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The beleaguered gold
stocks have spiraled lower this month, heaping misery on poor fools like me
naive enough to invest in them. Dwindling interest and capital has left this
realm a desolate wasteland, I’ve rarely seen anything so deeply out of
favor. In fact, relative to gold
the gold stocks are now back down to levels only seen briefly during
2008’s epic stock panic! Are they dying, gasping their last breath?
This question has
enormous implications for speculators and investors. If gold stocks are
doomed to never rally again, we ought to cut our losses and move on. But if
this embattled sector is likely to return to favor in the near future, then
its current extreme malaise is an incredible contrarian buying opportunity.
The more any sector is loathed and forgotten, the more potential its stock
prices have for massive rallies.
As I ponder this vexing
puzzle, my mind keeps returning to how the stock markets in general work. Any
stock is ultimately a fractional share of its underlying company’s
future profits stream. If those profits are high or rising relative to the
stock price, investors bid up the stock
to reflect its underlying economic reality. Over the long term, the markets
eventually price all stocks to fairly represent their profits.
And despite the many
challenges of mining gold, profits are rising dramatically. My business partner Scott Wright recently updated
his fascinating research thread proving this. By painstakingly analyzing detailed
data from individual major gold miners collectively representing nearly half of global mined
production, it is apparent gold-mining profits are amazing. Last year the
average gross margin of this elite group ran $915 per ounce, or an astounding 58%! Gold miners are making money
hand over fist.
As long as such fat
profit streams continue, the immutable law of long-term stock pricing guarantees gold stocks will eventually
be bid up to reflect their earnings. The only way today’s
brutally-cheap prices make sense fundamentally is if gold is on the verge of
a serious collapse. The price of gold is everything for the gold-mining
business, strictly controlling the profitability limits of mining this scarce
metal.
Gold is so dominantly
central to this sector that its stock valuations can best be expressed relative to gold. Since gold prices
directly control profitability, and profitability drives long-term stock
prices, gold naturally drives gold-stock price levels. My favorite way to
look at this relationship is via the HUI/Gold Ratio. It simply divides the
daily close in the flagship HUI gold-stock index by the daily close in gold
itself.
And as you can see in
this chart, the HGR looks positively apocalyptic
today. This critical ratio is rendered in blue, and slaved to the right axis.
Underneath for comparison purposes is the raw HUI in red. With the HUI in its
numerator, a rising HGR indicates the gold stocks are outperforming gold.
Conversely a falling HGR, the norm for the past year, means gold is
outperforming gold stocks.
Let’s buck
convention and cut to the chase at the lower right. This week the HGR slumped
to levels only seen two other times in this secular gold bull. The first was
way back in early 2002 when the gold-stock bull was just getting underway so
participation was light. And the second was briefly during late 2008’s once-in-a-century stock panic. Quite literally, relative to gold the
gold stocks are trading at stock-panic
price levels today!
Is this rational? Do
these dirt-cheap prices fairly reflect the current and future profits streams
the gold miners are spinning off? History argues no way. The entire
stock-panic event essentially encompassed the second half of 2008, with
normal market conditions existing before. Over the 5 years between mid-2003
and mid-2008, the HGR averaged 0.511x! The HUI
tended to trade at about half the
price of gold.
Now the longer any trend
in the stock markets persists, the more likely it is righteous and justified
by core underlying fundamentals. A 5-day or 5-week or even 5-month trend is
probably dominated by psychology. But a massive 5-year one transcending many greed-fear sentiment cycles
certainly isn’t. There has to be some underlying fundamental reason, or
it never would have lasted so long.
Thus I believe this
5-year pre-panic average HGR of 0.511x established
the baseline relationship of gold stocks to gold in normal market conditions. Ever since the depths of panic
despair in late 2008, I’ve believed and written that this HGR ought to eventually mean revert to
pre-panic norms. And though it hasn’t yet, that certainly doesn’t
mean it won’t. We and our subscribers have still made a lot of money in
gold stocks since the panic by betting on this HGR mean-reversion thesis.
And indeed as expected,
the HGR initially rocketed up fast out of its crazy-oversold panic lows. But
unfortunately it stalled out about a year later heading into autumn 2009.
Though it consolidated not far from those recovery highs for well over a year
after that, in early 2011 the HGR started to slump. And this troubling trend
has continued more or less unabated to this day, thrashing the poor gold
stocks.
While everyone is
understandably cursing the day they first heard about gold stocks now, there
are some critical things on this chart to consider. First, note that the last
time the HGR fell to today’s levels during the stock panic they weren’t sustainable for
long. With gold stocks so radically and irrationally beaten down relative to
gold, they were due for a massive rally for fundamental reasons. And indeed
one soon launched.
If gold stocks
couldn’t sustain such panic levels relative to gold even right after
the most extreme fear event of our lifetimes, why should they today when no one
is particularly frightened about anything? When stocks are battered to
ludicrous fundamental levels relative to their profits streams, contrarian
value investors soon pour in capital which bids up their prices and rectifies
the pricing anomaly.
Second, note that throughout
this entire secular gold and gold-stock bull, gold stocks’ favor in the
eyes of investors and speculators naturally flowed and ebbed. A year or so where traders love gold stocks and
bid them up dramatically relative to gold is followed by a year or so of
capital exiting. These sentiment cycles driven by popular greed and fear
happened before the panic and are still
happening after it.
So regardless of how high
gold stocks ought to be fundamentally relative to gold, after an entire year of underperformance
they are now due for a major outperformance
cycle. Some catalyst is almost certain to soon emerge that will entice
capital back into the forgotten gold stocks. This will drive them to rally
much faster than gold, probably for a
year or so if the duration of past sentiment cycles
continues to hold true.
Finally, how high are
gold stocks likely to go relative to gold as the wildly-pessimistic sentiment
today gradually yields to optimistic sentiment as they rally? After 3 rough
post-panic years, you may think that expecting a return to pre-panic HGR
norms around 0.511x is crazy. No problem. Even the post-panic average HGR (from 2009 on)
is now running at 0.364x, which we can use as a
conservative baseline.
As of the middle of this
week, the HGR closed at a hyper-discouraging 0.288x. To merely return to its
post-panic average of 0.364x, no big stretch by any
means, we would need to see a 27% HUI rally. And after being so radically
undervalued at panic levels, the odds are great that this sentiment-driven
mean reversion will overshoot. The more extreme the sentiment pendulum is
dragged in one direction (fear now), the farther it subsequently swings back
in the opposite direction (greed) to fully rebalance sentiment.
So how about 0.41x, which
is the HGR’s upper resistance in this depressed post-panic era. This
ratio has spent plenty of time above 0.41x in 2009,
2010, and 2011, so it isn’t some pie-in-the-sky goal. To just regain
this weak post-panic standard for greed and enthusiasm, the HUI would have to
surge 43% higher from here. And realize that all these targets assume gold merely stays flat, which
isn’t very likely given the rampant fiat-currency inflation around the
globe.
Thus even if you think
I’m a total nutcase for still expecting to see gold stocks regain
pre-panic norms sooner or later, the incredible opportunity in today’s
HGR mean-reversion play doesn’t require such a belief. Even purely in
depressed post-panic terms, gold
stocks are due for a major outperformance relative to the metal they mine
which will carry their stock prices a lot higher from here.
And zooming in to this
very post-panic period offers more detailed insights into what is going on in
the HGR. This next chart considers 2009 on, the “New Normal” as
elite bond investor Mohamed El-Erian likes to call
it. In addition to the first chart’s data, this one adds a third series
that shows where the HUI would hypothetically
be trading if the HGR mean reverted to its pre-panic secular average of 0.511x.
This post-panic
perspective really drives home just how incredibly cheap the gold stocks have
become relative to gold. The recent apocalyptic HGR levels are even below
early 2009’s secondary-panic-low ones. The state of gold stocks’
prices relative to their fundamental driver today is truly the worst
it’s been since the stock panic. And that event offered a once-in-a-lifetime ultra-cheap gold-stock buying op!
Prior to spring 2011, the
HGR was indeed regaining ground relative to gold. After a fast initial
recovery that made fortunes for brave contrarians like us willing to buy
during and after the panic when everyone else was terrified, the HGR
continued trending higher. Its rising uptrend is rendered above. At a couple
HUI major interim highs in this timeframe, the actual HUI peaked at 81% to
82% of where it would have hypothetically been trading at the pre-panic
average HGR of 0.511x.
But last April, the
strong support of this post-panic uptrend started to crumble. It wasn’t
that the gold stocks were falling initially, but gold was shooting up and the
HUI wasn’t following. While the metal rocketed a staggering 8.7% higher
that month (closing at new all-time record highs on half its trading days),
the HUI merely crept 3.4% higher. Gold-stock traders were understandably
skeptical of this metal’s exuberant surge.
And indeed the reckoning
soon started in May, when gold plunged 5.7% in its initial 4 trading days.
Despite not rallying earlier in line with gold, the gold stocks still took a
major blow from this worried gold psychology. The HUI plunged 10.0% over this
short span! This relative outperformance of gold (falling less in a
correction) drove the HGR down to 0.36x or so. This
HGR-support breakdown, especially in spring, wreaked tremendous sentiment
damage.
One problem was gold and
the gold stocks were heading into the dreaded summer doldrums. June, July, and August, when many traders are enjoying
long vacations and countless others lose focus on the markets, are usually a
wasteland for the precious metals and their producers. So there was little
incentive to buy the cheap gold stocks heading into last summer, thus the HGR
continued to drift lower.
And then gold did
something it has never done before in this entire secular bull, it defied all
precedent to rocket higher in July
and early August. Obama’s record profligacy and resulting
mind-bogglingly-huge deficits were on the verge of sparking the first
downgrade of US Treasuries in our nation’s history. No one knew how the
markets would react to such a catastrophe, so capital flooded into gold on
gigantic safe-haven demand. But the gold stocks didn’t really
participate, the uncertainty was too intense.
Thus the HGR’s
brutal collapse continued into August. Incredibly the day gold peaked at super-overbought levels that
month (which I warned about at the time), the HGR was
merely running at 0.319x. This was not much higher than what was seen in
early 2009 at the secondary stock-panic lows in a time of extreme
general-stock-market fear! Weathering this brutal May-to-August period sapped
the strength and will of the remaining gold-stock investors.
So as capital fled this
sector, instead of peaking at 82% of hypothetical HUI levels at its pre-panic
average HGR this flagship gold-stock index was merely hitting 66% to 67%.
Gold-stock investors and speculators had lost faith in this sector, too
demoralized to risk deploying new capital. All these events together were
really like the perfect storm for gold-stock psychology, collectively
spawning a slow spiral lower to today’s panic levels.
But once again,
don’t lose the forest for the trees. Yes gold stocks stink these days,
yes they have performed poorly for an entire year. This is inarguable. But
such episodes are not uncommon in the stock markets, which are moved around
by perpetual cycles of greed and fear. As sectors get too popular greed grows
extreme, sucking in all near-term buyers which leaves only sellers, so a
correction soon erupts.
But eventually the
resulting fear gets too extreme, convincing everyone susceptible to selling
to exit which leaves only buyers. And then the sector gradually returns to
favor as capital migrates back in to chase the resulting bargains. These
sentiment cycles, trader psychology, are what account for the lion’s
share of all short-term stock-market action. And boy, are the gold stocks
ever overdue for returning to favor again!
In addition to needing to
flow again after such a serious ebbing, gold stocks’ prices ultimately
need to reflect the profit streams their underlying companies can spin off.
Over the long term, the stock markets are a
weighing machine. Cheap stocks generating big profits attract contrarian
value investors, and their early buying ignites the rising stock prices that
attract in other traders. This process feeds on itself.
The only potential monkey
wrench in these inexorable market processes is a big plunge in the gold
price, which is very unlikely today. This entire secular gold bull has been
largely driven by massive
paper-money inflation all over the world. The major money supplies are being
grown by central banks at 7%-to-8% rates annually. Meanwhile the global mined
gold supply only increases by about 1% a year. So with far more paper money
available to chase relatively less gold, its secular bull remains far from
over.
And if gold doesn’t
plunge in the coming months, the HUI’s mean reversion back up to
reasonable levels relative to gold is probably inevitable. If you’re
skeptical, consider the example of silver. The Silver/Gold Ratio plunged in
the panic just like the HGR, and people thought silver would never regain
those levels relative to gold. But I took the contrarian side and argued the opposite. And indeed silver eventually regained favor and
not only attained its pre-panic SGR average, but greatly exceeded it in early 2011!
Mean reversions are one
of the most powerful forces in the financial markets. And gold stocks are in
the catbird’s seat with two huge ones in their favor. Not only do gold
stocks need to be much higher to reflect today’s prevailing gold prices
fundamentally, but this sector’s psychology is due for a radical shift
as well. Thus just like back during the stock panic, today’s
panic-priced gold-stock levels aren’t sustainable.
Though our gold-stock
positions have taken big hits in the past 5 months as well, we haven’t
given up on this sector. We continue to actively research it, looking for the
most fundamentally-promising companies to buy to ride the mean reversion. And
naturally the elite juniors continue to capture our attention. These small
companies’ gains should really
leverage the HUI’s as gold stocks inevitably return to favor.
We just finished a major
3-month deep-research project looking into the universe of junior gold stocks
trading in the US and Canada. Through hundreds of hours of painstaking
research, we gradually whittled over
600 juniors down to our dozen fundamental favorites. We profiled each in
a fascinating new 29-page report hot off the presses this week. It is a rare
opportunity to have one of our popular reports release right near panic-grade
lows. Buy yours today, a steal at just $95 ($75 for subscribers).
Of course we also publish
acclaimed weekly and monthly subscription newsletters loved by speculators and investors all over
the world. In them I draw on our vast experience, knowledge, wisdom, and
ongoing research to explain what the markets are doing, why, where they are
likely heading, and how to trade them with specific stock trades as
opportunities arise. We have plenty of great gold stocks on our books, which
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The bottom line is gold
stocks are so deeply oversold and out of favor that they are trading at panic
levels relative to gold. Such an anomaly wasn’t sustainable even with
the panic’s extreme fear, and it certainly isn’t sustainable
today. All stocks are ultimately priced to reflect their underlying profit
fundamentals, and gold stocks are no exception to this ironclad rule. And
their sentiment can’t stay this depressed forever.
So despite all the
gold-stock hate out there, this beaten-down sector is overdue for a major
rally. And even if you don’t believe pre-panic levels relative to gold
are attainable again, merely mean reverting by depressed post-panic standards
offers an enormous buying opportunity. Valuations and sentiment ebb and flow everywhere in the stock
markets, and gold stocks are not immune from these powerful forces.
Adam Hamilton,
CPA
March 24, 2012
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Adam? I would be more than happy to address them through my private
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- 2012 Zeal Research (www.ZealLLC.com)
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