Gold Stocksí Major Breakout
Adam Hamilton October 9, 2015 3193 Words
The left-for-dead gold stocks have rallied dramatically this past week, surging to a major breakout. This pivotal technical event reveals the hyper-bearish psychology plaguing this sector in recent months is dissipating, paving the way for investment capital to return. And given the fundamentally-absurd price levels in this battered sector, this new gold-stock buying is likely just the initial vanguard of a massive new upleg.
Even among contrarians, the overwhelming consensus view is that gold minersí stocks are doomed to grind lower indefinitely. Pretty much everyone even aware of this obscure sector totally despises it, the inevitable result of recent yearsí dismal price action. The flagship gold-stock index, the NYSE Arca Gold BUGS Index better known by its symbol HUI, certainly reflects the unbelievable misery in this business.
Over 4.0 years between September 2011 and September 2015, the HUI plunged 83.5% in a bear market of apocalyptic magnitude! This incredibly-large bear excelled in annihilating all interest in this sector. Almost everyone capitulated, scared away by the brutal mauling. Adding insult to injury, the benchmark S&P 500 general-stock-market index soared 63.5% over this same span. Gold stocks have been dreadful.
But as long as these companies can profitably mine gold, their stocks arenít going to zero. And since markets are forever cyclical, at some point gold stocks are absolutely going to reverse from secular bear back to secular bull again. And thereís a good chance this past weekís amazing technical events marked that transition. If this indeed proves to be true, the coming gains to be won in this sector will be legendary.
The gold miners are an exceptionally-volatile sector that not only suffers big bears, but enjoys enormous bulls. In the 10.8 years between November 2000 and September 2011, the HUI skyrocketed an utterly astounding 1664.4% higher! Multiplying your wealth by nearly 18x in a single decade is a life-changing legacy-creating event. And during that span, mainstream investors endured a 14.2% loss in the S&P 500.
So if the long-overdue next gold-stock secular bull market is indeed getting underway, the opportunity for early contrarians to earn fortunes is vast beyond belief. While it is gold stocksí ludicrously-cheap fundamentals resulting from epically bearish sentiment that make them so compelling, this past weekís major breakout is the potential new-bull confirmation signal. So letís look at technicals first, then fundamentals.
While the HUI is the premier gold-stock index, this sectorís dominant trading vehicle watched by investors and speculators is the GDX Market Vectors Gold Miners ETF. While itís only been around since May 2006, GDX is a fine sector benchmark that nearly perfectly mirrors the HUI. So letís consider this past weekís phenomenal price action in GDX terms before we dive into the fundamentals of why itís justified.
This chart looks at the gold-stock price action over the past year or so, and the majority wasnít bearish. From November to May, the gold stocks were actually rallying on balance. Their latest woes didnít begin until June, when these stocks suffered an anomalous breakdown relative to gold. The dominant driver of gold-mining profits is the price of gold, so gold-stock prices usually amplify goldís moves in lockstep.
And gold did weaken in June, retreating 1.5%. Since the stocks of the major gold miners that dominate the weightings in both GDX and the HUI tend to leverage gold by 2x or so, that should have pushed these benchmarks down about 3.0%. But with investors and speculators irrationally scared and fed up with this sector, GDX lost a wildly-disproportionate 9.3% that month! That inflamed already-bearish psychology.
But interestingly, the entire gold-driven precious-metals complex has always tended to be weak during the market summer of June, July, and August. This is the weakest time of the year seasonally for gold, with no outsized demand spikes coming from global income-cycle and cultural drivers. That has created the PM summer doldrums, where gold, silver, and the stocks of their miners usually drift sideways to lower.
That typical seasonal weakness and associated bearish psychology was greatly amplified this year as gold stocksí important 7-month-old uptrend support line decisively failed. So most traders capitulated and fled, a decision that surprisingly proved wise. July would witness the most extreme gold-futures shorting attack on record, a concerted effort by a large speculator to run long-side stops by crushing gold at an odd hour.
That event is exceedingly important to understand. It proves that goldís recent new lows were totally artificial, they had nothing at all to do with normal supply and demand. In a nutshell, late on a lazy Sunday evening in July a speculator sold short a jaw-dropping 24k gold-futures contracts in a single minute! The only purpose of such a huge, instant short sale outside of normal trading hours is outright price manipulation.
Gold plummeted $48 in that minute to $1086 on this selling, a major new 5.3-year secular low. And that sparked the extreme gold-stock plummet to fundamentally-absurd lows in July. Back in early August I wrote a whole essay detailing this extreme gold-futures shorting attack. You canít understand why gold stocks are so low, and such an epic buying opportunity, if you donít understand what triggered these lows.
During the two trading days straddling this gold attack, the metal plunged 4.1%. But with sentiment in the ravaged gold miners already so miserable, traders again rushed to exit. GDX plummeted 14.7% over that span, again wildly disproportionate to goldís own losses! A super-bearish technical pattern in gold-stock prices was forming known as a descending triangle, which is highlighted in this chart in blue.
Gold stocks were merely able to bounce back up to a rapidly-dropping upper resistance line before they were forcefully repelled lower again. No matter how strong the gold-stock buying, including early Augustís sharp surge, this descending triangleís resistance proved a graveyard in the sky. The fact that GDXís key 50-day moving average paralleled this resistance really bolstered it. Gold stocks were hopelessly trapped.
But in order to carve a descending triangle, prices also have to hold near a horizontal lower support line. And thatís exactly what happened in recent months. While GDX couldnít break out to the upside, it also didnít fail to the downside. This leading gold-stock ETFís all-time record low in early August essentially held strong. This confounded the legions of bears calling for gold stocks to keep on plunging deeper.
The gold stocksí descending triangle was coiling prices tighter and tighter. And this price formation is very bearish, as the highest-probability outcome by far is indeed a steep break to the downside once the triangleís right-side apex is hit. Read any textbook on technical analysis, and it will say that descending triangles are warning signs of imminent major downside. This led to exploding gold-stock short selling.
But looking at technical price action in isolation without considering sentiment and fundamentals isnít prudent. Obviously gold-stock bearishness was extreme beyond belief as prices were crushed lower and lower in recent months. And sentiment extremes are finite and inherently self-limiting. Once all the traders who want to sell low have already sold, that leaves only buyers which portends a sharp rebound rally.
Though GDXís history only extends to its birth in May 2006, the HUI indexís goes back a decade earlier to March 1996. So the all-time low in GDX terms in early August was accompanied by a 13.0-year low in HUI terms. The last time the gold stocks had traded at those extreme prices was way back in July 2002. The crazy part was gold was meandering around just $305 then, and had yet to exceed $329 in its young bull!
To see gold stocks priced as if gold was around $300 when it was actually near $1100 was ludicrous, it had to be an extreme anomaly spawned by extreme and unsustainable fear. So I took the lonely contrarian side on gold-stock prices in recent months. Rather than seeing the typical high-odds descending-triangle break to the downside, I advised our newsletter subscribers to game a major upside breakout.
Provocatively the bears tried to rely on a fundamental argument to bolster their keep-on-shorting-super-low-gold-stocks case. They claimed over and over again that the costs for mining gold in this industry centered around $1200. Therefore with gold well under $1200, this sector couldnít generate positive cashflows or profits. Soon nearly everyone believed them, that sub-$1200 gold simply wasnít survivable.
But after intensively studying and actively trading gold stocks for over 15 years, that number didnít make any sense to me. It didnít jibe with any of the deep fundamental research we do. So in mid-August as gold-stocks-to-zero calls drowned out all rational discourse, I analyzed the costs that all the leading gold miners in both the GDX and GDXJ ETFs reported in Q2í15. The former are the majors, the latter the juniors.
And it turned out that $1200 industry breakeven number was a total pile of bear crap, false propaganda! GDXís elite gold majors had average cash and all-in sustaining costs in Q2 of just $635 and $895. This meant the long-term viability level for this industry is under $900, far below the prevailing $1100+ levels of August. And GDXJís juniors looked better, with average cash and AISC of just $613 and $858 in Q2.
So the fact that gold miners were priced as if gold was around $300 and theyíd never earn a profit again, yet they were still earning on the order of $200 per ounce as an industry, was fundamentally ludicrous. It made zero sense. So we fought the extreme herd fear to aggressively buy elite gold and silver stocks in August and September. Iíve never seen a greater fundamental disconnect of stock prices anywhere.
The inevitable reversal out of this extreme stealthily began on the final trading day in September. That day the HUI enjoyed a super-bullish outside reversal. After falling on open to what wouldíve been a new 13.2-year closing low, the HUI surged sharply to a nice 3.1% gain. That day saw an intraday low below the previous dayís, an intraday high above the previous dayís, and a close right at that high.
Outside reversals often signal major trend changes. And just a couple days later on last Friday October 2nd, gold surged 2.2% after that total disaster on the US September jobs report. This unleashed frantic short covering in gold stocks, catapulting GDX 8.1% higher that day. Those sharp gains continued with 4.3% and 3.6% rallies Monday and Tuesday. The HUIís 3-day gains ran an even bigger 8.3%, 5.2%, and 4.3%!
The result of this flurry of gold-stock buying is the very-decisive major breakout shown above. Just as the fundamentals argued, gold stocksí descending triangle yielded to a rare upside breakout rather than the common downside one. And with both this formationís strong overhead resistance and GDXís oppressing 50dma overcome, this flashed a major buy signal to speculators and investors waiting on the sidelines.
While gold stocksí major breakout is very exciting, the reason it is so incredibly bullish for this sector is far more fundamental than technical. Remember all stock prices are ultimately a function of underlying corporate profits. And gold-mining earnings are driven almost exclusively by the price of gold. Higher gold prices lead to profits that grow far faster than gold is rallying. This profits leverage is critical to understand.
If a gold miner is producing its metal for $900, and gold is at $1100, it earns $200 per ounce. But if gold rallies 9% to $1200, this minerís costs, which are largely fixed on its mine build, remain at $900. So all of a sudden it is earning $300 per ounce, a gigantic 50% increase in profits. As gold rallies, the profits for mining it literally explode! And goldís new mean reversion higher means gold stocks are even more undervalued.
This last chart looks at the HUI/Gold Ratio, a construct that quantifies gold minersí stock prices relative to the gold price which drives their profits. And gold stocks have never been cheaper compared to goldís prevailing price levels than in the past couple months. This extreme anomaly all but ensures a major new gold-stock upleg is already underway or due imminently. This gold-stock rally is barely just beginning!
In late September, this HGR fundamental measure of gold-stock price levels hit an all-time low of just 0.093x! In other words, the HUI index was trading at just 9.3% the price of gold. This means nothing alone, but when considered within the context of HGR history it is an absurdly-extreme low. And extreme lows are never sustainable in forever-cyclical markets, they inevitably lead to big mean reversions higher.
This chart covers nearly 13 years of gold and gold-stock price history, a long secular span that witnessed virtually every kind of market condition imaginable. This ranged from mighty gold-stock bulls to a once-in-a-century general-stock-market panic. And throughout all of that, good times and bad alike, the gold stocks were always priced much higher relative to the metal that drives their profits and hence ultimately stock prices.
Between the middles of 2003 and 2008, the last time the markets were actually normal before that crazy stock panic in late 2008, the HGR averaged 0.511x. For a variety of reasons beyond the scope of this essay, I suspect that is normal territory for the fundamental relationship between gold prices and gold-mining profitability. Even at todayís measly $1150 gold, that historical 0.511x HGR would yield a HUI at 588.
Thatís a whopping 366% above current levels, and shows how extremely undervalued the gold minersí stocks are today fundamentally! But you certainly donít have to expect gold stocksí relationship to gold to return to pre-panic levels to be bullish today. During the most extreme fear event of our lifetimes by far, 2008ís stock panic, the worst level the HGR saw was 0.207x. At $1150 gold, even that implies a 238 HUI.
Even those peak-despair levels are 89% above todayís ridiculous ones! And the last time the HUI got so low relative to gold in late October 2008, it would more than quadruple over the next several years with a 319.0% gain. This trounced the S&P 500ís mere 39.7% rally over the same span. It hasnít been all that long since undervalued gold stocks earned fortunes for brave contrarians strong enough to buy them low.
But itís way too pessimistic to consider stock-panic lows to be normal, as the definitive VIX fear gauge soared way up above 80 then. A much more reasonable span to evaluate righteous gold-stock price levels in fundamental terms relative to gold came in the post-stock-panic span between 2009 and 2012. That was after 2008ís extreme panic, but before 2013ís extreme market distortions from the Fedís QE3.
During that secular span, the HGR averaged 0.346x. Given this metricís history, itís hard for anyone to argue that those levels are fundamentally unreasonable. At $1150 gold, this post-panic average HGR pegs the HUIís righteous level today at 398. Thatís 215% above this weekís dismal gold-stock price levels! So even being very conservative, gold stocks at least need to quadruple out of their recent extreme lows.
With the exception of the sharp mean reversion higher after 2008ís stock panic, gold stocks have been falling faster than gold almost continuously since April 2006. This is also an extreme span, defying normal history where gold stocks outperform and then underperform gold cyclically. Nothing in the markets moves in one direction forever, so after 9.5 years gold stocks are way overdue to outperform gold again.
That means they will rally faster than gold and drive the HGR higher again, mean reverting it back up to a reasonable norm instead of these extreme unsustainable lows. And gold stocksí gains will be really amplified by goldís own mean reversion higher. Since this metalís deep early-August secular lows after that extreme gold-futures shorting attack in July, gold has been slowly carving a new mean-reversion uptrend.
And the higher gold climbs, the more the gold-stock upside price targets rise thanks to these minersí inherent profits leverage to gold. At that conservative post-panic normal-year average HGR of 0.346x from 2009 to 2012, $1300, $1400, and $1500 gold yield HUI price targets of 450, 484, and 519. And believe it or not, even $1500 gold isnít particularly high. Gold averaged $1669 in 2012 before the Fedís QE3.
That wildly-unprecedented open-ended debt-monetization campaign is the sole reason gold and the gold stocks have suffered so much in recent years. As the Fedís QE3 bond buying and associated jawboning about more money printing levitated the stock markets, capital fled alternative investments led by gold. The resulting radical gold underinvestment will reverse as the Fed-inflated stock markets roll over.
As gold mean reverts higher in the coming years, the gold stocks are going to just soar out of their recent extreme lows that are totally unjustified fundamentally. And the Fedís coming rate hikes are no threat to gold, contrary to popular belief. Gold has actually rallied strongly in past Fed-rate-hike cycles that began when gold prices werenít near secular highs. Rate hikes have actually proven very bullish for gold!
So if youíre not deployed in these dirt-cheap gold stocks yet, you better get moving before this window of extraordinary buy-low opportunity closes. This is a very small sector compared to the broader stock markets, so once speculators and investors start returning the gains will really accelerate. And gold stocksí major breakout this past week signals that this shift of capital back into this battered sector has already begun.
When everyone else was warning to flee gold stocks and sell low in August and September, at Zeal we were buying low with reckless abandon. While this sectorís sharp August rally whipsawed everyone, we still have a whopping 28 new gold-stock and silver-stock positions on our trading books that were purchased in August and September! While these have already surged up to 47%, itís not too late to buy low.
Weíve long published acclaimed weekly and monthly newsletters detailing our specific stock trades. They draw on our decades of exceptional market experience, knowledge, and wisdom to analyze the markets from a unique contrarian perspective. Unlike most, we really do walk the walk in buying low and selling high. Since 2001, all 700 stock trades recommended in our newsletters have averaged annualized realized gains of +21.3%! Subscribe today, enjoy our 20%-off sale, and get deployed in elite gold and silver stocks before they really start moving!
The bottom line is gold stocksí major breakout this past week likely signaled the long-overdue major trend change. After being crushed to fundamentally-absurd prices by that extreme gold-futures shorting attack, gold stocks refused to fall any lower despite epic bearishness. And then they defied the odds to stage a powerful upside breakout from a bearish descending-triangle technical formation. Buyers are returning.
And while this technical green light is exciting, the real reason gold stocks are so incredibly bullish is their extreme undervaluation relative to the metal that drives their profits. Gold stocks recently hit all-time lows relative to gold, trading as if gold was around $300. As gold stocks more than quadrupling after 2008ís stock panic proved, such extreme sentiment-driven anomalies canít persist. So donít delay, buy low now!
Adam Hamilton, CPA October 9, 2015 Subscribe at www.zealllc.com/subscribe.htm