Absurd Gold-Stock Levels 3

Gold stocks remain the pariah of the investment world.  Despite gold’s strong early-year gains, the stocks of its miners have slumped to new secular lows.  This whole forsaken sector continues to languish at fundamentally-absurd price levels, an extreme anomaly that is long overdue to start unwinding.  The gold miners will be bid massively higher to reflect their impressive profitability even at today’s dismal gold prices.

Just this week, the flagship HUI gold-stock index plunged to a major new secular low.  On Tuesday as gold merely slid 0.3%, the HUI plunged 5.6% to 100.7.  This was an astounding new 13.5-year secular low, reeking of capitulation since gold’s price action certainly didn’t justify such a disastrous reaction in its miners’ stocks.  That left already epically-bearish gold-stock sentiment even worse, which is hard to believe.

The gold stocks are ultimately leveraged plays on gold, because prevailing gold prices determine their profitability.  And all stock prices eventually migrate to some reasonable multiple of their underlying corporate earnings, gold stocks are no exception.  Gold’s overwhelmingly-dominant role in gold-mining profits has led this sector to amplify gold’s price moves, typically by 2x to 3x in major gold-stock indexes like the HUI.

So Tuesday’s extreme 21.9x downside leverage was wildly outsized.  Gold stocks actually got off to a strong start in early 2016, surging 9.9% in this year’s first 4 trading days compared to gold’s 4.7% gain.  But as soon as gold pulled back, the gold stocks got sucked into the bearish maelstrom of the plunging general stock markets.  So by Tuesday, the HUI was down 9.4% year-to-date compared to gold’s 2.5% rally.

But this horrendous performance leading to calls for deep new lows is masking an ongoing bottoming.  Back in mid-July, gold was blasted by an extreme gold-futures shorting attack explicitly executed to manipulate gold prices lower by running long-side stop losses.  In the aftermath of that, the HUI dropped to 104.9 in early August.  That would prove major new support near 105 that held strong until this week.

Despite the vast bearishness arrayed against them, gold stocks held their ground for 5.5 long months.  Despite gold slumping to 7 new secular lows in November and December, the HUI didn’t fall materially under 105.  Despite the Fed’s first rate hike in 9.5 years in mid-December that was universally expected to obliterate gold, that support held.  And that continued into 2016 despite plunging global stock markets.

Even as of Tuesday’s new low, the HUI had only lost 4.0% since its initial early-August bottom.  Gold’s price edged 0.2% higher over that span, while the benchmark S&P 500 stock index plunged 10.4%.  With so many excuses to continue dumping gold stocks in the past half-year, their relative strength is a telltale sign of selling exhaustion.  Pretty much everyone who wants out has already long since sold and exited.

So this week’s abrupt plunge to crazy new secular lows despite flat gold prices felt like a capitulation, which has been long overdue.  The gold miners’ stocks are radically undervalued fundamentally, they have been pounded for years technically, and the extreme bearishness long plaguing them couldn’t possibly get any worse sentimentally.  Everything is in place for gold stocks to carve a major secular bottom.

While ironclad technical and sentimental arguments can be made for gold stocks reversing and mean reverting sharply higher, the fundamental case trumps everything else.  Despite this sector’s endless slide and universal antipathy, the gold miners’ underlying profit fundamentals are what’s going to turn around this left-for-dead sector.  Gold stocks are truly trading at fundamentally-absurd price levels today!

Since the vast majority of mining costs are effectively fixed during mine-planning stages, the dominant variable driver of gold-mining earnings is the price of gold.  And the relationship between these profits and gold is leveraged, not linear.  This reality is easy to grasp.  Imagine a gold miner producing gold for $850 per ounce.  In a $1050 gold environment, December’s secular low, this miner earns a $200-per-ounce profit.

The miners’ costs don’t change as gold rallies, so all those gains amplify the bottom line.  Since those Fed-rate-hike lows, gold has climbed back over $1100 in 2016.  At $1100 even, that’s a 4.8% gold-price rally.  Yet it still costs our miner $850 per ounce to produce, while selling that gold at $1100 now yields a $250-per-ounce profit.  That’s a 25% increase on less than a 5% increase in gold prices, excellent leverage!

Since profits ultimately determine stock prices, essentially all that matters for the gold miners is the price of gold.  Thus they have always moved in lockstep with gold, amplifying its price moves.  But as this first chart of gold and the HUI reveals, a radically-unprecedented disconnect emerged in early 2013.  And it has only worsened in recent years.  The gold miners’ stock prices are no longer reflecting prevailing gold levels.

This week’s bizarre capitulation selling pummeled the HUI to an extraordinary 13.5-year secular low.  It was the lowest HUI close since all the way back in July 2002.  Back then gold was trading near $305, and had yet to exceed $329 in its young secular bull.  This Tuesday, gold closed near $1087 or 3.6x higher.  Yet gold stocks were trading at levels last seen around $305.  Does that make any sense at all?

Absolutely not!  Such an extreme pricing anomaly in any other sector would lead to a stampede of new buying.  Imagine if Apple’s stock was trading as if it could only sell its iPhones for 3/11ths of their actual selling price.  Investors would rush in to buy this epic bargain, rapidly bidding up Apple’s stock price until it reflected actual underlying cash flows.  Only in ignored gold stocks can such a radical disconnect exist.

The ludicrous magnitude of this deviation is confirmed looking the other way, through the lens of gold.  Just after the Fed finally ended its 7-year-old zero-interest-rate policy in mid-December, gold fell to a deep 6.1-year secular low.  Where was the HUI the last time gold prices closed near $1050?  Trading way up over 390, 3.7x higher.  Gold-stock prices are so low that they need to quadruple merely to reflect gold today!

This hard fundamental truth about the mind-boggling gold-stock undervaluation really irks people with a vested interest in seeing gold stocks spiral lower into oblivion.  Gold-stock investors and speculators who succumbed to their own fear to sell into recent years’ major secular lows need to believe that was a rational decision.  So market commentators tickle their ears with endlessly-bearish gold-stocks-to-zero talk.

Thus whenever I write about the fundamentally-absurd gold-stock prices and their unparalleled vast opportunities for hardened contrarian investors, I get attacked by the already-sold-low crowd.  They have a desperate psychological need to perceive themselves as smart for selling low, they want to rationalize away their foolishness.  So they argue that gold mining simply isn’t profitable at today’s out-of-favor gold prices.

The implication is obvious, that gold stocks deserve to be priced as if gold was trading near $300 instead of $1100.  If they can’t earn any money, then their super-low price levels are probably fundamentally-righteous.  As a lifelong student of the markets and contrarian speculator, I love investigating counter arguments.  So every quarter after the gold miners have reported their earnings, I carefully analyze their results.

Gold miners generally report quarters a month or two after quarter-end, so the latest read available is from 2015’s third quarter.  Back in mid-November I analyzed the results of all the elite gold miners in the leading GDX Gold Miners ETF.  Consisting of the world’s biggest and best gold miners, this excellent gold-stock benchmark perfectly mirrors the HUI.  GDX’s 35 component stocks reflect industry-wide fundamentals.

I painstakingly scoured all the latest quarterly filings from all the GDX component stocks.  Before I got into the financial-newsletter business 16 years ago, I was a Big Six CPA auditing mining companies.  So I’m quite fluent in financial reporting and quarterly filings.  The combination of all these Q3 results from all the elite gold miners included in GDX shows exactly where this industry’s profitability is running today.

I wrote a whole essay on that research if you want to dig deeper.  It turned out that the average cash cost of the GDX gold miners was just $618 per ounce in Q3.  That’s their actual cost of production at the mine level.  At today’s $1100 gold prices, that implies cash operating profits of $482 per ounce!  Such massive 44% margins would be celebrated in any other industry, but they are totally ignored in the gold miners.

But cash costs are admittedly misleading, as mining costs extend far beyond these mine-level expenses.  So back in mid-2013, the World Gold Council introduced broader all-in sustaining costs.  These include all expenses necessary to sustain current production levels, adding in corporate-level administration, exploration, mine-development, mine-construction, and mine-reclamation expenses among others.

The elite gold miners of GDX, who represent the vast majority of world gold production, reported average all-in sustaining costs of just $866 per ounce in Q3!  This hard data reported to government regulators by the biggest and best gold miners drives a jagged stake through the heart of the popular myth today that gold mining isn’t profitable.  At $1100 gold, this industry can still earn a very impressive $234 per ounce!

With all costs necessary to maintain and replenish current production levels not far above $850, there is zero justification for gold stocks to be trading as if gold was 3/11ths of its current levels.  Now if this AISC metric was running at $1350, $250 over current gold prices instead of $250 under, you could certainly argue that almost any miserable gold-stock prices were fundamentally justified.  But that’s not the case today.

The only reason gold stocks are trading at such fundamentally-absurd prices relative to their profitability and the price of the metal that drives it is extreme fear.  Investors and speculators are understandably terrified of gold stocks after their horrific plunge since early 2013.  That’s when the Fed spun up its QE3 debt-monetization campaign to full speed, levitating the stock markets and sucking capital out of gold.

While underlying profit fundamentals always determine ultimate stock-price levels, extreme greed or fear sometime drag prices far away.  But these emotional extremes never persist.  Fear in the markets is finite, as eventually everyone susceptible to being scared into selling low has already done so.  That leaves only buyers, resulting in a secular reversal followed by a major mean reversion sharply higher as fear dissipates.

And gold stocks themselves are a great example of this.  Back in late 2008 this sector was crushed in the first stock panic in a century, a once-in-a-lifetime perfect storm of fear.  By late October 2008 that panic had blasted gold stocks to fundamentally-absurd price levels relative to gold, which I pointed out at the time was supremely bullish.  And indeed over the subsequent several years, the HUI would more than quadruple!

Incredibly, the gold-stock lows today are far more extreme than those seen in that stock panic.  This is true in both absolute terms and relative to gold.  The more extreme any price anomaly in the markets, the higher the odds for an imminent reversal and the larger the inevitable subsequent mean reversion will be.  Gold stocks’ radical price disconnect has positioned them to be 2016’s best-performing sector by far.

This last chart distills down the immutable fundamental relationship between gold-stock prices and the metal which drives their profits into a simple ratio.  Dividing the daily HUI close by the daily gold close yields the HUI/Gold Ratio.  When tracked over time, it shows when gold stocks are both overvalued or undervalued relative to gold.  And due to the extreme fear, they’ve never been more undervalued than today!

When the HGR rises, the gold stocks are outperforming gold.  That’s what happens normally during gold uplegs since gold-mining profits leverage the price of gold.  Conversely a falling HGR signals that gold is outperforming gold stocks.  This usually happens when gold is falling slower than gold stocks.  Note that this ratio has been falling on balance for over 8 years now, an extraordinary secular span of time.

The last time the financial markets were normal was before 2008’s stock panic, before the desperate Fed implemented QE and ZIRP and wildly distorted everything.  Over the 5-year span ending in mid-2008 just before that epic panic, the HGR meandered in a tight trading range between 0.46x support and 0.56x resistance.  On average the HUI traded at 0.511x the price of gold, with only minor and short-lived deviations.

That strong relationship was shattered by 2008’s stock panic, the first since 1907.  A panic is technically a 20%+ plunge in the broad stock indexes within a couple weeks.  Leading into early October 2008, the benchmark S&P 500 plummeted 25.9% in just 10 trading days!  The leading VIX fear gauge skyrocketed to 79.4, and gold-stock traders panicked like everyone else.  That battered the HGR to a 7.5-year low of 0.207x.

But once again those horrendous gold-stock price levels weren’t fundamentally justified.  They were just the result of epic fear that soon had to dissipate, just like today.  So the HUI soon reversed and started to mean revert dramatically higher.  The gold stocks climbed 319% over the subsequent 2.9 years, which earned fortunes for brave contrarians mentally tough enough to buy low when everyone else was too scared.

If there was a normal period after 2008’s stock panic, it was 2009 to 2012.  Everything went crazy again in 2013 as the Fed ramped up its unprecedented open-ended QE3 bond-monetization campaign, which levitated the stock markets.  The aggressive Fed jawboning about expanding QE3 if necessary any time the stock markets sold off created an effective Fed Put, so traders sold everything else including gold to buy stocks.

Stock investors dumped the flagship GLD gold-ETF shares at an epic record rate in early 2013, which cratered gold and obliterated gold stocks.  That sparked such extreme fear that it hasn’t dissipated to this day, leaving this hated sector unable to stage any meaningful uplegs in the QE3 era.  But back before that in 2009 to 2012, the HGR stabilized at a new post-panic average level of 0.346x.  That’s the new normal.

The relentless ongoing gold-stock selling culminated this week in that capitulation day, forcing the HGR down to 0.093x.  The HUI was trading at less than 1/10th prevailing gold-price levels!  That tied the all-time HGR low from late September 2015.  The gold stocks had never traded lower relative to gold, the metal that drives their profits and thus determines this sector’s fundamentally-righteous stock-price levels!

With the exception of gold stocks’ sharp mean-reversion rally in 2009, they’ve been falling relative to gold for over 8 straight years now.  No market moves in one direction forever, they are all forever cyclical.  And gold stocks are certainly no exception.  As the Fed’s radical market distortions created by QE and ZIRP continue to unwind, both gold stocks and gold itself will mean revert far higher to reflect their fundamentals.

And that imminent mean reversion out of unsustainable fear-driven extremes portends enormous gains for gold stocks in the next couple years.  Merely to return to that post-panic-average HGR of 0.346x at today’s gold prices would require the HUI to rocket about 275% higher from this week’s capitulation low to 375!  That’s where gold stocks should be trading near $1100 gold, as proved in 2009 when $1100 was last seen.

Gold stocks are so despised, so incredibly undervalued, that they need to nearly quadruple from here merely to reflect today’s low gold prices!  Is there any other sector in all the stock markets with such huge potential fundamentally-driven gains?  Not a chance, especially with a major new stock bear awakening,.  Gold and therefore gold stocks move counter to stocks and rally during stock bears, a rare and valuable attribute.

But that easy-quadrupling potential from these extreme secular gold-stock lows greatly understates their potential.  Why?  Because gold itself is also overdue to mean revert dramatically higher in 2016 as the Fed’s gross market distortions unwind.  Late last year when everyone hated gold, I laid out the strong case for a massive 2016 upleg.  And gold has already started powering higher on an investment-demand renaissance.

I don’t know how high gold will surge this year, but 20% is very conservative.  A 20% gold rally would leave this metal near $1275, in line with year-end targets from some major Wall Street banks.  At $1275 gold and the post-panic-average 0.346x HGR, the HUI’s price target would climb over 440.  That’s a 340% gain from this week’s capitulation low!  And gold stocks’ potential in coming years is even greater than that.

2012 was the last normal year before the Fed unleashed QE3 and destroyed the normal functioning of the markets.  Gold averaged nearly $1675 that year.  So gold’s potential mean reversion out of its Fed-conjured extreme lows is to far-higher price levels than a mere 20% upleg.  On top of that following any extreme, mean reversions tend to overshoot proportionally in the opposite direction.  Think about that for a second.

Not only does gold have a high probability of overshooting beyond its pre-QE3 average levels, but the gold stocks have great odds of blasting to an HGR way above its post-panic normal-year average!  So the upside potential in gold stocks in the coming years is vast, utterly unparalleled in all the markets.  This is why I remain a hardcore contrarian so super-bullish on gold stocks, nothing else can compete.

And though everyone has long forgotten, there is recent precedent for extreme outperformance by the gold stocks.  Between November 2000 and September 2011, the HUI powered 1664% higher in a life-changing secular bull!  While contrarian gold-stock investors multiplied their wealth by nearly 18x, the S&P 500 lost 14%.  Betting against the herd at secular extremes almost always pays off in a huge way.

All prudent investors and speculators need to have substantial gold-stock exposure in their portfolios.  With the gold stocks near fundamentally-absurd 13.5-year secular lows already, the downside risk is trivial.  Yet the upside potential is vast.  Gold stocks can be bought via that GDX ETF of course, but the greatest gains by far will come in the best of the individual gold miners with the most-superior fundamentals.

At Zeal we’ve long specialized in this obscure contrarian realm.  We’ve spent 16 years researching and trading the precious-metals miners and explorers, earning fortunes by buying low when few others would so we could later sell high when few others could.  And with gold stocks’ fundamental disconnect so darned great today, there’s never been a greater buying opportunity.  So we’ve been aggressively deploying.

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The bottom line is gold stocks remain at fundamentally-absurd price levels relative to gold which drives their profits.  Heavy capitulation selling just forced them to 13.5-year secular lows, prices last seen when gold traded just over $300.  Such a radical fundamental disconnect driven by irrational fear can’t persist, especially with gold already starting to mean revert higher.  Gold-mining profits will leverage its coming gains.

Gold-stock prices can’t defy their underlying profitability forever, so their long-overdue mean reversion far higher will soon be underway.  This gold-stock rally will feed on itself, attracting widespread interest during an accelerating general-stock bear where upside momentum is hard to find.  The early contrarians willing to buy in near these lows stand to multiply their wealth and earn fortunes.  Will you be among them?

Adam Hamilton, CPA

January 22, 2016

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