Gold stocks have lapsed back to despised status after late March’s sharp selloff. Thanks to their strong 2014 rally before that, traders were slightly warming to this abandoned sector. But despite the rekindled extreme bearishness, gold stocks remain the greatest bargain in all the stock markets. Their prices are still absurdly undervalued relative to gold which drives their profits, fantastic buys for brave contrarians.
The precious-metals miners and explorers are just reviled these days, the laughingstock of the stock markets. And this is understandable given their disastrous performance last year. While the benchmark S&P 500 stock index soared 29.6% in 2013, the flagship HUI gold-stock index plummeted 55.5%! That has to be one of the biggest sector performance gaps in history, a total nightmare for this small sector.
But it wasn’t always thus, prudent contrarians won great fortunes in gold stocks before 2013’s extreme outlying gold anomaly slaughtered them. In the 11-year secular span between late 2000 and late 2011, gold stocks as measured by the HUI skyrocketed 1664% higher! During that timeframe the S&P 500 actually slumped 14% lower. It’s hard to dismiss gold stocks’ potential if you participated in their massive bull.
And that life-changing secular bull was stealthily born in conditions much like today’s. The stock markets were near record highs, trading at dangerously-high valuations, and euphoric investors assumed they were in a riskless new era where stocks would rise forevermore. And gold stocks were overwhelmingly ignored or loathed, an anachronistic relic. The lack of interest forced their prices to brutally-deep lows.
The whole games of speculation and investing are about buying low then selling high. And what better time to buy low than when a sector is despised? Stock prices are a popularity contest driven by sentiment, so the less popular a sector is the cheaper its stock prices. And fundamentally gold stocks are almost as cheap today as they’ve ever been. They may be the only cheap sector left in these lofty stock markets!
Any company’s long-term stock price is ultimately driven by its underlying profitability. And profits in gold mining aren’t complicated. A miner extracts gold from an ore deposit at a cost which is largely fixed when the mine is developed. And then it sells this gold at market prices. For any given mine, the higher the gold price the greater the profits. Gold prices drive gold-miner profitability, and thus gold-miner stock prices.
So gold-stock levels have always been highly correlated with the gold price. Gold is the dominant driver of this sector’s fundamental earnings. And today’s gold-stock prices are truly fundamentally absurd compared to today’s prevailing gold prices. Gold stocks have almost never been cheaper relative to the driver of their profits. The hyper-bearish psychology spawned by 2013’s carnage has led to this extreme pricing anomaly.
This is easiest to understand by looking at the ratio of gold-stock prices to gold itself. Over the past decade or so, the HUI/Gold Ratio has been the most popular way to frame this comparison. The daily close in the flagship HUI gold-stock index is divided by gold’s daily close, and charted over time. The result shows the extreme undervaluation of gold stocks today, why they are such a screaming contrarian buy.
The HUI/Gold Ratio is rendered in blue, and in late March’s sharp gold-stock pullback it slumped as low as 0.168x. This number is meaningless without context, but in this post-stock-panic chart you can see that such HGR levels are very low. This isn’t far above the absolute low seen in early December, when the HGR hit 0.157x. That was its lowest since the earliest months of gold stocks’ bull 12.9 years earlier!
At today’s price levels, gold stocks have almost never been cheaper relative to gold which drives their profits! Realize that last year’s gold plunge that obliterated gold stocks was an extreme anomaly created by the Fed’s stock-market levitation sucking capital out of the flagship GLD gold ETF. Its outflows alone accounted for 84% of gold demand’s total global drop, driving gold’s worst year in a third of a century.
There was nothing at all normal about the gold markets last year, much like in 2008’s once-in-a-century stock panic. So the last normal span that we can use as a baseline is the post-panic years of 2009 to 2012. And during that time, the HGR averaged 0.346x. So by that conservative standard, recent weeks’ gold-stock prices were less than half normal levels! It’s like a 50%-off sale in gold stocks, epic bargains.
Even if gold did absolutely nothing, languished in the high $1200s forever, the HUI would have to soar nearly 106% from its recent pullback low merely to hit pre-2013 post-stock-panic norms relative to gold. What other sector is so cheap that it still needs to more than double just to hit fair-value benchmarks? There aren’t any. The extreme bargains present in gold and silver stocks today are truly extraordinary.
But man, it’s so darned hard to buy low. When a sector has fallen a long ways and been weak for a long time, everyone assumes it is doomed. The low prices spawn bearish psychology that feeds on itself. This pessimistic sentiment trumps or taints the sector’s fundamental outlook, leading to a universal belief that it is destined to spiral lower indefinitely. So most traders won’t touch it with a ten-foot pole.
Enter the contrarians, the pioneers who fight the crowd rather than succumb to groupthink. We have spent our trading lifetimes diligently studying market history, so we know all markets are forever cyclical. Extreme greed or fear and their resulting anomalously high or low stock prices never last, sentiment always mean reverts and then overshoots to the opposite extreme. So the more hated a sector, the more we want to buy.
As this chart shows, the HGR has been falling on balance since early 2011. That means the gold stocks have been underperforming gold, rallying less when it rises and falling more when it retreats. This is because gold stocks have drifted more and more out of favor. But popularity can’t decline forever, at some point there is no one left to hate and abandon these miners. And that bottoming process is underway.
Despite the hyper-bearish psychology universally plaguing the entire precious-metals realm since last spring, thanks to gold’s worst quarter in 93 years (Q2’13), the HGR has stabilized! For nearly a year now, the HGR has generally bounced along 0.17x at worst. Other than the brief foray under these levels in late December after the Fed’s surprise QE3 taper hit gold, gold stocks haven’t lost any more ground.
This nearly-year-long sideways grind in the HGR has carried it from its downtrend’s lower support to its upper resistance. Another couple months of gold-stock outperformance like we saw in January and February will break the HGR out of this downtrend for the first time! As hard as it is to believe, the gold stocks’ return to favor has already begun. And it will only strengthen, as nothing begets buying like buying.
Before gold stocks’ sharp recent pullback, which occurred near a time of normal seasonal weakness, they were one of if not the best-performing sector in all the stock markets. Between late December and mid-March, the HUI soared 35.9% higher in a span where gold only gained 15.0% and the S&P 500 was essentially flat at +1.3%. The sentiment and popularity shift in gold stocks away from hated has already begun.
If a major HGR reversal is indeed underway as all signs point to, we are transitioning from a period of gross gold-stock underperformance of gold back to outperformance. And with the HGR still so incredibly low, gold stocks have a long way to run before their prices normalize relative to gold. This is very exciting for contrarian investors, as we shouldn’t have to wait long to be rewarded for fighting the herd and buying low.
And the potential wins are far greater than merely a doubling in the coming year or two for several reasons. The gold price itself is heading higher as well, the best smaller gold and silver miners will see gains that far outpace the baseline HUI’s, and regaining the 0.346x pre-panic HGR is actually quite conservative. The confluence of all this together is what makes gold stocks such an epic contrarian buy.
Gold plunged last year due to heavy gold-ETF selling and the resulting heavy gold-futures selling. As the stock markets levitated thanks to the Fed’s money printing and jawboning, the interest in prudent portfolio diversification with alternative investments vanished. So capital fled gold to chase general stocks, crushing the metal. Yet these extreme outflows have already started to reverse, leading gold to mean revert.
This young year has already seen the early vanguard of the reversal of stock-capital flows back into gold ETFs. GLD just saw its first consecutive monthly holdings builds since late 2012, a very bullish omen. And futures traders have been aggressively buying gold as well, even on the critical long side. With so much capital migrating back into gold, its price has to rise. And that certainly affects HGR HUI-target levels.
At $1300 gold, the post-panic-average HGR of 0.346x implies a HUI around 450. That is a 99% gain from this week’s pullback levels. But at $1500 gold, this same HGR kicks the HUI target up near 519 or 130% higher. And at $1700 gold, it jumps near 588 or 160% higher. So the bigger 2014’s necessary and inevitable mean reversion higher in gold, the higher the gold-price targets get merely to return to normalcy.
And we are only talking HUI gains here, an index made up of the largest gold and silver miners. We’ve always traded and recommended smaller miners with far-superior fundamentals to the majors. These companies are far more profitable on a price-to-earnings basis, are growing their production and therefore future earnings far faster, and have much lower market capitalizations than the HUI’s majors.
Thus these elite smaller miners will far outperform the HUI as gold stocks recover, amplifying the gains for the brave contrarians willing to buy low when few others will. We’ve spent over a decade at Zeal endlessly studying the entire universe of gold and silver miners to uncover these elites with the best fundamental prospects. There aren’t many people in the world who understand gold stocks better than we do.
And finally, that 0.346x post-panic-average HGR target is actually quite conservative. Before 2008’s extraordinary stock panic, gold stocks traded at much higher levels relative to gold than we’ve seen in the post-panic era so far. This next chart, one of my favorites, extends this HGR comparison back to 2003. That really hammers home the point of just how incredibly dirt-cheap the gold stocks are these days.
Before that crazy once-in-a-lifetime stock-panic fear maelstrom sucked in gold and gold stocks, the HGR averaged 0.511x for a long secular 5-year span! This trading range was fairly tight too, oscillating between 0.46x support when gold stocks were out of favor relative to gold to 0.56x resistance when they were in favor. I still believe there is a great chance gold stocks will outperform enough to return to this pre-panic HGR.
Gold stocks have not just been falling out of favor relative to gold since early 2011, but since early 2006. That was actually the last time gold stocks won any semblance of popularity, and it was exceedingly profitable. When any fundamentally-sound sector falls out of favor on balance for 8 years running, there simply has to be a massive mean reversion afterwards. And these tend to overshoot in the opposite direction.
We have a great example of such an event in silver. For years after the stock panic, the similar Silver/Gold Ratio traded far below its pre-panic norms. Back in early 2009 I was ridiculed for predicting an overshooting mean reversion of silver prices relative to gold. Yet it happened, as the markets are forever cyclical. Don’t like market conditions today? Then wait a few months. Silver soared as it returned to favor.
By early 2011, the SGR had surged to its best levels of this secular bull as silver regained popularity with traders. And before silver was crushed by last year’s extreme gold anomaly, silver still remained near pre-panic levels relative to gold after that huge sentiment shift. There is no reason at all that gold stocks can’t do the same. This is a small sector that doesn’t need great capital inflows to catapult dramatically higher.
With sentiment so dismal these days, it is hard to even imagine what gold-stock prices would look like at that pre-panic-average 0.511x HGR. So I rendered a line back up in the first chart in yellow that shows where the HUI would have been trading in this post-panic era at a 0.511x HGR. Even today with gold still quite depressed, this implies a HUI fair value near 659! That is nearly a triple from today’s anomalous levels.
And a HUI triple is not far-fetched at all. During 2008’s stock panic, the HGR plummeted to 0.207x at worst. Gold stocks were absolutely loathed and left for dead, just like recent months. But out of that very peak despair, this sector started surging. The HUI would more than quadruple over the next several years. And recent months’ extreme HGR lows were way worse than late 2008’s, implying even more upside.
There was such extreme bearishness in gold stocks just a few months ago that the HUI actually fell to a 5.1-year low, levels last seen briefly in the dark heart of the stock panic. Such extreme undervaluations weren’t sustainable then and they aren’t now. If your goal is to buy low then sell high, would you rather buy euphoric general stocks near lofty 5-year highs or loathed gold stocks near dismal 5-year lows?
It’s true major gold-stock valuations don’t look good today, as they all suffered big non-cash writedowns from last year’s anomalous gold selloff. It will take a year for these to roll off the books and stop masking ongoing profitability. But if you get below the majors to look at smaller and mid-tier gold miners, they are actually very profitable right now. We have recently bought many elite miners with single-digit P/E ratios!
In fact we just recommended one in our brand-new monthly newsletter trading at an astounding 4.7x earnings! And its profits are still rising rapidly. This elite gold miner expects to grow its production by 11% this year to 230k ounces annually. And as the gold price itself recovers, its profitability for each ounce mined will leverage gold’s gains. Investors ought to be beating down the doors for deals like this.
The bottom line is the hated gold stocks remain an extraordinary contrarian buying opportunity today. They’ve almost never been cheaper relative to gold, which drives their profits and hence ultimately stock prices. After the last episode of similar extreme undervaluation during the stock panic, the leading gold-stock index more than quadrupled over the subsequent years. Mean reversions always follow extremes.
So another epic mean reversion higher in gold stocks is all but certain in the coming years. This sector that has fallen out of favor for so long will gradually return to favor, as markets are forever cyclical. This will largely be driven by gold’s own mean-reversion recovery upleg out of last year’s extreme lows, which will lead to gold-stock buying. As gold stocks start outperforming, capital will flock to chase their big gains.
Adam Hamilton, CPA of Zeal LLZ, Guest Contributor to MiningFeeds.com