Cheap Gold Stocksí Upleg Intact

Adam Hamilton     September 19, 2014     2739 Words

 

Gold stocks have plunged in September, crushed by the withering selling pressure from heavy futures shorting hammering gold.  As usual, these falling prices have kindled extreme bearishness on this left-for-dead sector.  But despite this rotten sentiment, gold stocksí young upleg remains very much intact technically.  This impressive resiliency is fueled by these minersí incredibly-cheap fundamental valuations.

 

Gold stocks are without a doubt the most despised sector in all the stock markets.  Thanks to the Fedís brazen debt monetizations and manipulations of interest rates, the global markets are distorted beyond belief.  Stock markets have soared to extreme valuations on the Fedís implied backstopping, leading to epic complacency, greed, and hubris.  That artificial levitation sucked vast capital out of alternative investments.

 

When stock markets do nothing but rally thanks to the Fed, the perceived need for prudent portfolio diversification with alternative investments like gold has vanished.  And with investor interest in gold virtually dead, the gold stocks have suffered mightily.  Nearly everyone believes they are doomed to spiral lower forever.  To be bullish on this loathed sector guarantees ridicule and mocking these days.

 

Nevertheless, a hardcore remnant of contrarian investors remains very bullish on this sector.  They have studied market history, and remember core truths that the Fed has blasted from most minds.  Markets are forever cyclical, they rise and fall.  Any extreme in sentiment and prices is soon followed by a major reversal.  Exceptionally-high greed-fueled prices soon fall, and exceptionally-low fear-drenched prices soon rise.

 

Contrarians know that successful investing demands buying low then selling high.  And the cheapest stocks are always the most hated, the sectors with the most universal and overwhelming bearishness.  They have the most potential to explode higher and multiply wealth when sentiment inevitably shifts the other way.  Thatís why smart investors including elite billionaire hedge-fund managers are long gold stocks today.

 

Gold-stock fundamentals are exceedingly easy to understand.  Gold miners obviously mine gold.  And their production costs are largely fixed when mines are built.  So their profitability is determined by the gold price.  When gold climbs, their profit margins and absolute earnings soar as their costs stay pretty stable.  So these companies are ultimately a leveraged play on the gold prices which drive their profits.

 

Across all the markets, any stockís underlying profitability determines what its fundamentally-sound price levels should be.  Gold stocks are no exception, as they will eventually climb dramatically to trade at reasonable valuations relative to their profits.  And not only will their earnings surge as the gold price itself recovers from todayís sentiment extremes, gold stocks are dirt-cheap relative to current low gold levels!

 

Gold stocks are now languishing at a fraction of their fair value relative to gold because of the epically bearish sentiment plaguing them.  But such emotional extremes never last, they are inherently self-limiting and soon burn themselves out.  When psychology in this gold-stock sector finally normalizes, the minersí beaten-down stock prices are going to surge higher to reflect their earnings fundamentals.

 

This first chart highlights todayís extreme anomaly in gold-stock price levels that was indirectly driven by the Fedís super-manipulative quantitative-easing campaigns and zero-interest-rate policy.  It looks at the ratio of gold-stock price levels relative to the gold price that drives their profits.  Since ETFs have grown so popular with traders, Iím using the dominant American ones as proxies for gold-stock and gold price levels.

 

Gold-stock prices are represented by GDX, the benchmark Gold Miners ETF.  And gold prices are represented by the mighty GLD SPDR Gold Shares gold ETF.  Dividing the price of the former by the latter and charting it over time shows whether gold stocks are gaining or losing ground relative to the metal that drives their profits and hence ultimately stock-price levels.  This chart is still a stunning wake-up call. 

 

 

This blue GDX/GLD Ratio line is the key to understanding why contrarians remain so bullish on such a seemingly-hopeless sector.  Before 2008ís crazy once-in-a-century stock panic sucked in gold stocks, they traded at a pre-panic average GGR of 0.591x.  In other words, a share of GDX was worth about 6/10ths of a share of GLD.  The epic fear generated by 2008ís stock panic shattered that long-standing relationship.

 

GDX plummeted 71% in a matter of months, as many if not most gold-stock investors capitulated and sold low in the dark heart of that panic.  Much like today, bearishness was off the charts.  But as Warren Buffett has wisely said, the time to be brave is when everyone else is afraid.  The greatest times to buy low are when a sectorís stock prices seem the most hopeless.  With most investors out, they are just too cheap.

 

In late October 2008, the GGR had cratered to just 0.227x.  The extreme and unsustainable selling that was driven by extreme and unsustainable bearish sentiment had crushed gold-stock prices to a fraction of their fundamentally-righteous levels relative to the metal that drives their profits.  Then, like now, contrarians like me bullish on gold stocks were mocked.  But we made fortunes as they inevitably mean reverted.

 

Over the next several years, GDX would more than quadruple with a 307% gain!  Buying low pays off big.  And coming out of such a crazy low-priced anomaly, gold stocksí gains easily exceeded those of gold itself.  So the GDX/GLD Ratio blasted higher, ultimately stabilizing around 0.419x over the next two-and-a-half years.  That level is critical to remember, because it persisted during normal post-panic years.

 

By August 2011 gold itself grew very overbought and overdue for a major correction, which I warned about right as it topped.  And as usual since gold stocks are leveraged plays on gold prices, they fell faster than gold which dragged the GGR back down.  It bottomed and reversed normally in mid-2012, but then the Federal Reserve launched its unprecedented open-ended QE3 campaign to manipulate financial markets.

 

QE3 changed everything in the markets, and temporarily destroyed the demand for gold.  Not only was the Fed monetizing bonds with new dollars created out of thin air, it was constantly jawboning that it was ready to ramp up QE if the economy (read ďstock marketsĒ) weakened.  So stock traders took this as an implied backstop, a Fed put on stock prices.  So market history be damned, they ignored all risks to keep on buying.

 

Capital fled from gold to chase the levitating general stock markets, driving a once-in-a-century gold plunge in the second quarter of 2013.  Gold stocks were crushed on this, ultimately falling 69% from their peak on a GDX basis to hit their worst levels since the stock panicís.  But the amazing thing was the GGR actually fell to an all-time low well below late 2008ís.  Gold stocks had never been cheaper relative to gold!

 

This mother of all gold-stock lows happened late last year, days after the Fed announced it was starting to slow down its massive QE3 bond monetizations.  Ever since then, gold stocks have been fighting the extreme bearish sentiment headwinds to rally on balance.  They are starting to regain ground compared to gold, with the GGR enjoying its best rallying streak so far this year since 2010.  Gold stocks have already reversed!

 

For 6 long years, gold stocks lost ground relative to gold.  As the relentlessly-downward-sloping GGR shows, they became cheaper and cheaper compared to their earnings power.  The GGR kept being repelled at the strong secular resistance line shown above.  But early this year the GGR made another attempt to break out to the upside, and that finally succeeded only a few months ago this past June.

 

This decisive GGR breakout on top of its strong new uptrend since late last year shows that gold stocks have reversed.  The 6-year downtrend in their prices relative to gold is over.  And that makes perfect sense.  The markets are forever cyclical, no trend lasts forever.  Contrary to the bearsí foolish assertions, there was just no way gold-stock prices could continue falling compared to the driver of their profits indefinitely.

 

After 6 years of the GGR retreating, how long is its mean reversion from bearish to normal to eventually bullish sentiment going to take?  Several years at least, and likely longer since great market cycles tend towards symmetry.  And thatís why gold stocks are so darned bullish and exciting today.  They are dirt-cheap after years of falling out of favor, so their upside potential from here is enormous beyond belief.

 

Remember that in the normal post-panic years before overbought gold corrected and before the Fedís extreme market manipulations of QE3, the GDX/GLD Ratio averaged 0.419x.  This week it slumped to 0.199x, actually well below the worst levels of 2008ís epic stock panic.  So merely for gold stocks to regain fundamentally-normal prices relative to gold at todayís levels GDX would have to surge 110% higher!

 

You read that right.  Even at todayís dismal $1250ish gold prices, gold stocks would need to more than double from here to reflect the metalís impact on their profitability now.  And thatís a very conservative target for two reasons.  First, after such extreme bearishness gold stocks shouldnít stop rallying at merely normal sentiment.  The great emotional pendulum should swing far back into the opposite greed side.

 

So at some point in the next several years, gold stocks are highly likely to power much higher than that post-panic GGR average.  Theyíll likely attain the pre-panic average of 0.591x, and maybe even higher for a short spell when euphoria flares.  Second, gold itself isnít going to keep languishing near $1250.  As the Fedís artificially-levitated stock markets inevitably roll over with QE3 ending, gold is going to surge.

 

Alternative investments thrive when conventional ones are struggling.  So once the lofty stock markets decisively roll over, investors will remember goldís unparalleled value as an essential asset to diversify portfolios.  Capital will flood back in.  Provocatively despite popular wisdom, rising rates will help thisGold has thrived in rising and high-rate environments historically since they hit stocks and bonds hard.

 

Thatís why I still strongly believe gold stocks are going to at least quadruple over the coming several years again just like they did after 2008ís anomalous stock-panic low.  Pick any GGR higher than the post-panic average, and a gold price way higher than todayís, and the gold-stock price targets surge accordingly.  At a 0.6x GGR and $2000 gold for instance, GDX would quintuple from todayís low levels.

 

Being a quasi-prominent contrarian on the stock markets and gold, my e-mail inbox explodes whenever the former surges near highs or the latter wilts.  Myopic traders with no understanding of market and sentiment cyclicality gloat about how stocks will rise forever while gold falls forever.  What a dumb bet.  And weaker investors succumb to bearish groupthink and fret that some major new gold plunge is imminent.

 

But despite all the fear and bearishness on gold and gold stocks this past monthís futures-shorting-driven selloff has generated, its impact on the GGR is trivial.  Note above that the recent weakness in gold stocks relative to gold barely registers in this long-term chart, and the GGR remains near both its 200-day moving average which recently turned higher and its new uptrendís support.  There is no damage.

 

That is true technically too.  While gold stocksí dirt-cheap fundamentals are the key reason contrarians are so bullish on them, their price action looks fine despite the past monthís selloff.  This next chart looks at gold-stock technicals through the lens of the flagship GDX gold-stock ETF.  Though its price action is a secondary concern, so many traders are worked up about this latest selloff that it bears examination.

 

 

Despite all the sound and fury and the bearsí supreme hubris this week, GDX remains within its major new uptrend that was born almost 9 months ago in late December 2013!  Gold-stock prices are near support and look to be bottoming at another higher low.  Weíve seen gradual and sustained buying of gold stocks by smart investors all year long despite the fierce headwinds from the Fedís stock-market levitation.

 

GDXís 200-day moving average, which usually signals the long-term trend direction, continues to move higher after reversing several months ago.  And GDXís 50dma crossed back above its 200dma twice this year, confirming gold stocksí Golden Cross buy signal.  There is literally nothing bearish about this chart, it is actually powerfully bullish for a young upleg.  Gold stocks continue to advance on balance technically.

 

Long-term investors look to major downside fundamental-pricing anomalies to buy low, like the GGR today reveals.  But short-term speculators look at trends and support approaches.  And GDXís chart clearly shows gold stocks are at their third best buying point since their decisive reversal late last year.  Buying when prices near support in strong uptrends is one of the best ways to make money in trading.

 

Zooming out to the bigger picture technically, gold stocks have been consolidating sideways in a massive basing formation since last summer.  The second quarter of 2013 was goldís worst quarter in a whopping 93 years, so it spawned off-the-charts bearishness.  Ever since, the vast majority of traders have been utterly convinced that gold, silver, and their minersí stocks are doomed to spiral lower forever.

 

These weathervane bearish calls couldnít have been more wrong though.  Enough buyers emerged to snatch up all the sellersí gold-stock shares, leading to the past 15 monthsí bottoming consolidation zone.  If gold stocks couldnít be hammered lower with gold sentiment so epically bearish for so long, just imagine how they will soar when psychology mean reverts out of these extremes.  Itís going to be amazing.

 

So with gold stocks exceedingly cheap fundamentally and at an outstanding buy point technically, what are you going to do?  Have you forged yourself into a contrarian tough enough to fight the crowd and buy low?  Or are you slave to herd groupthink?  Will you buy low when a sector is deeply out of favor and reversing higher?  Or will you wait until after gold stocks already double and miss the easy gains?

 

The right answers are so glaringly obvious.  The high and loved stock markets canít rise forever and are long overdue for a serious selloff.  And low and hated gold and the stocks of its miners canít fall forever and are long overdue for a gigantic mean-reversion upleg.  With bearishness in gold extreme with it near consolidation lows, and its miners epically undervalued, how can this not be an ideal time to buy low?

 

At Zeal weíve always been hardcore contrarians, buying low when few others will to multiply fortunes.  So while gold stocks remain the pariah of the stock markets, weíve continued to diligently research them to prepare for their coming massive moves higher.  Just this week, we finished our latest 3-month project to ferret out the best advanced-stage junior gold explorers.  These elites have vast upside potential dwarfing GDXís.

 

We started with over 600 junior gold stocks, and gradually narrowed them down to our dozen favorites with the best fundamentals.  All these winners are profiled in depth in our brand-new 23-page report.  It is incredibly fortuitous to have one of our deep-research projects conclude when gold stocks happen to be at a super-bullish major low.  So donít tarry, buy your new report today while these stocks remain dirt-cheap!

 

With the stock markets and gold at such extremes, cultivating a contrarian mindset has rarely been more important.  Weíve long published acclaimed weekly and monthly newsletters to help investors and speculators like you gain that critical contrary perspective.  They draw on our decades of hard-won experience, knowledge, wisdom, and ongoing research to explain whatís going on in the markets, why, and how to trade them with specific stocks.  Subscribe today before Wall Street fleeces you blind!

 

The bottom line is gold stocks remain radically undervalued relative to the metal which drives their profits, even at todayís dismal gold levels.  After falling faster than gold for 6 long years, this secular trend has reversed over the past year.  This was despite the extreme bearishness plaguing this sector.  Gold stocksí mean reversion back up to normal valuations should run for at least several more years.

 

And after suffering such epic valuation anomalies, gold stocks are again due to at least quadruple like they did after 2008ís stock panic.  The futures-shorting-driven gold selloff over the past month pushed gold stocks back down to their new uptrendís support, creating a fantastic buying opportunity.  While not everyone is smart or tough enough to fight the crowd and buy low, those contrarians that do will be richly rewarded.

 

Adam Hamilton, CPA     September 19, 2014     Subscribe