Another Look at Cheap Gold Stocks

Gold had a tough December, falling 10.5% to grind along near its worst levels since July. This sparked hyper-bearish sentiment and end-of-gold’s-secular-bull talk. Naturally gold stocks fared even worse in this rampant gold pessimism, with the flagship HUI gold-stock index plunging 14.7%. But this selling was radically overdone, as compared to gold’s absolute levels gold stocks remain incredibly cheap.

Gold stocks, of course, are in the business of mining gold. Since the costs for mining a particular gold deposit are largely fixed during that mine’s planning stage, higher gold prices generally translate directly into higher profits. And universally in all sectors of the stock markets, higher profits lead to higher stock prices. Ultimately every stock is merely a fractional stake in its underlying company’s future profits stream. So higher profits and future profits potential entice investors to buy into and bid up any stock.

At Zeal we’ve done a lot of work looking at gold-mining profits over the past decade or so. During a secular gold bull, which we have enjoyed since April 2001, gold rises on balance. Global demand for this metal grows faster than global supplies, so competition for this scarce and desired resource drives higher prices. And despite higher mining costs driven by inflation and other commodities’ bull markets, both absolute profits and profit margins have continued expanding greatly throughout this gold bull.

The gold price truly is the overwhelming primary fundamental driver of gold-stock valuations and therefore gold-stock prices. So when gold stocks get too cheap relative to the metal they mine, it is time to buy low. And later when they grow popular and get too expensive relative to gold, it is time to sell high. This relationship is easiest to capture with the HUI/Gold Ratio. The HGR simply divides the closes in this leading gold-stock index by the price of gold, and charts the results over time.

And as you can see in this secular HGR chart, gold stocks are about as cheap today as they’ve been throughout this entire gold bull. The only exception was the crazy stock panic in late 2008 and its immediate aftermath, which was very short-lived. The HGR is rendered in blue off the right axis, superimposed over the raw HUI itself in red on the left axis for comparison. Gold stocks are dirt-cheap.

As of the middle of the first week of the new year, the HUI closed at 521 while gold was running $1,612. This yields a HUI/Gold Ratio of 0.32x. This information in isolation is useless, but seen in the context of this gold bull it is very illuminating. As this chart reveals, the HGR is now back near levels only seen during the stock panic. Gold stocks are almost as cheap relative to gold today as they’ve been throughout its entire secular bull.

Obviously the first true stock panic in 101 years was an epic discontinuity, the greatest super-storm of fear we will see in our lifetimes. Commodities, including safe-haven gold, were hit exceptionally hard. Investors and speculators alike literally panicked, selling everything they could at any price they could get as they stampeded for the exits. A sizable fraction of traders couldn’t handle this extreme stress and the losses they incurred by succumbing to their own fear, so they capitulated to never return to the markets.

But before that crazy event, the HGR had traded in a tight secular trading range for five solid years. The gold-stock valuations as measured by this ratio usually meandered between 0.46x support and 0.56x resistance. When the HGR was low in this range, it was time to buy gold stocks cheap. When it was high, it was time to sell and capitalize on their rich prices. The five-year pre-panic average HGR was 0.511x. In other words, the HUI tended to trade at about half the price of gold.

Even though gold fell precipitously during the stock panic, down 27.2% in just under four months, the HUI fared much worse. At worst within that same span, it plummeted an absurd 67.7% in less than 3.5 months. Hence the apocalyptic plunge in the HGR in late 2008 on this chart. The gold stocks got so insanely oversold relative to gold that the HGR hit its worst levels of this entire secular gold bull.

I wrote about how ridiculous this was at the time, so we bought gold stocks aggressively in the dark heart of the panic despite the extreme fear. And we were richly rewarded for this stubborn contrarianism, logically forcing ourselves to be brave when everyone else was afraid. On Oct. 28, 2008, the day after the HUI’s panic low, I told our Zeal Speculator subscribers:

“Yet the HUI closed near 152 yesterday, which is end-of-the-world levels as far as I am concerned. This index hasn’t been this low since mid-2003. Where was gold trading back then? In the $350s. Is this madness or what? We have a gold price over twice as high yet stock prices are apparently discounting mid-2003 gold levels. This is clearly not rational and reflects the sentimental nature of this stock selloff.”

At the time I figured the HGR would eventually regain its pre-panic secular trading range. After all, if a secular fundamental trend holds strong for five years running, should a mere short-lived psychological event permanently break it? Unfortunately, far more former gold-stock traders simply gave up forever because of that panic than I could have imagined at the time. Still though, gold stocks were super-cheap and crazy-oversold so they did indeed surge sharply in a fast initial recovery.

By December 2009, despite losing two-thirds of its value in the stock panic, the HUI had nearly regained its best pre-panic levels. This once-beleaguered gold-stock sector had more than tripled with a massive 236.9% gain in about 13 months. But despite this fantastic and hugely-profitable progress, the HGR had still stalled out in late 2009. While the gold stocks were still rallying, they weren’t advancing as fast as gold.

This was troubling back then, and is still troubling today. My business partner Scott Wright and I have spent endless hours discussing whether or not the former constituency of gold-stock shareholders from the pre-panic days will ever fully return. They might not. But even if they don’t, great quantities of new capital should easily dwarf what was invested in gold stocks prior to the panic. Given the incredible profit fundamentals of gold mining during a secular bull, gold stocks can’t stay excessively cheap for long.

While the HUI forged ahead to new all-time highs in 2010 and 2011, the HGR continued to remain weak before collapsing last summer. For extraordinary reasons likely never to be repeated, primarily the first USA credit downgrade in our nation’s history, gold rocketed higher last summer to very-overbought levels. But the gold stocks lagged far behind, to their credit gold-stock investors were skeptical of the staying power of gold’s blisteringly-fast advance. So the HGR started collapsing despite all-time-record gold prices.

Unfortunately even though the gold stocks had failed to leverage last summer’s wild gold rally, they still leveraged its downside when gold’s inevitable overdue correction arrived. So the HGR continued to drift lower. By early October it was back down to levels only seen before surrounding the stock panic. And obviously in hindsight given the HUI’s gigantic 2009 recovery rally, those lows were an unsustainable anomaly as I told our subscribers as they occurred.

If an HGR in the low 0.30s wasn’t sustainable during that extreme fear maelstrom of late 2008 and early 2009, why on earth should it be sustainable in the far-more-normal markets of recent months? Even if you are skeptical that the HUI can ever return to its pre-panic average HGR, today the gold stocks are super-cheap even by their pathetic post-panic standards. Today we are blessed with one of the best gold-stock buying ops of this entire secular gold bull.

This next chart zooms in to this post-panic period. The same HGR and raw HUI data from above are included, along with an additional series in yellow. It shows a hypothetical HUI at that secular pre-panic average HGR of 0.511x. It is roughly where the HUI probably would be trading if the stock panic hadn’t scared such a large fraction of the early gold-stock investors away from this high-flying sector.

After its fast initial recovery out of those secular-bull lows, the HGR started rising in a nice new uptrend. This continued until spring 2011, with the gold stocks essentially basing high (in post-panic context) relative to gold. But then this uptrend’s support failed as gold continued powering to new secular-bull highs while the gold stocks refused to follow. This collapse eventually dragged the HGR back down to March 2009 secondary-panic-low levels that persist today.

In addition to the HGR itself, there is an alternative way to measure how the benchmark major-gold-stock index is faring compared to gold. It looks at where the actual HUI is trading compared to where that hypothetical HUI at the 0.511x pre-panic average HGR would be trading at. Expressed as a percentage, this metric is shown above at some key highs and lows in the HUI’s post-panic uptrend.

Way back in April 2009, just emerging out of those secondary stock-panic lows about a month earlier, the actual HUI was merely trading at 62% of where the hypo HUI would have been. But as the far-more-oversold gold stocks recovered faster than gold, this gradually recovered to 82% by December 2009. Then for the next year and a quarter or so, this metric generally improved. It would run between the high 60s to low 70s at major gold-stock lows to the low 80s at major highs.

But the horrendous gold-stock performance relative to gold in much of 2011 scuttled this HGR recovery. In the past few quarters, the actual HUI has only traded at 67% of where the hypo HUI would be at best. And at HUI lows it has slumped back down to the low 60s again, and even hit 61% as recently as late December. Once again these levels were way too cheap to be sustainable after the panic, and are almost certainly way too cheap to be sustainable today.

Even if you don’t think the HGR will ever claw back up into that pre-panic range, simply consider its post-panic one. It has traveled between roughly 0.31x on the low side, where we were recently, to 0.43x on the high side back in late 2009. But let’s be conservative and just call resistance 0.40x, a level exceeded in both 2010 and 2011 as well when the gold stocks were near interim highs. At $1,600 gold and a 0.40x HGR, the HUI would be trading at 640. This is almost 25% higher than where it was trading this week.

And believe it or not, that pre-panic average HGR is certainly attainable again. And given the incredible fundamental profit dynamics of mining gold in a secular gold bull, I suspect it will be. Investors ultimately chase profits and future profits potential, which gold stocks have in spades. The best investors in the world are sector-agnostic, they will buy wherever stocks are cheapest relative to profits. The great potential in gold-stock profits going forward should attract in tons of new capital, forcing the HGR higher.

Provocatively, back in early 2009 I made a similar case about the Silver/Gold Ratio. Silver, being far more speculative than gold, was hit much harder during the stock panic. It also had something of a pre-panic trading range relative to gold, its primary driver. I argued then, and subsequently, that silver would not only return to its pre-panic average but exceed it. Like this HGR analysis, traders thought I was nuts for believing silver would ever be as valuable relative to gold again.

But not surprisingly, starting in late 2010 as silver really caught favor with speculators again, it soared higher far faster than gold. Not only did the SGR hit its pre-panic average, but it rocketed much higher to achieve its best levels by far of this entire secular bull. This recent SGR example is a great lesson in never underestimating the power of mean reversions to restore a secular fundamental relationship after sentiment knocks it out of place.

At its old five-year pre-panic average HGR of 0.511x and today’s $1,600 gold price, the HUI would be trading near 818. This is 57% higher than where it was trading this week. Yes, the major gold stocks could rally 50%+ from here and still merely be valued at average levels relative to the metal that drives their profits. And I still believe, despite the tough post-panic slog, that the HUI logically ought to regain its old pre-panic secular ratio with gold. Fundamentals always ultimately triumph.

And as I always point out in this type of secular ratio analysis, these numbers all assume gold stays flat. As gold’s secular bull continues powering higher, the rising denominator in the HGR pulls up the HUI targets. And remember that the HUI is comprised of the giant gold stocks, which have a lot of inertia due to their large market capitalizations. The smaller gold stocks, especially the left-for-dead juniors, should really leverage a move by the HUI to regain more reasonable fundamental levels relative to gold.

And despite all the rampant bearishness gold’s healthy correction spawned, its secular bull is far from over. All over the world, fiat-paper money supplies are growing at 7% to 8% annual rates. Last year in the US, the Fed grew our own broad money supply (MZM) by 9.4%. The euro is being inflated too, which it has to be given the euro-zone countries’ excessive debt loads. But meanwhile, the global above-ground gold supply continues to grow at its meager historical average of around 1% a year. Such slow growth has helped make gold history’s ultimate money.

With the world’s supply of paper money that can bid for gold soaring 7x to 8x as fast as the gold supply itself, how can this metal not be driven higher? Gold is the primary financial asset of refuge in inflationary times, and the world’s central banks are inflating with a vengeance to lessen their countries’ debt burdens. And if gold remains popular and continues to power higher in its secular bull, you can be sure that gold stocks will inevitably return to favor sooner or later.

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The bottom line is gold stocks are very cheap relative to gold today. This is true both in pre-panic and post-panic context. The gold stocks have been so unloved in recent months that they were languishing near lows last seen emerging out of the stock panic in early 2009. And just as those low valuations were unsustainable then, they are unsustainable now. Gold stock prices, like all stock prices, will eventually reflect their underlying profit fundamentals.

While it is challenging psychologically to buy any sector when it is out of favor, that’s the only way to earn big money in the stock markets. Contrarians know the only times prices are low is when others are scared, so they have to suck it up and be brave. And with gold stocks recently trading near late-panic extremes because the necessary gold correction scared people, there has rarely been a better buy-low opportunity. 

Adam Hamilton, CPA

January 10, 2012

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