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.
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.
© Copyright 2000-2015, Zeal Research (www.zealllc.com). Zeal Research is a US-based investment research company – you can visit their website at http://www.zealllc.com/. Zeal’s principals are lifelong contrarian students of the markets who live for studying and trading them. They employ innovative cutting-edge technical analysis as well as deep fundamental analysis to inform and educate people on how to grow and protect their capital through all market conditions. All views expressed in this article are those of the author, not those of TheBull.com.au. Please seek advice relating to your personal circumstances before making any investment decisions.