After surging
sharply in August and early September, gold stocks have been consolidating
sideways ever since. Naturally this loss of momentum has sapped the nascent
trader enthusiasm for this sector. But stalling out temporarily certainly
doesn’t negate gold stocks’ dazzling fundamentals. They remain
deeply undervalued relative to gold, the metal that drives their profits and
hence ultimately their stock prices.
While
sentiment (greed and fear) dominates short-term stock-price swings, over the
long run stock prices are nearly exclusively determined by fundamentals. Investors buy stocks to
own fractional stakes in the underlying companies’ profit streams. The
bigger those profits grow, the higher the stocks are bid of the companies
earning them. And for gold stocks, the gold price controls the vast majority
of profitability.
Unlike most
other companies, gold miners effectively have infinite demand for their
product. They can easily sell every single ounce of gold they manage to
produce. They never have to discount, the market price is what they get. And
with mining costs largely fixed, higher gold prices flow directly into
bottom-line profits. And because of these fixed costs, profits rise much faster than the underlying gains
in gold.
This profits leverage is easy to
understand. Imagine a miner selling gold today for
$1700 that it produced for
$700. Its profit is $1000 per ounce. But if gold rises 25% to $2125,
profits would surge to $1425 since production costs are essentially fixed as
mines are planned and built. That’s a 43% increase in profits driven by
a 25% gold rally! This profits-leverage growth is more exponential than
linear as gold climbs.
But the great
opportunities in gold stocks today are not due to this future potential, but a colossal past disconnect. Thanks to the incredible
damage 2008’s epic stock panic wreaked on sentiment, gold stocks have
been heavily neglected in recent years. Thus they are trading as if gold was
far lower than today’s prevailing prices. But this glaring fundamental
anomaly won’t last forever, stock prices will reflect profits.
The flagship
gold-stock index these days is the NYSE Arca Gold BUGS Index, better known by
its symbol HUI (“huey”). This week with gold near $1775, the HUI
was trading near 500. The first time the HUI hit 500 was back in March 2008,
when gold had just achieved $985 for the first time ever. Even though
prevailing gold prices are 80% higher
now, the gold stocks are trading as if gold was still under $1000. This is
madness.
Not
surprisingly, gold-stock valuations reflect this. Back in late June I updated
my decade-long thread on gold-stock
valuations. The elite component stocks of the HUI, the lion’s share
of the world’s gold miners, were trading at their lowest valuations of their entire secular bull. At 12.0x
earnings, they were far cheaper than the benchmark S&P 500’s 17.8x.
Gold stocks have somehow become value investments!
But my
favorite way to illustrate this fundamental disconnect is with the venerable
HUI/Gold Ratio. The HGR is exactly what it sounds like, the daily HUI close
divided by the daily gold close. When charted over time, this ratio reveals
the relative performance of gold stocks compared to the metal that drives
their profits and hence ultimately their stock prices. The HGR is rendered in
these charts in blue.
Prior to that
epic discontinuity sparked by 2008’s once-in-a-century stock
panic, the HGR spent 5 years meandering in a tight secular trading range. This
ran from roughly 0.46x on the low side to 0.56x on the high side. This range
is the baseline normal relationship
for gold-stock prices relative to gold in the absence of the brutal
psychological aftermath of the panic. Without that event, these levels would
have persisted.
Because the
HUI is the numerator of this ratio, a rising HGR indicates the gold stocks
are outperforming gold. Usually this means gold stocks are rising faster
during a major gold rally. Occasionally traders got so excited about gold
stocks that they greedily bid them above the HGR’s 0.56x resistance for
a brief spell. This last happened in early 2006, a euphoric time when gold
stocks were just rocketing higher.
And the
opposite is also true, a falling HGR indicates gold is outperforming the gold
stocks. Prior to the panic, this typically meant the gold stocks were falling
faster than gold during major gold corrections. Only once in those pre-panic
years did gold stocks slump so deeply out of favor that the HGR’s 0.46x
support was temporarily broken. Provocatively that was just before that massive 2006 HUI upleg.
On average
during those 5 pre-panic years ending in mid-2008, the HGR ran 0.511x. In
other words, the HUI tended to trade at just above half the level of the gold
price. A 5-year span is a long
time, absolutely secular. This encompassed nearly all possible sentiment
environments, from rampant greed late in major uplegs to crippling fear late
in major corrections. 0.511x is the long-term normal baseline HGR.
But of course
the crazy stock panic changed everything. That insane fear superstorm drove
gigantic and unprecedented demand for the US dollar as a global safe haven.
Thus the US Dollar Index soared in its biggest and fastest rally
ever. So naturally gold took a big
hit, plunging 27.2% at worst between July and November 2008. But the gold
stocks fared far worse, the HUI plummeting 67.7% over a similar span!
With gold
stocks dropping far faster than gold, the HGR entered a sickening free fall.
By the time fear peaked and it finally bottomed, it was trading at April 2001
levels. That was when this secular gold bull was born, so gold stocks were
acting as if gold’s bull never
even existed. Though most traders were blinded by fear, this anomaly was
an incredible buying opportunity. So we aggressively bought then.
And indeed the
HGR started surging dramatically after the panic, the beaten-down and left-for-dead
gold stocks were rallying far faster than gold. But as I’ll dig into in
the next chart, this recovery soon stalled. The gold stocks were still
rallying, but merely pacing gold. And since late 2011, the HGR has again
collapsed. Incredibly, gold stocks were recently back at panic levels relative to gold this past summer!
The stark
contrast between pre-panic and post-panic gold-stock valuations compared to
the metal that drives their profits is amazing. Before the panic, the HUI
averaged 0.511x the price of gold for 5
years running. Since the panic, this average HGR has plunged to 0.350x.
So gold stocks have been nearly a third
less valuable relative to gold in this post-panic era than they were in the
normal times before it.
The critical
question for speculators and investors to consider is why did this happen?
Since gold stocks’ conventional
valuations based on profitability were recently as cheap as they’ve
been in this entire secular bull, the answer has to be psychology. The stock panic was so scary that it frightened a
sizable fraction of pre-panic gold-stock investors into abandoning this
sector and never coming back.
Being in the
newsletter business, I received countless capitulation e-mails in late 2008
and early 2009. Speculators and investors were foolishly extrapolating the
extreme anomaly of the stock panic forward indefinitely, so they sold near
the panic lows to safeguard the dwindling remnant of their capital. And after
selling at the worst-possible point in this entire secular bull, they are too
demoralized to ever return.
This next
chart zooms in to the result of this wholesale abandonment of gold stocks,
the dark post-panic era. In addition to the HGR in blue and the HUI itself in
red, a third series is shown in yellow. It is where the HUI would
hypothetically be trading if it returned to its pre-panic average of 0.511x
the price of gold. The massive gap between these normal HGR levels and
today’s is the huge opportunity in gold stocks.
In the first
year or so after the stock panic, the gold stocks’ recovery relative to
gold was indeed fast as expected. But it stalled out and stabilized between
late 2009 and early 2011. Though gold stocks continued to rally nicely, they
merely paced the gains in gold. Still, much lost ground was made up. The
actual HUI recovered to 81% of where it would have been at a
0.511x HGR, compared to just 41% in the depths of the panic.
But in
mid-2011, an unfortunate chain of events began that ultimately led us into
today’s morass. After achieving new all-time highs in early April 2011,
the HUI started consolidating. But gold kept on advancing, powering 8.7%
higher that month to the HUI’s 3.4%. This gold outperformance broke the
HGR below its post-panic uptrend’s support line, and really started to
damage gold-stock psychology again.
With gold
stocks failing to follow gold to new all-time highs, traders began to wonder
if they were broken. There was all kinds of talk, even on CNBC, of gold being
a way superior investment to the far-riskier gold stocks. And if gold stocks
can’t leverage gold’s gains, that idea would certainly be
correct. But everyone was forgetting the HUI had just rallied 300% since the panic lows compared to
gold’s own 120% advance.
And with these
gold-stocks-are-dead ideas fresh in everyone’s minds, the 2011 summer doldrums arrived right
on schedule. So gold, silver, and the HUI drifted sideways to lower as usual.
But then in July, an extraordinary event transpired. With mere weeks to go
until the US Treasury’s deadline, it looked like Obama and the Congress
weren’t going to reach a deal on raising the US’s statutory debt
ceiling in time.
With the risk
of the first-ever US default on its sovereign debt looming large, gold demand
soared. No one knew what would happen, and how it would impact the usual safe
havens of the US dollar and US Treasuries. So gold blasted 8.3% higher in
July 2011, something utterly unprecedented in this bull. And the HUI only
gained 4.2%, as gold stocks will never be as safe as gold. So the gold-stock
hate ballooned.
A crappy weak
compromise deal narrowly averted the US debt default, but it resulted in
Standard & Poor’s downgrading Washington’s debt for the first
time in history. So the stock markets plunged in early August 2011, igniting
even more safe-haven gold demand. So gold soared another 16.5% in the first few weeks of that month, and again the
gold stocks couldn’t keep pace as evidenced by the HUI’s parallel
11.3% gain.
So the HGR
drifted lower and lower on these extraordinary events. But unfortunately
euphoria was creeping into gold, its unprecedented summer rally catapulting
it to very-overbought levels.
So it soon corrected, dragging the gold stocks down with it. Even though they
didn’t really participate in its US-debt-default-scare rally, they were
still sold off in the aftermath. Gold stocks fell ever more deeply out of
favor.
The remaining
pre-panic speculators and investors had had enough, they started exiting en
masse. Whenever CNBC talked about gold, the focus was usually on how terrible
gold stocks were and how stupid it was to buy them instead of gold itself.
All this negative sentiment fed on itself in early 2012, ultimately
culminating in a stunning gold-stock
capitulation in mid-May. It was an utter bloodbath.
Such extreme
pessimistic, bearish, and fearful sentiment forced the HGR back to panic levels! The HUI was only
trading at 48% of where it ought to be compared to the pre-panic average HGR.
Relative to gold, the gold stocks were nearly as loathed as they were during
2008’s crazy stock panic. And relative to their conventional valuations
(P/E ratios), gold stocks became considerably
cheaper than during the panic.
Of course
bottoming in May just before the summer doldrums wasn’t a great time,
as gold, silver, and their miners tend to merely grind sideways through June,
July, and August. So the HGR slumped to a secondary low in late July. Hardly
anyone wanted anything to do with gold stocks, despite their incredible
cheapness. I wrote about this extensively this past
summer, and we loaded up on cheap gold stocks.
And indeed
since then the gold stocks have amplified the gains in gold’s young new
upleg. After carving a major double-bottom in May and July, the HGR surged
back above its 200dma last month for the first time since early 2011.
Although they remain dirt-cheap relative to gold, gold stocks are slowly
starting to return to favor again. Even the discussions on CNBC finally recently
began extolling their virtues!
The odds are
overwhelming that the huge HGR slump greatly exacerbated by the
US-debt-default scare was an anomaly,
an unsustainable sentiment extreme. It was a perfect storm to breed
incredible fear and pessimism in this sector. And after the only two other
comparable episodes, mid-2005 and late 2008, the HUI soared dramatically in
its biggest uplegs of its entire secular bull. Extreme fear sparks extreme
rallies.
Fundamentals
always trump psychology in the long run. The gold miners are making profits
hand over fist at recent gold levels, driving this sector deep into
value-investment territory. Eventually new
investors inevitably take notice of extreme values in any sector, and
then capital floods in to buy the cheap profit streams. This bids the stocks
higher, forcing the irrational fear suffered at the lows to rapidly abate.
And this very
process is already underway. Between late July and mid-September, the HGR
surged from 0.245x to 0.297x. This is the strongest HGR rally seen since
mid-2009 just after the panic. And the HGR’s last major breakout above
a sharply-downward-sloping 200dma was also last witnessed in that same
timeframe. Remember that was early in the post-panic gold-stock recovery that
led the HUI to quadruple!
Though I
really doubt the HUI will quadruple again in this new upleg, its potential
gains are still massive even from this week’s 500 levels. Even if you
are a raging gold-stock pessimist, it isn’t a stretch to think gold
stocks will return to their post-panic-average
HGR of 0.350x. Assuming gold merely stays flat, this implies we are due for a
gold-stock rally approaching 25% in the coming months. That’s not bad
at all.
Maybe you are
a little less fatalistic on this ridiculously cheap sector with fantastic
fundamentals. What if gold stocks rally so strongly that they regain enough
favor to challenge their best post-panic
levels relative to gold? At late 2009’s 0.430x HGR, the HUI would have
to surge over 50% from this week’s levels. And once again this is
assuming gold itself doesn’t rally during its usual strong season.
Personally I
have no doubt the pre-panic-average HGR of 0.511x will eventually be
regained. Silver was once in a similar situation, hopelessly below its
pre-panic-average levels compared to gold. And traders gave up on it too. Yet
in late 2010 and early 2011 it greatly returned to favor, and so much capital
flooded in that it temporarily surged way above even its best
pre-panic levels! Mean reversions often wildly
overshoot.
At a flat gold
price and a 0.511x HGR, the HUI would need to power over 80% above this
week’s levels! It would not surprise me at all if this happens by next
spring, as we are still early in the strongest season of the
year for gold, silver, and the PM stocks. And the assumption that gold will
merely stay flat throughout it is pretty darned silly. On the Fed’s new
open-ended QE3 campaign
alone, a 25% gold rally is likely.
If gold
rallies 25% between now and its usual spring peak, obviously the HUI’s
upside targets at various HGR levels grow considerably. That would take gold
near $2200, meaning a post-panic-average HGR of 0.350x would imply coming
gold-stock gains around 55%. And returning to the pre-panic-average HGR of
0.511x takes the target upleg above 125% gains! Gold stocks’ potential
from here is simply vast.
And the same
is true of silver and the silver stocks, since they too key off of
gold’s performance. We’ve been buying silver stocks too at Zeal,
which we just finished researching for our latest fundamental report. We
spent 3 months painstakingly whittling over 100 publicly-traded silver stocks
down to our dozen fundamental favorites. Each is profiled in a fascinating
new 29-page report. Buy yours today!
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The bottom
line is gold stocks remain anomalously cheap relative to gold. A perfect
storm of adverse psychology drove gold stocks back down to panic levels
compared to the metal they mine. But after that unsustainable fear extreme
this past summer, gold stocks are already starting to return to favor.
Sentiment is reversing as they’ve rapidly regained ground relative to
the product which drives their profits.
But this
long-overdue period of gold-stock outperformance is just getting started.
Similar fear extremes earlier in this secular bull ignited its biggest and
most-exciting uplegs. Couple this with the highly favorable seasonals between
now and spring, and the Fed’s new unlimited inflation campaign, and
gold stocks ought to soar in the months ahead. Join us and get deployed now
before the next surge higher.
Adam Hamilton, CPA
October 12,
2012
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