Cheap Gold Stocks

Not even mighty gold escaped late September's commodities massacre, so gold stocks never stood a chance. They were sucked into the violent maelstrom of commodities-stock selling, plunging sharply. And as usual when gold is weak, the gold stocks amplified its downside. The result is very cheap gold stocks today, great bargains. Relative to gold, they've been hammered back down near panic levels.

Throughout the entire stock markets, the long-term price of any individual stock is ultimately driven by its underlying company's profitability. The more any company earns, the higher its stock price will eventually be bid to reflect those profits. And for gold miners, the price of gold is directly responsible for the lion's share of their profitability. During a secular gold bull, gold prices generally rise much faster than mining costs. This leads to expanding gold-mining profit margins.

So over time higher gold prices directly translate into greater gold-mining profits, which ultimately entice investors and speculators to bid up gold-miner stock prices. Thus general gold-stock price levels are best understood in relation to the gold price that drives them. This critical fundamental relationship is a powerful trading tool too. When gold stocks get too cheap relative to gold, it is a great time to buy low.

And this is certainly the case today, as is readily apparent in the HUI/Gold Ratio. This HGR has been my favorite tool for quantifying the relationship between gold and gold stocks for many years now. It simply takes the flagship gold-stock index, known by its symbol HUI, and divides its close by the price of gold. Charted over time, this ratio provides outstanding insights into when gold stocks are cheap or expensive relative to the precious metal they bring to market.

In order to understand just how cheap gold stocks are today, we need some secular context. This first chart looks at the HGR over the better part of the last decade. It is slaved to the right axis in blue. For comparison, the raw HUI gold-stock index is rendered in red off the left axis. Thanks to the recent commodities and commodities-stock scare, gold stocks are now at some of their cheapest levels of their entire secular bull!

This week, the HUI slumped to 513 despite gold trading around $1642. The first time the HUI hit this level in March 2008, gold had just crossed over $1000! Today's weak gold stocks despite such strong gold prices were enough to drive the HUI/Gold Ratio down to 0.313x. As you can see in this chart, the only time the HGR has been lower was during 2008's epic once-in-a-century stock panic. Talk about cheap!

The better you understand HGR precedent in this bull, the wilder this recent anomaly appears. For a continuous 5-year span before the stock panic, the HGR generally meandered between support of 0.46x and resistance of 0.56x. Over this secular span of time in normal market conditions, the HGR averaged 0.511x. In other words, the HUI gold-stock index generally traded around half the prevailing gold price.

Knowledge of this HUI/Gold Ratio trading range was very profitable for speculators and investors alike. When the HUI neared or knifed below its 0.46x support, it was a great time to seize the cheap-gold-stock bargains and buy low. The low HGR levels flagged,in real-time, some of the best entry levels in this entire secular bull. Then later when the HUI neared or exceeded its 0.56x resistance, it was time for speculators to realize profits and sell high in anticipation of a healthy bull-market correction.

But this long-established secular HGR trading range suddenly shattered when the brutal stock panic slammed into the global markets in late 2008. The HGR literally plummeted, the panic impact was massive beyond belief. Because the HUI is the numerator of this ratio, a falling HGR means it is underperforming gold. Or stated the other way, gold is outperforming the HUI. Usually this happens when gold stocks are falling faster than gold, which is typical since they leverage its downside.

By the time that ultra-rare stock panic climaxed, the HGR was back to April 2001 levels. Incidentally, that was the very month gold's secular bull was stealthily born. So the stock panic temporarily erased the entire gold-stock bull relative to gold! Despite this general panic spilling into gold stocks, we fought the extreme fear then to aggressively buy crazy-oversold bargains in this sector. The ridiculously-low HGR was a major impetus for that contrarian campaign that later proved wildly profitable.

But though the HGR's initial post-panic recovery was fast, meaning gold stocks rallied far faster than gold to greatly outperform the metal they mine, it stalled out by late 2009. This was around the time the HUI itself was regaining its pre-panic levels. And even though the HUI has still rallied much since then, hitting many new all-time highs in 2010 and 2011, it is still cheap relative to gold. Especially now, as the HGR recently collapsed out of its post-panic trading range.

This carnage is much easier to see if we zoom in on this post-panic period. As you digest this second chart, don't forget that the pre-panic secular-average HGR in normal market conditions was 0.511x. And anything under the 0.46x support that largely held for 5 years means gold stocks are cheap relative to gold (and bull-market precedent). This chart adds a yellow hypothetical HUI line, showing where the HUI gold-stock index would be trading if it was at its pre-panic average HGR of 0.511x the price of gold.

After its fast initial recovery from the ridiculous gold-stock-panic price levels, the HUI stalled just below its pre-panic support of 0.46x in late 2009. The gains in gold were starting to outpace the gains in gold stocks, their traditional leverage relative to gold faltering. Partially due to surging interest in the GLD gold ETF, gold was getting more popular than gold stocks among big capital including hedge funds. The gold stocks couldn't keep pace.

Still, even though the HUI lost some ground relative to gold in Q4 2009, by early December that year both gold and the HUI were overbought and due for a healthy correction. With the HGR up near 0.42x then, the HUI was trading near 82% of where it would have been if it had regained its pre-panic HGR average of 0.511x. The month of December is important, as gold enjoys a strong seasonal rally leading into it.

The subsequent healthy correction into early 2010 was sharp, and as usual the gold stocks leveraged gold's downside. By early February the HGR hit a low under 0.35x, and the HUI slumped back to 68% of where it would have been trading at its pre-panic average HGR. But the gold stocks were very oversold then, as revealed by the Relative HUI at the time. And the HGR had hit what would become its post-panic support.

This support line is very clear in this chart. For fully 2 years after the secondary stock-panic lows in March 2009, the HGR bounced near this support line. And this critical ratio was gradually regaining ground on balance, gold stocks were once again being bid higher faster than the gold price was rising. The next major HUI upleg peaked in early December 2010, and once again the HUI was trading at 81% of where it would have been at its pre-panic secular-average HGR of 0.511x.

But in May 2011, despite the HUI itself just hitting new all-time highs over 600, this post-panic HGR support line started to decisively fail. The general stock markets were due for a correction, weighing on sentiment universally including among gold-stock traders. And with the dreaded gold summer doldrums approaching, traders dumped gold stocks at much faster rates than gold itself was being sold. With the HUI falling faster than gold, the HGR collapsed again.

Given the weak summer seasonality of gold and gold stocks, this wasn't particularly troubling at the time. It looked like a temporary correction-driven anomaly that would be quickly reversed as gold stocks started rallying in their next upleg. But then something really extraordinary happened. The growing fears over the acrimonious debt-ceiling debate in Washington and European sovereign-debt woes led to huge off-season demand for gold. This metal soared dramatically in July, yet the gold stocks couldn't keep pace.

The anxiety-driven gold buying in July and August was enormous, driving anunprecedented 27.4% summer gold surge in just 7 weeks! But the gold stocks lagged well behind, the HUI only rallied 17.9% over this span which dragged the HGR even lower. The day gold peaked in late August, the HGR was back under 0.32x. This was near the lowest levels the gold stocks had traded relative to gold since March 2009, right after emerging out of the secondary stock-panic lows.

Torn in August between following gold higher and the stock markets lower, the gold stocks couldn't leverage gold's big gains. And unfortunately for this metal, it had simply rallied too far too fast. As I warned the trading day before it topped, gold was extremely overbought and due to correct hard. On top of that, the fear and anxiety from the sharp stock correction that had fueled gold's blistering ascent were already fading.

As expected, gold indeed plunged in September. While it had been drifting lower for a month after getting so overbought, it fell sharply after the Federal Reserve failed to launch a third inflationary quantitative-easing campaign. The next morning some economic data out of China was misinterpreted which scared commodities traders into assuming the Chinese economy was slowing dramatically. Though not true, all commodities and commodities stocks were dumped aggressively in a brutal bloodbath.

And once again as usual, the HUI still amplified gold's downside despite failing to participate in its rare summer upside. So again the HGR was driven down to March 2009 levels, among the cheapest in gold stocks' entire secular bull. While this gold-stock selling was perfectly understandable psychologically, traders were scared, it made zero sense fundamentally. Even after correcting, gold above $1600 remained at wildly-profitable levels to mine that were never even seen before mid-July!

So gold stocks are extraordinarily cheap relative to the price of gold today. We haven't seen anything like this since the stock panic, an incredible time to snatch up unloved gold stocks at dirt-cheap prices. That previous stock-panic anomaly of low gold-stock prices was quickly reversed with a massive HUI upleg in 2009 that far outpaced the underlying gains in gold. Given the fact that such low HGR levels were never seen before the panic, and they couldn't persist after it, odds are today's anomaly won't last long either.

It will take a mighty gold-stock upleg to rectify, which could be one of the biggest of this bull market. The reason is major players on Wall Street including elite hedge-fund managers and private-equity guys are starting to get involved. They are publicly acknowledging just how cheap gold stocks are, and how far these miners will have to rally before once again reflecting prevailing gold prices. This panic-like anomaly in gold stocks may be the catalyst that finally entices serious mainstream capital into them!

And this beaten-down sector's near-term potential is indeed staggering. Earlier this month, the HUI plunged to 61% of the levels it would have been trading at if the pre-panic HGR average was regained. By both December 2009 and December 2010, the HUI had rallied to back up over 81% of its hypothetical levels. Assuming gold does nothing in this seasonally-strong time and stays near $1650, the HUI would have to soar 33% from this week's levels by December to merely hit this conservative 81% metric again!

But with mainstream capital getting interested in this small sector for the first time in its entire secular bull, it wouldn't surprise me to see the HGR surge back up near its pre-panic average of 0.511x. At dead-flat $1650 gold, this implies a near-term HUI target of 843. This is 64% above this week's levels! Seeing such a massive gain in the HUI's next major upleg would merely carry it back up to normal levels relative to gold, no great stretch.

Of course you can easily weave far-more-bullish scenarios. If gold rallies in the coming months as it ought to this time of the year, the HUI targets based on HGRs ratchet considerably higher. And many traders will play gold stocks in smaller more-leveraged miners and juniors, which will enjoy gains well better than the giant miners of the HUI. And if traders get really excited about gold stocks in the coming months, the HGR could even exceed its pre-panic average to approach its old 0.56x secular resistance!

For some, a major gold-stock upleg driving the HGR back up into its pre-panic range seems way too optimistic. Maybe gold stocks will never regain their secular pre-panic levels relative to the metal that drives their profits, they fear. While anything is possible, consider silver's example. During the stock panic, silver's levels relative to gold plummeted out of their pre-panic range just like the HUI's. And the Silver/Gold Ratiolooked as hopelessly broken as the HUI/Gold Ratio does now.

But earlier this year when silver finally caught the attention of mainstream money managers, it rallied so massively that it soared way above its pre-panic range to the best levels seen relative to gold by far in its entire secular bull. Once a small out-of-favor sector like silver or the gold stocks catches a major bid from serious mainstream capital, it can skyrocket in monumental uplegs that defy imagination. Given gold stocks' incredible gold-driven fundamentals, there is no reason to expect them to stay out of favor forever.

Their cheapness is even evident in conventional price-to-earnings valuation analysis. I wrote an essay back in March that shows a chart of the market-capitalization-weighted-average P/E ratio of the HUI component companies. As October 2011 dawned, the MCWA P/E of the HUI was just 21.1x (very cheap for gold stocks). So even in conventional valuation terms the gold stocks are trading about as cheaply as they've been since the panic. This also happens to be down near the secular support of the HUI P/E trend.

Relative to gold or actual profits, there is no arguing that gold stocks are very cheap today. Investors and speculators who can stomach these volatile and challenging markets have an incredible opportunity to buy gold stocks at some of their lowest levels relative to gold in this entire secular bull. While it is never easy fighting the crowd and being brave when others are afraid, the rewards are well worth the angst.

At Zeal we've been steadfastly forging this unpopular contrarian course for over a decade. We buy fear and sell greed, the exact opposite of what the great majority of traders do. Our resulting track record is outstanding. Since 2001, during a secular stock bear no less, all 591 stock trades recommended in our subscription newsletters have averaged annualized realized gains of +51%! You can't grow your capital by 50%+ a year on average unless you're willing to buy low when few others want to.

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The bottom line is gold stocks are now very cheap. Relative to gold, they are at their lowest levels of this entire secular bull except for during the stock panic. And immediately after that once-in-a-century anomaly, gold stocks soared dramatically far outpacing gold's gains. Gold stocks are so darned cheap today that even elite mainstream money managers are taking notice. Their buying alone could ignite a mighty upleg.

Like all stocks, the price levels of gold stocks are ultimately driven by their underlying profitability. And with gold so strong, gold miners' profits are huge. So inevitably sooner or later, investors and speculators will flood in to bid them back up to levels reflecting today's much-higher prevailing gold prices. The resulting gains in gold stocks should be massive, richly rewarding the contrarians who own them.

Adam Hamilton, CPA

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