Gold Stocks Recovering / Commodities / Gold and Silver Stocks 2018

The battered goldminers’ stocks are finally starting to recover after a rough few months.  Their prices slid with gold in July,plummeted in a brutal forced capitulation in August, and then dropped again inan echo capitulation into mid-September. That left them at fundamentally-absurd price levels wildly disconnectedfrom their actual profitability, leaving this sector with big mean-reversionupside ahead as it bounces back.

The leading gold-stockinvestment vehicle and increasingly benchmark is the GDX VanEckVectors Gold Miners ETF.  As of this weekit still had $8.5b of net assets even at today’s super-depressed gold-stockprices.  That dwarfs everything else in the1x-long major-gold-miners ETF space, running 40.5x bigger than its next largestcompetitor!  So GDX is the dominant proxyfor the fortunes of the gold miners’ stocks.

This small contrariansector has had a tough 2018, with GDX down a serious 19.1% year-to-date as ofthe middle of this week.  That’s mostlyexplainable by gold’s own 8.0% YTD swoon. Since their earnings are so dependent on prevailing gold prices, themajor gold miners’ stocks tend to leverage gold’s trends by 2x to 3x.  With theirdownside leverage running 2.4x so far this year, that’s right in line withprecedent.

But this seriousgold-stock weakness is a recent thing.  Back in mid-June, gold and GDX were tradingat $1302 and $22.66.  Gold was dead flatin 2018 at that point, and GDX wasn’t much worse with a 2.5% loss.  That was actually pretty resilient given themarket backdrop.  The US dollar wasstrengthening with its US Dollar Index up 2.8% YTD.  The dollar’s fortunes heavily drivegold-futures speculators’ trading.

And gold investment remaineddecent then too despite the flagship S&P 500 stock index (SPX) climbing4.1% YTD by mid-June.  Gold investmentdemand wanes when stock markets are euphoric. Gold’s best investment proxy is the physical gold bullion holdings heldin trust for shareholders of the leading GLD SPDR Gold Shares gold ETF.  They were only down 1.0% YTD then, soinvestors weren’t materially selling.

Thus the gold-stockstory today isn’t a 2018 one, but a past-few-months one.  In July gold fell 2.3% on a big 2.3% draw inGLD’s holdings thanks to a strong 3.6% SPX rally.  Why prudently diversify stock-heavyportfolios with counter-moving goldwhen stocks seem to do nothing but rally indefinitely?  The weakness in gold that month forced GDX4.6% lower, which made for 2.0x downside leverage which was on the light side.

But things really wentpear-shaped in August.  A mountingemerging-markets currency crisis centered on the plummeting Turkish lira goosedthe USDX on safe-haven buying.  So goldplunged 4.1% during that month’s first half on a sharp 2.2% USDX surge.  The gold stocks, which are ultimatelyleveraged plays on gold, took it on the chin. GDX plummeted 14.7% in that short span making for serious 3.6x downside leverage!

That naturallydevastated the already-fragile psychology in gold-stock land, leaving itstraders despondent and super-bearish.  Sothe gold stocks couldn’t muster a recovery in August’s second half withgold.  While it rebounded 2.2% intomonth-end, GDX could only stage a pathetic 2.1% rebound.  Overall in August, gold fell 2.0% while thegold stocks per GDX plunged 12.8%.  Thatwas the result of a forced capitulation.

With gold stocks sodeeply out of favor, there aren’t many investors and speculators left in themwho don’t want to be there.  Only hardenedcontrarians remain, traders who aren’t spooked by mid-August’s gold low near$1174.  But they still have to run stoplosses, and lots of those were triggered as gold stocks fell exacerbating theirplunge.  That forced technical sellingbegot more selling, snowballing out of control.

I wrote a whole essayexplaining gold stocks’ forcedcapitulation several weeks ago.  Thatheavy-if-not-extreme gold-stock selling wasn’t voluntary or even sentiment-driven.  But it stoked raging bearishness as GDX waspummeled to a deep 2.6-year low.  It’s rare for major gold stocks to leveragegold’s downside by an extreme 6.4x, definitely not sustainable.  But exceptional sentiment extremes still taketime to dissipate.

So the bleeding goldstocks were brutalized again in early September, suffering a truly-anomalous echo capitulation.  During the first third or so of last month,GDX plunged another 5.3% despite gold edging just 0.2% lower.  That leverage was crazy, off the charts.  But the gold stocks finally startedrecovering after that odd event, ultimately ending September essentially flatat -0.2%.  That was better than gold’s0.7% loss.

Unfortunately all thiscarnage in recent months really wreaked havoc technically.  This chart shows GDX since early 2016, a spanstill considered a gold-stock bull because gold’s own bull remains inforce with no 20%+ bear-market declines. August’s cascading forced selling in gold stocks drove a major supportbreakdown, and ultimately snowballed to a deep multi-year low.  But the gold stocks are now recovering.

Since GDX’secho-capitulation low in mid-September, it has rebounded 8.4% at best as ofearlier this week.  That far outpacedgold’s little 0.5% rally in that span, for extreme upside leverage of16.8x.  That’s already proving that goldstocks’ anomalous forced capitulation and secondary echo capitulation weren’trighteous fundamentally.  We are in theearly weeks of a mean-reversion rebound likely to run at least a few months.

That portends majorgains for contrarian speculators and investors willing to buy in low while sentiment still feels miserable.  The gold stocks as rendered by GDX had beenmeandering in a consolidation basing trading range between $21 to $25 for 19.3months before August’s breakdown.  Thegold stocks need to mean revert back up into that strong trend, which wouldrequire GDX rallies of 12% to 33% from current levels.

The former would merelyreturn GDX to its lower support of $21, while the latter would carry it back upto its resistance of $25.  The oddsdefinitely favor a bigger-rather-than-smaller mean-reversion rally.  When sentiment extremes force prices wayoutside of normal trading ranges, their inevitable rebounds tend to overshootproportionally towards the opposite extreme. That ought to at least be high in GDX’s trading range.

Traders invariably makemajor mistakes in judgment at price extremes, the consequence of our very humannature.  We tend to extrapolate currentprices out into the indefinite future, assuming they are the new norm ratherthan a short-lived anomaly.  And we alsofigure those price levels must be fundamentally justified since they happen toexist in the markets.  Both areincredibly wrong, blinding traders to great opportunity.

Between mid-June tomid-September, GDX plunged 22.5% on an 8.1% gold drop.  That 2.8x leverage is on the high side ofnormal, but it’s still rare to see such a big plunge in gold-stock price levelsin such a short 2.9-month span.  The lasttime anything remotely like this happened came in late 2016.  Gold and gold stocks plunged after Trump’ssurprise election victory ignited a massive taxphoria rally in stock markets.

That ultimatelyhammered GDX 39.4% lower over 4.4 months by mid-December that year.  Then, just like now, traders got all wrappedup in the popular bearishness major lows always generate.  They assumed the gold miners were faring sopoorly they’d keep spiraling lower indefinitely.  Yet as always around major lows, that extremebearishness was dead wrong.  GDX surged 34.6% higher to rebound in thenext 1.8 months.

That’s right in linewith what GDX needs to see in the coming months to regain the high side of itslong consolidation trend.  Continuing toextrapolate prices rarely works for long once they are driven to major extremesas evidenced by sentiment.  When everyonewaxes super-bearish on gold stocks after a big and fast plunge, that’s when tofight the crowd and start betting heavily for a sharp reversal and meanreversion.

The recent capitulationgold-stock levels are wildly unjustifiedfundamentally as well, which means they can’t last for long.  I’ve been a hardcore contrarian speculatorand investor for decades now, and run a small financial-research companyspecializing in contrarian trading.  Oneof my projects every quarter just after earnings season finishes is diggingdeep into the latest results from the major gold miners of GDX.

While Q3’18 is in thebooks, most major gold miners won’t report how they are doing operationally andfinancially until 4 to 6 weeks after quarter-end.  So the latest-available fundamental dataremains Q2’s.  In mid-August I exploredthat in depth for GDX goldminers’ Q2 results.  Themost-important fundamental metric for this sector is all-in sustaining costs, revealing how much it costs to mine andreplenish each ounce of gold.

In Q2 the top 34 GDXgold miners representing nearly 92% of this ETF’s total weighting reportedaverage AISCs of $856 per ounce.  That was right in line with past-yearprecedent as well, with these GDX miners’ AISCs in the preceding 4 quartersrunning $867, $868, $858, and $884.  Foryears now, the major gold miners have reported average AISCs usually between$850 to $875 or so.  Those are far belowgold prices!

At worst duringmid-August’s capitulation climax, gold closed near $1174.  Assuming Q2’s $856 average AISCs hold intoQ3, which is very likely based on recent years’ history, the major gold minersof GDX were still earning $318 per ounce! That makes for hefty 27% profit margins even when gold was at itsworst.  This forsaken sector was stilldoing fine fundamentally at gold’s recent lows, there was no threat at all.

That’s why mostcontrarian speculators and investors didn’t sell out of fear in early Augustand again in early September, but simply because the trailing stops on their trades were hit.  Risk management is very important for anyportfolio, and gold stocks are more volatile than most so stops are essential.  We saw plenty of our trades stopped out too,even though we run very-loose 25% trailing stops that don’t trip often.

Despite gold-miningcosts remaining way under recent prevailing gold prices, Q3 will be a worsequarter for gold miners than Q2.  Gold’saverage quarterly price fell 7.2% from $1306 in Q2 to $1211 in Q3, which willdefinitely hit earnings.  But again themajor gold miners’ $856 average AISCs are still $355 under that weaker Q3 goldprice!  This sector’s stock prices shouldbe a heck of lot higher given such strong profits.

GDX is relatively new,born in May 2006 when gold stocks were soaring and heavily in favor.  To go back farther in history, anothergold-stock benchmark like the HUI NYSE Arca Gold BUGS Index has to instead beused.  At worst in early September, theHUI closed at 134.0.  That’s the samelevel the HUI first traded at way back in May 2002, when gold’s entire pricewas $316 which was as high as it had been in its young bull.

Consider the ludicrousabsurdity of all this.  At their recentecho-capitulation lows, the gold miners’ stocks were trading at prices firstseen 16.4 years ago when the whole goldprice was considerably smaller than their current profits!  That makes no sense at all, it’s an extremeanomaly resulting from unsustainable extreme bearishness.  Like any stocks, gold-stock price levels mustultimately reflect their underlying earnings.

So a major meanreversion higher is inevitable, as today’s gold-stock prices are fundamentally absurd.  Its primary driver is going to be a powerfulupleg in gold itself, which will bring speculators and investors back to thebeaten-down gold stocks in droves.  Two thingsare going to force gold dramatically higher in coming months, speculators andinvestors normalizing their own recent extreme bearish positions on gold.

Again GDX was pounded22.5% lower during 2.9 months into mid-September where gold dropped 8.1%lower.  The sharp USDX rally inside thatspan drove gold-futures speculators to short sell aggressively.  In roughly that same timeframe, speculators’total gold-futures shorts skyrocketed 156% higher in just 10 weeks!  That catapulted them to an incredible new all-time-record high of 256.7k contracts,off-the-charts extreme.

Legally these epicshorts must soon be closed by buyingoffsetting longs to cover them.  Thatmeans big gold buying that will propel gold sharply higher proportional to itsshorting-driven drop.  If you don’tunderstand this whole short-selling-driven gold dynamic of recent months, youcan’t understand how truly explosive gold’s near-term upside is.  I wrote a comprehensive essay digging into all this in early September.

Because gold wasplunging in that most-extreme hyper-leveraged gold-futures short selling inhistory, the investors fled in sympathy. GLD’s holdings plunged by 10.1% over that span, a massive draw in just afew months.  That left them at a deep 2.6-yearlow of their own in mid-September, and investment selling has continuedmodestly since pushing them lower still. Investors have to do big buying to reestablish positions.

I wrote another essaydigging deeply into these gold-investmentdynamics in late September, which is equally important to understand.  The upshot is speculators and investors alikesold their gold exposure to exceedingly-low and abnormal levels in recentmonths.  Thus when they inevitably startbuying back in to unwind bearish bets and reestablish new long positions, it’sgoing to require really-large capitalinflows to do.

As of the latest dataavailable this week, the gold-futures speculators would have to buy to cover atruly-staggering 147.2k short contracts to return to mid-June levels.  That’s the equivalent of 457.9 metric tons of gold. Meanwhile American stock investors would have to buy enough GLD sharesto force its holdings back up another 97.1t or 13.3% to return to mid-Junelevels.  Either alone would push golddramatically higher!

Speculators will beforced to buy gold futures simply because gold starts rallying and theirhyper-leverage leaves them very vulnerable. Any US-dollar weakness will also contribute to gold-futures buying.  And the investors will return becausespeculators’ gold-futures buying drives gold higher or the stock markets start materiallyrolling over.  Ominously the latter isgetting more likely every day with the Fed’s QT now full-steam.

Since mid-2000 I’vewritten 829 of these weekly web essays,a heck of a lot of research and work. Out of all those, last week’s Fed QT is Bull’s Death Knell is easily one of the most-important!  Every trader out there needs to understandFed quantitative tightening and its dangerously-bearish implications for theselofty stock markets.  And anything that’sbearish for stocks is bullish for gold, since investors buy on stock weakness.

The gold stockssuffered capitulation selling and are anomalously low today because gold itselfwas hit by exceptional gold-futures and investment selling.  That left gold stocks exceedingly undervalued compared to their current earnings, not to mention wildly oversold.  So oncegold starts powering decisively higher again on speculators and investors buying,the gold stocks will be off to the races with huge potential upside.

While investors and speculators alike cancertainly play gold stocks’ coming mean reversion with the major ETFs like GDX,the best gains by far will be won in individual gold stocks with superiorfundamentals.  Their upside will farexceed the ETFs, which are burdened by over-diversification and underperformingstocks.  A carefully-handpicked portfolioof elite gold and silver miners will generate much-greater wealth creation.

At Zeal we’ve literally spent tens of thousands of hours researchingindividual gold stocks and markets, so we can better decide what to trade andwhen.  As of the end of Q2, this hasresulted in 1012 stock trades recommended in real-time to our newsletter subscriberssince 2001.  Fighting the crowd to buylow and sell high is very profitable, as all these trades averaged stellarannualized realized gains of +19.3%!

The key to this success is staying informed and beingcontrarian.  That means buying low whenothers are scared, before undervalued gold stocks soar much higher.  An easy way to keep abreast is through ouracclaimed 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.  Subscribe today, forjust $12 an issue you can learn to think, trade, and thrive like contrarians!

The bottom line is goldstocks are already recovering.  Theirrecent forced capitulations were extreme anomalies that aren’tsustainable.  Cascading stop-loss sellingbattered gold-stock prices to exceedingly-low levels that are fundamentallyabsurd.  The gold miners’ stocks must bebid much higher to reflect their underlying earnings in today’s gold-priceenvironment.  That portends an inevitablemean-reversion rally.

And it should overshootdramatically as gold itself powers much higher. Gold suffered extreme selling in recent months from gold-futuresspeculators and GLD investors.  Theformer will soon be forced to cover their still-near-record gold-futuresshorts, while the latter will buy as gold rebounds and the stock marketsweaken.  Nothing attracts traders to goldstocks like higher gold prices, so major-to-massive buying is nearing.

Adam Hamilton, CPA

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