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Gold stocks have
suffered heavy collateral damage following the Federal Reserve’s
hawkish surprise late last month, which ignited enormous
gold-futures selling by American speculators. This devastated
sector has been battered back down near last summer’s deep secular
lows. But these gold-stock price levels are fundamentally absurd,
the product of extreme and irrational sentiment that can’t persist
for long.
Today’s gold-stock
price levels are the greatest fundamental disconnect in the
entire stock markets, an epic opportunity for contrarian investors
and speculators! The entire gold-mining industry is trading as if
the price of gold, the overwhelmingly-dominant driver of its
profits, was just a small fraction of prevailing levels. Gold
stocks are radically underpriced fundamentally based on their
current and future earnings power.
Stock-market
fundamentals are simple. Investors buy stocks to own fractional
stakes in the underlying companies’ future profits streams. While
popular greed and fear bull stock prices around over the short term,
they ultimately mean revert to some reasonable multiple to their
underlying companies’ earnings in the long run. Profits are the
core fundamental foundation of stock prices, universally throughout
all sectors.
In the gold-mining
industry, prevailing gold prices almost exclusively determine
profitability. While gold mines are expensive to operate, their
costs are largely fixed in the planning stages before construction
even begins. So higher gold prices translate directly into higher
profits, fundamental strength ultimately supporting higher stock
prices. And the relationship between gold and profits isn’t linear,
but highly leveraged.
This is easy to
illustrate. With elite gold miners’ operating results still being
released for Q3, the
latest full data
remains Q2’s. The leading gold miners of the flagship GDX Gold
Miners ETF reported average cash and all-in sustaining costs of $635
and $895 per ounce that quarter. The latter number can be rounded
up to $900, and represents the complete costs necessary to
sustain current production levels.
When this industry
can mine gold for $900 per ounce, and the metal is trading near
$1100, it earns a $200-per-ounce profit. As gold rallies, those
mining costs essentially remain fixed. This leads to profits
that really amplify gold’s gains. If gold merely rallies 10% to
$1210 in this example, industry earnings would climb to $310 per
ounce which represents a massive 55% gain. That’s serious upside
leverage!
Because of this
ironclad innate fundamental relationship between gold prices and
profitability in the gold-mining industry, gold-stock prices have
always followed gold. But that key relationship started breaking
down in 2013, and has cascaded to crisis proportions since. This
huge disconnect is readily evident in this first chart, which
compares the benchmark HUI gold-stock index to its earnings-driving
gold price.
Before 2013,
gold-stock prices closely mirrored and amplified the gold price.
The higher gold, the greater prevailing gold-mining profitability,
and thus the higher gold-stock price levels. Gold-stock prices were
behaving normally, meandering around righteous fundamental levels
based on reasonable multiples of underlying companies’ earnings
streams. From time to time, sentiment extremes would spawn
temporary deviations.
Sometimes traders
became so enamored with gold stocks that they grew greedy, and bid
this sector up to lofty heights not supported by fundamentals. This
last happened in spring 2006, when the soaring gold stocks were
commanding much favor. Other times, traders lapsed into fear and
despair and sold gold stocks to levels far below reasonable ones
based on profits. 2008’s once-in-a-century stock panic is the best
example.
But overall,
gold-stock prices tracked gold. Visualize that ultimate
fundamental relationship as a straight line. While excessive greed
or fear can temporary pull prices far above or below that core
fundamental line, eventually gold-stock prices always mean revert
back to that reasonable baseline. Until early 2013 that is, when
the markets started radically changing on extreme central-bank money
printing and jawboning.
That’s when the
Fed ramped its wildly-unprecedented
third
quantitative-easing campaign to full steam. QE3 was radically
different than QE1 and QE2 because it was open-ended, with no
predetermined size or end date like its predecessors. Top Fed
officials deftly used this to its advantage, continually implying it
was ready to increase the size of QE3’s debt monetizations if the
stock markets suffered any material swoon.
Stock traders
interpreted the Fed’s incessant jawboning exactly as intended, soon
believing an effective Fed Put was in place. So they started
aggressively buying already-high stocks, creating recent years’
extraordinary
stock-market levitation devoid of normal healthy selloffs until
very recently. With the stock markets surging straight up on
central-bank-easing hopes, traders sold everything else to chase
stocks.
Including gold,
which plummeted in early 2013 on a combination of
extreme
gold-futures selling by American speculators and
epic differential
selling of GLD gold-ETF shares by stock investors. The
resulting gold plunge was horrific, especially in the second quarter
of 2013 which saw gold plummet 22.8%! That was its biggest
quarterly loss in 93 years, which spawned this festering
disconnect in gold-stock prices.
Even though gold
prices soon stabilized as that excessive selling inevitably burned
itself out, gold-stock price levels kept falling as investors and
speculators fled. This culminated with major new secular lows in
both the metal and its miners in early August 2015. But despite the
lower gold prices, gold-stock price levels were so far from
fundamentally reasonable and righteous that they truly entered the
realm of the absurd.
Gold’s major
secular low came in early August following an extreme
gold-futures
shorting attack in late July exquisitely executed to
manipulate the gold price lower. Gold slumped to $1084, a major
new 5.5-year secular low not seen again until this week after the
Fed put a December rate hike back on the table. With gold below
$1100, the gold-stock prices certainly shouldn’t have reflected
September 2011’s $1894 peak.
But they should
have been reasonable relative to gold, which was trading at
levels last seen in February 2010. Where were gold stocks trading
per the HUI the last time those recent secular lows were seen? This
index averaged 397 that month! Yet in August 2015 as gold revisited
those same levels, the HUI was limping along near 105.
This made no sense at all fundamentally given the elite gold miners’
sub-$900 costs.
The flagship
gold-stock index continued bottom-feeding near 105 in September,
when it made a marginal new secular low just under 105. That
happened to be the lowest HUI close since July 2002 a whopping
13.2 years earlier! Where was gold trading the last time
gold-stock price levels were that low? Around $305! And at that
point, the best level gold had yet seen in its young new secular
bull was merely $329.
Think about the
gross incongruity of this extreme pricing anomaly. While
gold slumped to a 5.5-year low, gold stocks plunged to a 13.2-year
low. While gold was around $1100 and the elite miners were earning
$200 per ounce on an all-in-sustaining-cost basis, the gold stocks
were priced as if gold was $800 lower near $300. Absurd is the only
word to describe this, these prices are
fundamentally-absurd!
Imagine if Apple’s
stock was trading as if it could only sell iPhones for 3/11ths of
their actual selling price. Such an epic fundamental disconnect
could only be caused by one thing, excessive fear. And once
that inevitably burned itself out and dissipated, capital would
flood back in to bid this stock back up to reasonable levels that
adequately reflected its profitability. The same thing is
guaranteed to happen in gold stocks.
Like the entire
financial markets, the stock markets in general and gold stocks in
particular are forever cyclical. Prices perpetually
oscillate around that
reasonable-valuation-based-on-underlying-earnings line. Excessive
greed first catapults prices far above fundamentally-righteous
levels, which is then later followed by excessive fear that pummels
prices far below them. Since neither extreme can last, cycles
exist.
Eventually a point
is reached in these popular-greed-fear sentiment waves when
emotional extremes hit absolute peaks. On the fear side, once
prices fall far enough for long enough everyone susceptible to being
frightened into selling low is already out. Only brave contrarian
buyers remain. And with prices hammered to extreme
fundamentally-absurd lows relative to underlying corporate earnings,
the upside is great.
So buyers
gradually return to the radically-undervalued sector like gold
stocks today, just a trickle at first. But since nothing begets
buying like rising prices, the gains driven by the early buying
attract in more investors and speculators. They too buy, amplifying
the capital inflows which soon snowball into even broader interest
in the rallying sector. This virtuous circle of buying out
of extreme lows is immensely profitable.
Gold stocks
themselves offer a perfect example. During that incredible
once-in-a-lifetime stock panic in late 2008, the gold stocks
plummeted 70.6% per the HUI in a matter of months. In the dark
heart of that panic, everyone was utterly convinced this sector was
doomed to spiral lower indefinitely. It was literally left for
dead, abandoned in crushing despair. Sound familiar? That’s
exactly what’s happening today!
Yet out of those
very extreme lows carved in peak fear, a massive new upleg
was being born. Buyers started to return as fear burned itself
out. This eventually attracted in so much capital that the despised
gold stocks would more than quadruple over the next several
years! The HUI’s incredible 319.0% gains over that span dwarfed the
benchmark S&P 500’s 39.7% rally by over 8x, really multiplying
contrarians’ wealth.
Our current
extreme cyclical low in gold stocks is also going to yield to a
mighty mean reversion higher to fundamentally-reasonable gold-stock
price levels. The cyclical nature of gold-stock prices relative to
the gold price which drives their profits is even more apparent
through another construct known as the HUI/Gold Ratio. This simply
divides the daily HUI closes by gold closes to quantify their
relationship over time.
The HUI/Gold Ratio
distills down this dominating fundamental relationship between
gold-stock prices and the price of the metal which overwhelmingly
drives their profitability. When the HGR is rising, the gold stocks
are rallying faster than gold usually because the former are
returning to favor. When the HGR is falling, gold is rallying
faster than gold stocks usually because the latter are falling out
of favor.
Before 2008’s
incredible stock panic, the fundamental link between gold-stock
prices and gold worked normally. For 5 full years leading into the
middle of 2008, the last normal years before that epic panic
discontinuity radically altered psychology, the HGR generally
meandered between 0.46x support on the low side to 0.56x resistance
on the high side. Gold-stock prices were cyclical within this
secular trend.
The average HGR in
those pre-panic years was 0.511x. In other words, the benchmark HUI
gold-stock index tended to close at levels around 51% of prevailing
gold prices. Keep that normal-condition metric in mind, we’ll come
back to it. Unfortunately that normal-year fundamental relationship
between the gold miners and the metal they mine was shattered by the
mind-boggling fear maelstrom of 2008’s stock panic.
The gold stocks
plummeted far faster than gold, blasting the HGR down to a 7.5-year
low of 0.207x. That was essentially a secular-bull low, as the gold
stocks hadn’t traded that cheaply relative to gold since the very
dawn of their mighty 2000s bull market. But in the dark heart of
that stock panic with epic fear being utterly suffocating, that
emotional extreme wasn’t sustainable. Peak fear had been
reached with a vengeance.
So as I
predicted at the
time based on this same HGR fundamental analysis, gold stocks
soon started to rocket higher again as capital returned. Over the
next several years the HUI more than quadrupled, with far-higher
gains in the smaller fundamentally-superior gold miners we prefer to
own. During the normal years following 2008’s crazy stock panic,
2009 to 2012, the HGR averaged 0.346x over that secular span.
Remember that
number too. But in early 2013, the Fed’s extraordinary stock-market
levitation fostered by the implied promise to ramp QE3 whenever
stocks faltered started seducing investors away from gold at a
wildly-unprecedented rate. As gold plummeted in the second
quarter of that year, effectively a once-in-a-century event,
investors and speculators alike fled gold stocks before they
stabilized once again.
But in late 2014
and a second time in mid-2015, the gold stocks suffered subsequent
waves of panicked selling as gold was battered to deeper lows by Fed
machinations. American futures speculators, who are the
dominant driver
of gold’s price these days with investors largely missing in
action, arrived at the belief that Fed rate hikes were gold’s mortal
nemesis. So they aggressively dumped gold in a highly-leveraged
way.
That ultimately
forced the HGR down to its recent all-time low of 0.093x in
late September 2015. Never before had the gold-mining
industry’s stocks been priced so cheap relative to the price of the
metal that overwhelmingly drives their profits! And these recent
new record lows are even more surreal given the fact they greatly
exceed the depths of 2008’s stock panic, the most extreme fear event
we’re likely to see in our lifetimes.
Zoom back out and
consider the extraordinary incongruity of this. Like all markets,
the gold stocks are forever cyclical. They flow and ebb, rising and
falling as they gain favor and lose favor with investors and
speculators. Yet essentially since spring 2006, the
gold-mining stocks have been falling on balance relative to gold
which determines their earnings and thus ultimate
fundamentally-righteous price levels.
So for a
mind-blowing 9.4 years now, gold stocks have been mostly falling out
of favor. Is that normal or sustainable? Doesn’t fear eventually
have to peak? Gold mining is a tiny contrarian sector compared to
the broader stock markets, so sooner or later everyone involved has
to hit peak despair. I suspect that very point is happening this
year, which will prove to mark a major reversal to HGR
advances in coming years.
Gold stocks are so
devastated that their value is extreme, and sooner or later here
institutional money managers are going to recognize that and start
returning. An industry earning $200 per ounce at $1100 gold isn’t
going to zero. And as that inevitable sentiment shift away from
radically-extreme fear happens, the gold stocks are going to catch a
mighty bid. Their upside per their fundamental relationship with
gold is vast.
As of this week,
the HUI was trading at the dismal level of 110. The first time it
hit that level in April 2002, gold was at $312. So at this week’s
$1085 gold, gold stocks should be priced radically higher.
If they merely rallied enough to restore 2008’s stock-panic-nadir
HGR of 0.207x, the elite major gold miners that dominate the HUI and
GDX ETF would have to soar 104% higher from here! Doubling is
nothing to sneeze at.
If the gold stocks
regain enough favor to just return to their post-panic average HGR
of 0.346x, we’re looking at 241% gains from here in the large gold
miners’ stocks. And if enough capital returns to push the HGR back
up to pre-panic secular norms of 0.511x, the HUI and GDX would
skyrocket 404% higher! And those headline gains would be dwarfed by
the upside witnessed in the best of the smaller gold miners.
If that’s not
enough to convince someone to take a serious look at deploying
capital in gold stocks, they are simply not interested in buying low
and selling high. And incredibly, this devastated sector’s upside
potential based on near-certain HGR mean reversions is greatly
understated. How can that be? As gold itself rebounds and mean
reverts higher, much larger gold-stock rallies will be necessary
for HGR reversions.
2012 was the last
normal year before the radical market distortions spawned by the
Fed’s QE3 debt-monetization campaign and its associated jawboning.
That year, gold averaged $1669. Sub-$1100 gold is not normal at all
in a surreal economic environment witnessing the most extreme
central-bank money printing in world history! Relatively more money
chasing relatively less gold guarantees higher prices.
But let’s be even
more conservative. Between 2010 and 2012, the 3-year span before
QE3, the average gold price was $1490. Let’s round that to $1500.
Gold returning to $1500 in the next year or two should be easy
considering how extreme and rampant fear and despair are in it
today. Plug in those same well-established HGR targets to $1500
gold, and the likely upside in this battered sector is far more
impressive.
If the HGR merely
returned to 2008’s extreme panic lows, the HUI and GDX upside at
$1500 gold rockets up to 182% from here. At that secular post-panic
average HGR of 0.346x, the leading gold stocks would have to soar
371% higher! And finally a full mean reversion of the HGR to its
secular pre-panic average of 0.511x would require a 596%
gold-stock bull market at $1500 gold. Gold stocks’ coming
potential is truly unrivaled.
But you certainly
don’t have to be this optimistic to deploy capital in gold stocks
today while everyone loathes them. If you merely see a solid
probability of a doubling in the coming year, which is the
worst-case mean-reversion scenario, you should be buying up these
epic bargains hand over fist. Where else in these lofty,
overvalued,
and overextended Fed-levitated stock markets is a near-term doubling
even possible?
And don’t worry
about gold in
Fed-rate-hike cycles. There have been 11 since 1971, and in the
6 that started with gold near major lows this metal enjoyed stellar
average gains of +61.0% over those exact Fed-rate-hike cycle
spans! During the last one between June 2004 and June 2006, the Fed
hiked no fewer than 17 times to blast its federal-funds rate 425
basis points higher. Gold surged up 49.6% during that!
While gold lost
ground in the other 5 Fed-rate-hike cycles since 1971 as futures
speculators universally believe will happen today, its average loss
was just 13.9%. Even more interesting though, all of these
Fed-rate-hike cycles began with gold near major secular highs.
That certainly isn’t the case now. Fed rate hikes are very damaging
to lofty stocks and bonds, rekindling gold investment demand for
portfolio diversification.
You can prepare to
multiply your wealth in this long-overdue gold-stock mean reversion
higher back up to fundamentally-reasonable levels relative to gold
in a couple ways. The flagship
GDX gold-stock
ETF will beautifully track this sector’s progress. But if you
want far bigger gains than the major miners, the best of the elite
fundamentally-superior smaller miners will see ultimate gains
dwarfing those seen in GDX.
That’s what we’ve
long specialized in at Zeal. We are hardcore contrarians who’ve
spent the last 16 years studying and trading the markets in order to
buy low when few will to later sell high when few can. We’ve been
aggressively buying the best of the elite gold and silver stocks in
recent months, and all those trades are detailed in our acclaimed
weekly and
monthly
newsletters for speculators and investors.
They draw on our
decades of exceptional experience, knowledge, wisdom, and ongoing
research to explain what’s going on in the markets, why, and how to
trade them with specific stocks. They will help you both cultivate
an essential contrarian perspective and multiply your wealth. And
with general stocks looking exceedingly toppy, that’s going to prove
incredibly valuable.
Subscribe today and get deployed!
The bottom line is
gold stocks have been pummeled down to fundamentally-absurd price
levels relative to the metal which overwhelmingly drives their
profits. Investors and speculators have left this battered sector
for dead as they chased the Fed’s extraordinary stock-market
levitation of recent years. This has left the gold-mining sector a
wasteland of fear and despair, spawning the fundamental bargains of
a lifetime.
Gold stocks are no
exception to the ironclad market rule of endless cyclicality. They
can’t fall out of favor forever, sooner or later capital will return
to chase these extreme bargains. And the long-overdue mean
reversion higher is going to create great fortunes for the hardened
contrarians smart enough and tough enough to fight the herd and buy
these extreme lows. Gold stocks’ vast upside potential is unrivaled
in all the markets.
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