided by the daily close in gold, and the resulting ratio charted.  This has led to massive profits from timing buying and selling.

But these days more and more investors are shifting their capital away from holding individual stocks into exchange-traded funds.  This trend is understandable yet unfortunate, as a carefully-handpicked sector portfolio of elite stocks will nearly always outperform the broader baskets held by ETFs.  But that’s the way things are going, for better or for worse.  So I’ve long been wondering about the HGR’s ETF equivalent.

The HUI itself can’t be bought, but the flagship GDX Gold Miners ETF can be.  GDX is a worthy gold-stock benchmark, as it is well-constructed with quality component gold and silver stocks and tracks the classic HUI almost perfectly.  And if GDX is replacing the HUI in the gold-stock/gold ratio numerator, why not throw in the GLD gold ETF in the denominator?  So this week I took my first deeper look at the GDX/GLD Ratio.

This new GGR is functionally identical to the old HGR, quantifying gold-stock price levels relative to the underlying gold price which drives their profits and hence ultimately stock prices.  So naturally the GGR reveals the same picture the HGR has, that gold-stock prices have been losing ground relative to gold for a long time and are radically undervalued.  Here’s the chart since GDX’s first full year of trading in 2007.

The blue GGR is slaved to the right axis, and shows gold stocks’ performance relative to gold.  When the GGR is rising, gold stocks are outperforming gold.  This can be from either rallying faster than gold in major uplegs, or falling slower than gold in major corrections.  But the latter never actually happens.  When the GGR is falling, gold is outperforming gold stocks by rising faster in uplegs or falling slower in corrections.

Incredibly for nearly 7 years now, gold stocks have been underperforming gold on balance!  The GGR has done little more than fall and fall and fall.  Other than the 17-year secular bulls and bears endlessly oscillating through stock-market history, any trend in any market running for 7 years is exceedingly rare.  Most trends reverse after 4 years, 5 on the outside.  The longer any trend runs, the bigger the subsequent mean reversion.

So right off the bat, it’s immediately obvious there is a huge anomaly in gold-stock pricing today.  No matter how vociferously the bears argue, gold stocks aren’t going to fall relative to gold and therefore their profits forever.  At some point this trend, which is essentially a secular bear in gold-stock sentiment, will absolutely reverse.  And odds are this past year’s basing has finally ushered in that critical inflection point.

To game where this hated sector is heading, we first have to understand how it got here.  Back in 2007 before 2008’s once-in-a-lifetime stock panic, the GGR averaged 0.591x over the first 8 calendar quarters of GDX’s existence.  The share price of the GDX gold-stock ETF meandered around 0.6x the share price of the GLD gold ETF.  Even if these pre-panic levels never return, today’s ultra-low GGR is wildly bullish for gold stocks.

During that epic stock panic, the extreme general-stock selling led to gargantuan safe-haven demand for the US dollar (cash).  So as the US Dollar Index skyrocketed in its biggest and fastest rally ever witnessed over such a short span in late 2008, the alternative currency gold was hammered in crazy-heavy futures selling.  So gold fell too during the stock panic, terrifying gold-stock investors into panicking as well.

Gold stocks plummeted so much faster than gold that by late October 2008 near the panic’s nadir the GGR had free-fallen to just 0.227x.  Gold stocks were trading at just 3/8ths of their pre-panic levels relative to gold which drives their profits, which was absurdly cheap as I pointed out at the time using the HGR.  And as expected, after being loathed and extremely undervalued gold stocks started soaring again.

Mean reversions out of extremes are the most powerful and profitable forces in all the financial markets.  Riding one has enormous benefits for your wealth.  Over the next several years after those super-irrational stock-panic lows, gold stocks as measured by GDX would more than quadruple with a 307.0% gain.  This trounced the S&P 500’s measly 39.7% gain over this span by nearly an entire order of magnitude!

After such a tremendous bull run, gold and the gold stocks needed to correct.  The metal was simply very overbought, as I warned right at its August 2011 top.  And the necessary gold correction, and the resulting GDX correction from its all-time record high, was totally normal until mid-2012.  At that point gold and the gold stocks bottomed.  The miners outperformed so the GGR climbed higher again for the better part of a year.

But in early 2013, the US Federal Reserve foolishly and recklessly chose to use record money printing to monetize bonds along with jawboning to drive the stock markets higher.  The Fed implied it was going to backstop stock prices, by being ready to ease more to arrest any material selloff.  So the stock markets started to dangerously levitate, gradually sucking capital and interest away from alternative investments including gold.

American stock traders dumped their GLD shares far faster than gold itself was being sold, which forced this massive ETF’s custodians to liquidate bullion to raise the capital necessary to sop up the excess GLD-share supply.  So GLD saw shockingly-large record outflows of 552.6 metric tons of gold last year, which was 84% of the total drop in global gold demand!  As gold fell, the gold stocks were pulled into the carnage.

Nothing was normal about last year, the Fed made it the most anomalous year in the markets seen in our lifetimes after the 2008 stock panic.  The resulting fear, despair, and loathing in precious metals was breathtakingly extreme.  Nearly everyone predicted gold, silver, and their miners’ stocks would continue sliding forever.  Except for a handful of hardcore contrarians like me, who argued they were bottoming.

We’ve been proven right, although this bottoming process has taken far longer than I ever imagined a year ago.  Despite facing howling headwinds since then as the Fed’s insane stock-market levitation continued, gold and the gold stocks have bottomed.  They’ve spent this past year basing, with big new buyers absorbing all the relentless selling pressure.  This has led to the GGR stabilizing since last summer.

And this ETF-based gold-stock/gold ratio is starting to break out from its incredible 7-year downtrend!  Just in recent weeks, the GGR has poked its head above its secular resistance.  While it’s early still and we’ll need a few more months to confirm this nascent breakout, it has wildly bullish implications for gold-stock prices.  Contrarian investors willing to buy low in this past year when few others would are going to win fortunes.

Since the end of last June, the GGR has averaged 0.196x during this massive precious-metals basing.  That is anomalously low and utterly unsustainable.  Even during 2008’s wild stock panic, the most extreme fear superstorm most of us will ever see in our lifetimes, the GGR briefly hit a considerably-higher 0.227x before gold stocks bounced violently and surged for years relative to gold.  This should happen again.

After plummeting 71% in that stock panic, such extreme lows and unbalanced hyper-bearish sentiment led GDX to more than quadruple in the subsequent years.  And since that record peak this ETF has lost a nearly identical 69% and fallen to even more extreme lows relative to gold.  Thus I fully expect this next coming mean reversion in gold-stock price levels to quadruple them again, their upside potential is massive.

The entire history of the GDX/GLD Ratio since this gold-stock ETF was born in May 2006 averaged 0.405x.  And that is right in line with the post-panic normal range of this key gold-stock pricing indicator in the 10 calendar quarters following 2008’s stock panic, 0.419x.  So no matter what, the GGR ought to return to this normal range in the coming year or two.  From this week’s levels, that means a 107% GDX surge!

This next chart zooms in on the GGR and GDX itself over the past several years or so, highlighting how far up normal gold-stock valuations relative to gold are from here.  The case for a double in gold-stock prices from today’s dismal levels is a no-brainer, an exceedingly-high-probability-for-success contrarian trade.  Extreme price lows accompanied by extreme bearishness always breed extreme mean reversions.

As part of their year-long basing process, flushing out all the defeated capitulating former gold-stock investors who foolishly sold low, GDX hit a 5.1-year low in late December.  Gold stocks hadn’t traded at lower absolute price levels since 2008’s stock panic, after which they more than quadrupled.  But even more important was their pricing relative to gold, with the GGR falling to a sub-panic all-time record low.

And that’s the first of two reasons why a gold-stock quadruple is coming over the next several years or so.  Financial-market prices and sentiment are like a giant pendulum.  The farther they are pulled to one extreme by excessive greed or fear, the farther they necessarily swing to the opposite extreme in the subsequent mean reversion.  Like pendulums, these reversions don’t magically stop right in the middle at normal again.

Their kinetic momentum carries them through to the opposite ends of their arcs.  So there is almost no chance the next gold-stock cyclical bull will conveniently stop around the normal post-panic average GGR of 0.419x.  They are going to overshoot proportionally.  Doubling the 0.217x difference between today’s GGR and that average, and adding it onto today’s levels for a full overshoot, yields a GGR target of 0.636x.

That sounds high, and it is.  But overshoot extremes don’t last for long, as the universal greed necessary to fuel them quickly burns itself out.  And that GGR level certainly isn’t unprecedented.  In the second half of 2006, just after GDX was born when gold stocks were last popular, the GGR averaged 0.623x.  A standard mean-reversion overshoot of gold-stock prices relative to gold takes their projected gains to more than a triple.

The quadruple potential comes from gold itself, which is also universally hated and thus still trading at anomalous levels far below where it should be.  As the wildly overvalued and overextended US stock markets inevitably roll over into their next serious selloff that will likely grow into a new cyclical bear, gold will return to favor as an essential portfolio diversifier.  Western investment demand for it will come back.

Between American stock investors migrating capital back into GLD, and American futures speculators buying to cover their record precious-metals shorts, gold is going to rebound dramatically in the coming years.  And the higher gold goes, the higher gold stocks will need to be bid to keep the GGR in line.  Even plugging in very conservative numbers yields incredibly impressive gold-stock price-target levels.

For example, last year’s Fed-driven anomaly led gold to plunge 27.9%.  If it merely regained 25% from its year-end-2013 level, a pathetic mean reversion after such a wild extreme, it would hit $1507.  That’s a low gold price, as gold traded above that continuously for 21 months ending at last April’s gold panic.  Translate that into $150ish GLD terms, and a 0.63x GGR overshoot yields a GDX target price of $94.50!

That’s nearly a quadruple from today’s dismal GDX levels, and given the epic record money printing by the crazy Fed that’s just starting to come home to roost in the form of wicked inflation, I expect gold prices to surge to new record highs well above $2000 in the years to come.  So the resulting gold-stock target levels are far higher than this conservative example indicates.  Gold stocks are an incredible investment here!

And in addition to the mean reversion in gold prices igniting serious gold-stock buying, another catalyst is coming too.  The second quarter of 2013’s epic GLD capital outflows led to the worst quarter for gold in 93 years.  So many of the miners took huge non-cash writeoffs in Q2’13 for the resulting impairments of their gold projects.  These more than erased operating profits, leaving this sector temporarily devoid of earnings.

So with no conventional P/E ratios over the past year since those writeoffs, investors have shunned this sector not knowing how to value it.  But once Q2’14 earnings are reported in late July and August, Q2’13 will roll off the books.  Thus gold stocks will have price-to-earnings ratios again, and they will be super-low given gold stocks’ battered price levels.  This should spark a surge of heavy institutional buying.

Although owning GDX to ride this mean reversion is fine, a custom portfolio of expertly-handpicked individual gold miners with superior fundamentals will vastly outperform it.  GDX is overly-diversified, and the larger gold miners that will see smaller gains are heavily weighted.  At Zeal we’ve spent well over a decade researching gold and silver miners and explorers, and our accumulated expertise is priceless.

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The bottom line is the cheap gold stocks have been basing for an entire year now.  After the extreme once-in-a-lifetime Fed-driven GLD-selling anomaly in 2013, bearishness was epic.  Yet despite the ongoing stock-market-levitation headwinds, the precious metals and their miners’ stocks consolidated instead of spiraling into the abyss like everyone predicted.  New investors absorbed all of the relentless selling.

This strong basing has led to a nascent breakout from the tired 7-year trend of gold stocks underperforming gold.  Today this despised sector is radically undervalued relative to the metal which drives its profits and hence ultimately stock prices.  So as gold-stock prices and gold itself mean revert in the coming years, gold stocks should easily quadruple.  There’s no other sector in the stock markets with such bullish potential.

Adam Hamilton, CPA

June 20, 2014

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