Gold Mining Stocks Valuations / Commodities / Gold and Silver Stocks 2020

The gold miners’ stockshave spent the past half-year mired in a high consolidation.  They haven’t been able to break out, but aren’tbreaking down either.  This technicalpurgatory is working to slowly bleed off overboughtness and rebalance sentiment.  This necessary process to eradicate greedfrom the last upleg peak is never exciting. But today’s low gold-miner valuations reveal great upside potential intheir next upleg.

The world’s leading anddominant gold-stock trading vehicle and benchmark is the GDX VanEck VectorsGold Miners exchange-traded fund.  It commanded$13.2b in net assets in the middle of this week, 2.7x larger than its next-biggestcompetitor GDXJ.  The major gold miners’stocks included in GDX soared this past summer, blasting higher after gold’s decisive breakout toits bull market’s first new highs in several years.

GDX’s strong 29.0%surge over the next 2.5 months into early September capped a larger 76.2% uplegover 11.8 months.  Naturally last summer’ssharp rally generated much excitement and greed in this small contrarian sector.  So the gold stocks needed to correct orconsolidate, either selling off deeply enough or drifting sideways long enoughto restore sentiment balance.  Excessivegreed is inherently unsustainable.

So after peaking at a3.1-year high of $30.95 in early September, GDX initially started correctingwith a 15.4% retreat over the next 1.3 months. That’s really small as far as gold-stock corrections go, as this bull’sprior two averaged 35.4% GDX losses over 11.8 months!  And this sector as measured by GDX had shownno major technical bottoming signals, like falling back to or under its key200-day moving average.

But since then that proto-correctionmorphed into a high consolidation. After that mid-October correction low, GDX spent the next couple monthsmeandering between $26 to $28.  Gold breaking out of itsown correction downtrend on Christmas Eve unleashed enough gold-stock buying tofuel a parallel breakout by the miners. GDX surged as high as $29.50 on close, and since then has mostly driftedfrom $28 to there.

This chart shows thepast half-year’s correcting and consolidating price action within the contextof this broader gold-stock bull.  This sectorremains in a technical no man’s land, neither correcting far enough nordrifting long enough yet to signal all-clear. This leaves a glass-half-full-or-half-empty thing, with gold-stockoutlooks something of a Rorschach Test for traders.  This setup can be used to argue their ownbiases.

The bulls rightfullypoint to impressively-resilient major gold stocks holding most of last summer’smassive gains.  The bears highlight theequally-valid fact GDX has totally stalled out for nearly 5 months, failing toadvance despite gold’s recent major new secular highs.  Odds are gold is going to prove the arbiterof what this sector does next.  The goldstocks are ultimately leveraged plays on gold, amplifying its fortunes.

Gold itself has twodominant primary drivers, speculators’ gold-futures trading and investmentbuying.  In recent weeks I’ve writtenextensively about both.  Specs’ collectivepositioning in their hyper-leveraged gold futures is effectively all-in.  Their long bets are way up at all-time-recordhighs, while their short-side bets are down near gold-bull lows.  Thus their capital firepower for buying more is effectively exhausted.

These influential tradersremain far more likely to sell big to unwind these excessively-bullish betsthan to buy materially more.  Identifiablegold investment demand has beenmostly weak on balance too ever since September when gold’s last upleginitially crested.  While gold powered tonew highs earlier this month on that flaring conflict between the US and Iran,they didn’t hold since specs and investors weren’t buying much.

Whatever gold does nextis absolutely critical for gold stocks’ near-term outlook.  Over 80% of individual gold-stockprice moves are driven by gold’s own trends. Gold is the tide the gold-mining boats rise and fall on as a fleet.  Fundamentally-superior gold stocks canoutperform their sector when gold is rallying in uplegs, but they still fallwith their peers when gold is correcting. Gold stocks need gold buying to advance.

Gold-futures speculatorsneed to somehow keep adding bullish bets even from near-record levels wherethey are tapped out.  Gold investors needto flood back in despite the general stock markets levitating toall-time-record highs spinning off great euphoria.  These are both tall orders, with majorselling from both key camps much more likely than material additionalbuying.  So it’s prudent to stay wary ongold stocks here.

That caveat understood,the major gold miners’ fundamentals look excellent.  From a high level this is a simple businessfinancially.  The miners wrest all thegold they can from the bowels of the Earth, then sell it at whatever the marketsoffer.  The difference between prevailinggold prices and their total extraction costs is their profits.  The more gold they can produce, and thehigher they can sell it for, the better their earnings.

The best widely-adoptedmeasure of gold-mining expenses is all-in sustaining costs.  AISCs include all direct cash costs, as wellas everything else necessary to maintain and replenish operations at currentgold-production levels.  After every quarterlyearnings season, I dig deeply into the AISCs of the major and larger-mid-tiergold miners included in GDX.  The latestread came from Q3’19 results in mid-November.

The top 34 GDX goldminers collectively commanding 94.1% of this leading ETF’s overall weighting hadaverage AISCs of $910 per ounce in that latest reported quarter.  Q3’s numbers will remain the most recent forsome time yet.  Q4 results typically take an additional month or so to release, since they included auditedfull-year numbers.  So the next round of gold-minerAISCs won’t be fully out until mid-March.

The last 4 reportedquarters of GDX average AISCs ran $889, $893, $895, and $910.  That averages out to $897 per ounce, which wemay as well round to $900.  Gold-minervaluations, how cheap or expensive their stock prices are, are partiallydetermined by their mining costs relative to prevailing gold price trends.  This spread drives their earnings, andultimately their stock prices gravitate to some reasonable multiple of those.

In Q3’19 gold averaged$1474 per ounce, while again the GDX gold majors’ AISCs averaged $910.  That implies industry earnings of $564 perounce!  That makes for massive 38%profit margins, very-high levels most other industries would kill for.  That was a radical increase thanks to gold’s powerfulbull-breakout surge into that quarter. In Q2’19, gold’s far-lower $1309 average price yielded much-lowerearnings.

That quarter the GDX majors’AISCs averaged $895, implying $414 profit margins.  Thus Q3’s soared a massive 36.2% sequentiallyon 12.6%-higher average gold prices quarter-on-quarter!  There’s no doubt gold stocks’ strong upleg endingin early September was fundamentally-righteous. The year-over-year comparisons are even more stunning.  Back in Q3’18, gold was averaging just $1211 emergingfrom major lows.

The GDX gold miners’average AISCs that quarter ran $877, implying industry profit margins of $334per ounce.  So year-over-year the major goldminers dominating GDX saw their earnings skyrocket 68.9% on 21.7%-higheraverage gold prices!  Yet despite goldstocks’ strong upleg, they still didn’t rally enough to reflect such amazingprofits growth.  GDX’s average price fromQ3’18 to Q3’19 merely climbed 40.1%.

The gold miners’ stocksarguably didn’t climb high enough in their latest upleg to adequately reflecttheir radically-better fundamentals.  Thatcertainly left them undervalued at early September’s GDX peak.  And that trend has persisted.  Gold largely consolidated high in Q4’19instead of correcting following its own mighty upleg, the strongest of its bullso far.  That made for even-higher averagegold prices of $1483 last quarter.

Assuming GDX AISCsremain around their average $900 level, that implies the gold miners ought tobe reporting profits around $583 per ounce in Q4.  That’s even better than Q3’s despite goldstalling out, and a staggering 72.0% higher YoY from Q4’18’s levels!  And while Q1’20 remains very young, thanks tothat US-Iran geopoliticalspike gold is averaging a much-higher $1554 so far.  Gold-mining earnings are strong.

Obviously if gold rollsover into a correction this quarter, these hefty profits will fade fast.  The major gold stocks of GDX generally leveragematerial gold moves by 2x to 3x, because their earnings have similarleverage to gold prices.  Another importantfactor to consider is gold-production levels. Overall earnings depend not just on the spread between prevailing goldprices and AISCs, but how much gold the miners harvest.

In such a capital-intensiveindustry where mines are nearly always operating 24x7x365, you’d think theircollective output would be fairly constant. Interestingly enough, it’s not.  Themajor gold miners’ outputs vary considerably quarter to quarter!  This is readily evident in the global goldproduction data from the venerable World Gold Council.  Each quarter it publishes the best fundamentaldata available on gold.

The new Q4’19 GoldDemand Trends report hasn’t been released yet, they are typically published justover a month after quarter-ends.  But thedecade of quarterly GDTs before that reveals fascinating gold-productiontrends.  Sequentially from the priorquarter, Q1s, Q2s, Q3s, and Q4s have averaged global gold output growth of-7.5%, +5.1%, +5.0%, and +0.5%!  Thatvariability is enormous and unexpected.

Q4s’ gold production dominatedby the major gold miners tends to only rise slightly.  That’s good news for the upcoming Q4’19results.  With mostly-flat production,the earnings picture painted by the gold-AISC spread remains valid.  The major gold miners dominating GDX shouldreport outstanding earnings in their Q4 results.  That will contribute to gold stocks lookingbetter fundamentally, more undervalued, in coming months.

But their Q1’20production, which will be fully reported by mid-May, is far more problematic.  That is likely to drop sharply from Q4’19’s,with Q1s averaging -7.5% QoQ!  And that Q1plunge over the past decade or so isn’t the result of outliers.  The raw data since Q1’11 shows Q1 sequential global-gold-mining-outputdrops of -7.2%, -6.9%, -7.4%, -11.0%, -9.4%, -3.5%, -8.7%, -6.2%, and-6.8%!  That’s certainly a tightgrouping.

Last summer I explainedwhat’s likely driving this Q1-drop phenomenon in another essay.  In a nutshell mine managers are choosing Q1sto take production hits from running lower-grade ores through their mills, andscheduling temporary shutdowns then for maintenance and expansions.  Winter weather creates operational challengestoo, with the majority of the world’s land masses and gold mines in the northernhemisphere.

Another Q4-to-Q1production slump is almost certain this year, which will push down gold-minerearnings and thus raise valuations. While the miners won’t report any Q1 production results until earlyApril at best, there could be selling in anticipation of this slump.  That could exacerbate any gold-stockcorrection driven by gold rolling over into its own correction, temporarily tarnishingperceptions of gold-stock valuations.

Gold-stock price levelsare ultimately dependent on underlying corporate earnings.  And they in turn are driven by prevailinggold prices.  The higher those are, thebigger the profit margins after all-in sustaining costs are paid.  So the core valuations of gold miners’ stockscan be distilled down into their relationship with gold prices.  This shortcut bypasses the voluminous andtedious research work analyzing quarterly results.

The ratio betweengold-stock price levels and prevailing gold prices can be expressed in the GDX/GLDRatio, or GGR.  It simply divides thedaily close of this leading GDX gold-stock ETF by the daily close in themassive and dominant GLD SPDR Gold Shares gold ETF.  Charted over time, this valuation proxyreveals whether gold stocks are getting more expensive or less expensiverelative to the metal they mine.

This chart superimposesthe GGR over the raw GDX through this entire secular gold-stock bull.  When the GGR is rising, the gold stocks areoutperforming gold.  After spending thebetter part of 2017 and 2018 stuck in a downtrend where relative gold-stockvaluations were falling, they finally started recovering in this latestupleg.  It began back in mid-September 2018,when the GGR fell to 0.155x which was a 2.6-year low.

As GDX powered 76.2%higher over the next 11.8 months, gold stocks regained much lost groundrelative to the metal which drives their profits.  That’s normal during gold uplegs.  The GGR peaked the same day GDX did in earlySeptember 2019, hitting 0.211x.  Eversince it has ground sideways to lower, just like the gold stocks.  This gold-stocks-to-gold ratio offers someimportant insights on today’s gold-stock valuations.

While GDX’s last uplegpeaked in early September, the gold miners’ advance relative to gold stalledout nearly 7 weeks earlier in mid-July! From then on, the gold stocks were just pacing gold’s gains rather thanamplifying them by 2x to 3x like usual.  Acouple factors likely contributed.  Thissummer’s powerful gold-stock rally started in late May, but GDX didn’t break outabove its multi-year $25 resistance until late June.

Gold-stock speculatorsand investors remained skeptical of that surge initially, which is understandableafter GDX failed multiple times at $25 since late 2016.  Just 2.5 months elapsed between gold’s decisivebull-market breakout in late June and its upleg topping in earlySeptember.  That’s not enough time to reverse great apathy and lingering doubt fueled by several years of goldstocks grinding sideways to lower.

Although gold-stockpsychology was rapidly improving in July and August, it hadn’t shifted deepenough back into greed yet to fuel outsized gold-stock gains.  That gold breakout happened at an unfortunatetime too.  Summers tend to be weak for gold seasonally,leaving prudent gold-stock traders more wary of that upleg than they’d be atother times of the year.  And July and Augustare peak summer vacation months.

So the gold miners didn’thave their full constituency watching and joining in during that usually-lethargicsummer-doldrums span.  Had that same GDXrally happened in October or November, it would’ve grown much larger with multiplesmore traders paying attention and chasing it. That gold-stock surge happened at the wrong time to attract enoughcapital to get really big.  And then itwas truncated prematurely by gold.

Gold faced a massive gold-futures-selling overhang in early September, which I warned at the time. The gold-futures speculators who dominate its short-term price actionwere effectively all-in, with longs near record highs and shorts very low.  Their buying firepower was exhausted, theirfinite capital fully deployed.  So theycouldn’t keep piling in even if they wanted to. Thus gold’s upleg stalled and peaked, and GDX followed.

Ominously the specgold-futures situation in recent weeks is even more extreme than earlySeptember’s!  That’s the highest-octaneargument for gold and gold stocks to correct deeper from here rather than continuingto consolidate high.  But back to thelast upleg peak, the major gold miners’ stocks never got to overvalued levelsrelative to gold.  Last summer’s 0.211xGGR high was really low for a major upleg topping.

Back in early August2016 when this gold-stock bull’s maiden upleg peaked, the GGR blasted higher to0.244x.  Had this latest upleg seen a similargold-stock valuation, GDX would’ve soared to $35.78 instead of $30.95!  That probably would’ve happened if that gold-stocksurge had occurred in a better time of the year and lasted a few months longer.  Gold stocks never getting overvalued supportsthis high consolidation.

But if the massivepent-up gold-futures selling forces gold to deeper correction lows in the comingweeks or months, the gold stocks have plenty of room to fall.  This week’s GGR of 0.196x isn’t high at allin an absolute sense, but it remains above this 4.1-year-old gold bull’s 0.187xaverage.  The GGR could very well see a supportapproach before the next gold-stock upleg, and that’s running down near 0.183xnow.

In order to return to thosekinds of GGR levels at this week’s gold prices, GDX would have to retreat 6.9%from here.  That’s material downside.  And if gold itself corrects, the GGR-supporttarget naturally gets proportionally lower. At worst after its latest upleg, gold had only corrected 6.4% over 2.7months by late November.  This gold bull’sprior couple corrections averaged much-larger 15.5% selloffs over 6.0 months!

So if the massive gold-futures-sellingoverhang forces gold a relatively-modest 10% lower from its latest early-Januarypeak, gold and GLD would fall back to $1415 and $133.17.  At that GGR-uptrend-support level of 0.183x,that implies GDX dropping to $24.37. That’s plenty serious, another 15.5% lower from this week’s levelsmaking for a total gold-stock correction of 21.3%.  Gold-stock downside risk remains.

Gold stocks never gotovervalued relative to gold in their last upleg, and are still cheap relative to gold on a long-term basis.  From 2009 to 2012in those last quasi-normal years after 2008’s stock panic but before the Fed’s extreme stock-marketlevitations gutted gold investment demand, the GGR averaged 0.381x!  But over the coming weeks and months, goldstocks still have room to correct even from low valuations.

Ultimately the goldstocks will gravitate to reasonable multiples of their underlying earnings,which means far-higher stock prices given their hefty profits today.  Valuations drive long-term stock prices.  But over the short-term, sentiment always trumpsvaluations.  So if gold corrects moredeeply on that enormous gold-futures-selling overhang, the gold stocks willfall with it.  Thus it’s prudent toremain cautious given this setup.

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The bottom line isgold-miner valuations remain quite low.  Lastsummer’s gold-stock upleg was truncated prematurely before gold stocks’ strongleverage to gold hit full stride.  So thegold miners’ stocks failed to reach overvalued levels relative to gold, helpingthem consolidate high since.  And on along-term basis, the gold stocks are still cheap compared to the metal theymine which overwhelmingly drives their profits.

The hefty gold-miningearnings are likely to grow even larger in Q4 results.  But near-term downside risks still aboundgiven speculators’ excessively-bullish positioning in gold futures.  Gold stocks will follow and amplify gold’sprice trends, regardless of their fundamentals. But once gold-futures selling normalizes the specs’ bets, the goldstocks ought to be screaming buys ahead of gold’s next upleg.  Be ready to deploy for that.

Adam Hamilton, CPA

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