Adam Hamilton: Cheap Gold Stocks Basing

The small contrarian gold-mining sector remains deeply out of favor, universally ignored. Thus the gold stocks are largely drifting listlessly, totally devoid of excitement. But that's the best time to buy low, when few others care. The gold stocks continue to form strong technical bases, paving the way for massive mean-reversion uplegs. And they remain exceedingly cheap relative to gold prices, which drive their profits.

Being a gold-stock investor feels pretty miserable and hopeless these days. The gold stocks have been consolidating low for 14.2 months now, stuck in a seemingly-endless sideways grind. There are still gains to be won, but they are mostly within that low-trading-range context. We haven't seen one of the huge uplegs gold stocks are famous for since the first half of 2016. So most traders have given up and moved on.

That's understandable psychologically, but unfortunate for multiplying wealth. Sometimes it takes a while for gold stocks to catch a bid, but once they get moving they often soar. This sector is so small relative to broader stock markets that even minor shifts in capital flows can drive enormous gains. While it's hard waiting for gold stocks to return to favor, the vast upside when they do is well worth the buying-low pain.

The leading gold-stock measure and trading vehicle is the GDX VanEck Vectors Gold Miners ETF. It was the original gold-stock ETF launched in May 2006, and still maintains a commanding advantage in popularity. This week, GDX's net assets of $7.7b were 24.0x larger than its next-biggest 1x-long major-gold-stock-ETF competitor! GDX is as big as all the other gold-stock ETFs trading in the US combined.

GDX's price action shows why gold stocks are such compelling investments when everyone hates them. After gold stocks were universally despised in mid-January 2016, GDX soared 151.2% higher in just 6.4 months! After the previous time sentiment turned so overwhelmingly against gold stocks in October 2008, GDX rocketed 307.0% higher over the next 2.9 years. Buying gold stocks low has proven very lucrative.

That quadrupling of GDX after 2008's first-in-a-century stock panic was actually the tail end of a vastly-larger secular gold-stock bull. Many years before GDX was even a twinkle in its creators' eyes, that gold-stock bull started stealthily marching higher out of total despair. It can't be measured by GDX since that ETF started too late, but the classic HUI NYSE Arca Gold BUGS Index reveals the magnitude of that bull run.

Over 10.8 years between November 2000 and September 2011, the gold stocks as measured by the HUI skyrocketed an astounding 1664.4% higher! And that was during a long bear-market span in the general stock markets, where the flagship S&P 500 drifted 14.2% lower. The gains in gold miners' stocks as they mean revert from out of favor to popular are so epically enormous that they far outweigh any time lost waiting.

Gold stocks are even more attractive today given the exceedingly-overvalued and dangerous US stock markets, which are on the verge of a long-overdue major bear. Market valuations remain deep in literal bubble territory despite early-February's correction. The simple-average trailing-twelve-month price-to-earnings ratio of the elite S&P 500 stocks was still 31.5x at the end of last month, above the 28x bubble threshold!

The market-darling stocks investors love today are crazy-expensive, portending huge downside in the next bear. The most-popular stock among professional and individual investors alike is Amazon.com, a great company. Yet AMZN stock is now trading at a ludicrous 252.5x earnings! That means if profits held steady it would take new investors today a quarter millennium just to recoup their stock purchase price.

Meanwhile the world's largest gold miner in 2017-production terms, Barrick Gold, is now trading at a TTM P/E of 9.5x. That's dirt-cheap by any standards! And ABX's profits-growth potential is greater than AMZN's. Last year Barrick mined 5.32m ounces of gold at all-in sustaining costs of $750 per ounce. That was $508 under gold's average price of $1258 last year, fueling fat full-year profits over $1.5b on $8.4b in sales.

Every 10% increase in prevailing gold prices boosts Barrick's earnings by 25%. And the average gold price so far in 2018 is already up 5.7%, so gold miners' profits are growing fast. I'm not a Barrick Gold investor, and am just using this leading major gold miner as an example. There are plenty of smaller mid-tier gold miners with far more upside profits leverage to gold prices. Gold stocks are darned attractive!

They are one of the last bargain sectors remaining in these overheated stock markets. They are one of the only sectors that can rally in major bear markets, because they follow gold which drives their profits. Gold investment demand surges in weak stock markets, which brings investors back to gold stocks. At some point, investors are going to figure out how compelling gold stocks are today and stampede back in.

Despite the apathetic sentiment plaguing them, the gold stocks are still looking fine technically and even better fundamentally. This first chart looks at gold-stock technicals as rendered by their dominant GDX ETF. Given how bearish traders have waxed on gold miners, you'd think they are spiraling relentlessly lower. But they are actually consolidating nicely, establishing a strong base from which to launch their next upleg.

After plunging to fundamentally-absurd all-time lows in mid-January 2016, GDX soared into a major new bull market. While its 151.2% surge in just 6.4 months was undoubtedly extreme, that emerged out of even-more-extreme lows. And it merely catapulted GDX to a 3.3-year high in early-August 2016, nowhere close to secular topping levels. But the gold stocks were very overbought then, and soon corrected hard.

GDX's enormous 39.4% correction in 4.4 months after that initial bull peak was also extreme, the result of a couple major anomalies. First gold-futures stops were run on major gold support failing, which ignited parallel cascading stop-loss selling in the gold miners' stocks. Then investors fled gold in the wake of Trump's surprise election victory, which led stock markets to soar on widespread hopes for big tax cuts soon.

Gold-stock selling finally exhausted itself in mid-December 2016, the day after the Fed's 2nd rate hike of this cycle. Just a couple weeks later, GDX entered its now-14.2-month-old trading range that persists to this day. It is a basing consolidation trend running from $21 support to $25 resistance, which makes for a 19.0% trading range. This has held rock solid ever since, which has made gold-stock trading fairly easy.

My strategy has been simple. Given the extreme undervaluations in gold stocks that I'll discuss shortly, a massive new upleg is likely to ignite anytime. So I want a full trading book to reap those enormous gains when they inevitably arrive. Thus every time GDX slumped down into the lower quarter of its consolidation range, between $21 to $22, I've been adding positions in great mid-tier gold miners with superior fundamentals.

All this is shared in real-time with our newsletter subscribers, who graciously support our research work. Buying low in the context of this vexing gold-stock consolidation has driven some great trades despite lackluster overall action. One example is Kirkland Lake Gold, an elite mid-tier miner. I added a new position in our popular weekly newsletter in December 2016. A year later I sold it for a hefty 184% realized gain!

So while this gold-stock trading range has sure felt dull, it has still created plenty of trading opportunities. And over the past month or so since that sharp stock-market correction, GDX has largely meandered in that lower quarter of its range near support again. That means it's an excellent time to deploy capital in the unloved and cheap gold miners' stocks today. Another surge higher is due, and it could be a big one.

While GDX $21 support has proven strong since the end of 2016, so has GDX $25 resistance. The gold stocks have tried and failed to break out above $25 four separate times since early 2017. A couple of the attempts were close, but weren't sustainable as gold retreated. Once that $25 breakout finally comes to pass, investors will realize something different is happening and rush to chase gold stocks' upside momentum.

Before early February's sharp stock-market plunge that changed everything, I was looking to the release of gold miners' Q4'17 operating and financial results as a potential catalyst to fuel that $25 breakout. That didn't happen though, as gold and especially gold stocks were sucked into the fear surrounding the unprecedented stock-market volatility shock a month ago. That dragged GDX back down near support, which held.

This recent support approach is probably a blessing in disguise, offering another chance for investors to deploy capital in cheap gold stocks before they really start moving again. The great and sad paradox of the markets is investors are least willing to buy when stocks are low and out of favor, which is the exact time they should be buying before later selling high. Gold-stock prices can't and won't stay this low forever.

With stock-market volatility back, the highly-likely catalyst to ignite that GDX $25 breakout is gold rallying on resurgent investment demand. Gold is largely ignored when stock markets are high and investors are euphoric, as they feel no need to prudently diversify their portfolios. But once stock markets sell off for long enough to spook investors, they start shifting capital back into gold which often moves counter to stocks.

With the US stock markets still trading deep into bubble territory in late February, and euphoria remaining rampant as evidenced by the blistering bounce rally following that early-month plunge, there's no way the stock-market selling is over yet. It will have to resume sooner or later with a vengeance to actually start rebalancing away greedy sentiment. When that happens, gold and gold stocks will soon catch major bids.

The fact gold stocks have held strong in their consolidation trading range for well over a year now is a glass-half-full kind of thing. It testifies to relatively-strong investment demand given the terribly-bearish sentiment pervasive in this sector. The longer prices base during bull markets, the greater the upside potential in their next upleg. It likely won't take much of a gold rally to blast GDX back up through $25 again.

This strong technical picture and an inevitable sentiment mean reversion are reason enough for gold stocks to surge dramatically higher. But supercharging that is the dirt-cheap state of gold stocks today in fundamental terms. That includes current gold-mining profits compared to prevailing gold-stock prices, as well as near-future earnings-growth potential as gold itself continues mean reverting much higher ahead.

I'm well into my quarterly research work analyzing the Q4'17 results from the major gold miners of GDX. Unfortunately due to the complexities of preparing annual reports, the Q4 reporting season up to 90 days after quarter-ends is double the 45-day deadlines for Q1s through Q3s. So all the data isn't quite in yet, but I expect to have enough to delve deeply into the major gold miners' Q4'17 results in next Friday's essay.

In the meantime, a great fundamental proxy for gold-stock valuations is the HUI/Gold Ratio. This is as simple as it sounds, dividing the daily close of that classic gold-stock index by the daily gold close and charting the resulting ratio over time. This reveals when gold stocks are expensive or cheap relative to the metal which drives their profits. And this sector has rarely been more undervalued than it is today!

This week the HGR was way down at 0.131x, meaning the HUI index's close was running just over 13% of gold's close. That's incredibly low historically, showing that the gold miners' stocks have been wildly underperforming gold. The gold stocks are trading at levels today implying gold and their profits were radically lower. This is a colossal fundamentally-absurd disconnect that can't last forever, it has to unwind.

GDX and the HUI were way down at $21.57 and 173.4 in the middle of this week. The first time the HUI ever hit this level was way back in August 2003, years before GDX was even born. Back then gold was only running $357, and had yet to trade above $380 in its entire young secular bull. Let that sink in for a second. Gold stocks are trading at prices today first seen when gold was in the $350s fully 14.6 years ago!

This week gold was trading near $1325, an enormous 3.7x higher. That should certainly be reflected in gold miners' stocks. Today's super-low gold-stock levels aren't much above the HUI's stock-panic lows back in October 2008. There was only a week where the HUI traded lower than today at peak fear in the stock markets, and gold averaged $732 during that extreme span. This week it was trading 81% higher!

This is incredibly illogical, only explainable by irrational sentiment. If any other stock-market sector was trading at levels from a decade or more earlier despite the selling prices of its products doubling to quadrupling, investors would be beating down the doors to buy. That would rightfully be seen as a huge and unsustainable anomaly, a rare chance to buy deeply-undervalued stocks at decade-plus-old prices.

And it's not just gold that's far higher, so are the profit margins for mining it. With the new Q4'17 results from GDX's major gold miners not all out yet, the latest data we have this week is Q3'17's. During that previous quarter, the top GDX miners averaged all-in sustaining costs of just $868 per ounce. The costs of mining gold industrywide don't change much, which is what creates profits' big upside leverage to gold prices.

My still-incomplete Q4'17 analysis shows AISCs very similar to last quarter's. That makes sense, as the past year's quarters ending in Q3'17 had collective GDX AISCs of $875, $878, $867, and $868. Mining gold costs similar amounts regardless of prevailing gold prices, at least over medium-term multi-year spans too short for new gold mines to be built. So Q4'17 AISCs are likely to remain around these levels.

Assuming $868 carries forward into Q4'17 and Q1'18, gold-mining profits are really growing. Average gold prices surged from $1276 in Q4 to $1330 quarter-to-date in Q1. That's up 4.2% sequentially, really strong. This implies major gold miners' earnings are surging 13.2% QoQ in our current Q1'18 from $408 to $462 per ounce! That would make for strong 3.1x upside profits leverage to gold, which is impressive.

And whether the major gold miners are collectively earning $400, or $450, or even $500 per ounce today, such profits alone are much greater than the $350s prevailing gold price the first time the HUI traded at today's levels. With fat profits like this heading much higher as this gold bull continues, it's ridiculous for gold stocks to be priced as if gold was still in the $350s like mid-2003 or the $730s like in 2008's stock panic.

This extreme anomaly can't and won't last. The gold stocks should be priced for today's prevailing gold prices around $1325. The first time gold hit $1325 in October 2010, the HUI was trading at 522. That is triple today's ludicrous levels! The gold stocks more than quadrupled in the years following 2008's stock panic, another irrational situation where sentiment had battered gold stocks to fundamentally-absurd levels.

Between that first-in-a-century stock panic and extreme central-bank easing that really hit full steam in 2013, the last quasi-normal years in the markets were 2009 to 2012. During that post-panic span the HGR averaged 0.346x. If the HUI would merely mean revert back up to those levels relative to gold, it would have to soar to 458. That's 164% higher than this week's levels, upside unparalleled in any other sector.

For 5 years before the stock panic, the HGR averaged 0.511x. While gold stocks might not be able to sustain levels so high anymore, they could certainly blast up there in a temporary mean-reversion overshoot. After extremes, prices don't simply migrate back to the average. Instead they overshoot proportionally to the opposing extreme as sentiment is equalized. That implies a HUI level of 677, 290% higher from here.

No one knows how high gold stocks can go, but there is zero doubt they are radically undervalued given today's gold prices and the gold-mining profits they generate. Whether you expect this battered sector to quadruple again like after the stock panic, or merely double, that dwarfs the potential of the rest of the stock markets. Especially with the S&P 500 trading at bubble valuations after a long central-bank-goosed bull.

The gold stocks are truly a coiled spring today, ready to explode higher soon and trounce everything else. They are deeply out of favor, incredibly undervalued, and one of the only sectors that can rally sharply when general stock markets sell off. If you want to multiply your wealth this year by fighting the crowd to buy low then sell high, this small and forgotten contrarian sector is the place to be. Nothing else rivals it.

While investors and speculators alike can certainly play gold stocks' coming powerful upleg with the major ETFs like GDX, the best gains by far will be won in individual gold stocks with superior fundamentals. Their upside will far exceed the ETFs, which are burdened by over-diversification and underperforming gold stocks. A carefully-handpicked portfolio of elite gold and silver miners will generate much-greater wealth creation.

At Zeal we've literally spent tens of thousands of hours researching individual gold stocks and markets, so we can better decide what to trade and when. As of the end of Q4, this has resulted in 983 stock trades recommended in real-time to our newsletter subscribers since 2001. Fighting the crowd to buy low and sell high is very profitable, as all these trades averaged stellar annualized realized gains of +20.2%!

The key to this success is staying informed and being contrarian. That means buying low before others figure it out, before undervalued gold stocks soar much higher. An easy way to keep abreast is through our acclaimed weekly and monthly newsletters. They draw on my vast experience, knowledge, wisdom, and ongoing research to explain what's going on in the markets, why, and how to trade them with specific stocks. For only $12 per issue, you can learn to think, trade, and thrive like contrarians. Subscribe today, and get deployed in the great gold and silver stocks in our full trading books!

The bottom line is gold stocks are basing technically and cheap fundamentally today. While this small contrarian sector has largely been forgotten, its past year's consolidation trading range continues to hold solid. The longer the basing, the greater the potential upleg when investors return. And despite trading at levels implying vastly-lower gold prices, the major gold miners are actually earning fat profits today.

Those earnings will surge dramatically as gold continues powering higher in its own bull market. It's only a matter of time until investors see the extreme market-leading value inherent in the gold miners' stocks. And with stock-market volatility roaring back after long years of central-bank suppression, diversifying portfolios with gold will soon return to favor. The gold stocks will soar as investment buying drives gold higher.

Adam Hamilton, CPA

March 9, 2018

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