The battered gold miners’ 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 in an echo capitulation into mid-September. That left them at fundamentally-absurd price levels wildly disconnected from their actual profitability, leaving this sector with big mean-reversion upside ahead as it bounces back.
The leading gold-stock investment vehicle and increasingly benchmark is the GDX VanEck Vectors Gold Miners ETF. As of this week it still had $8.5b of net assets even at today’s super-depressed gold-stock prices. That dwarfs everything else in the 1x-long major-gold-miners ETF space, running 40.5x bigger than its next largest competitor! So GDX is the dominant proxy for the fortunes of the gold miners’ stocks.
This small contrarian sector has had a tough 2018, with GDX down a serious 19.1% year-to-date as of the middle of this week. That’s mostly explainable by gold’s own 8.0% YTD swoon. Since their earnings are so dependent on prevailing gold prices, the major gold miners’ stocks tend to leverage gold’s trendsby 2x to 3x. With their downside leverage running 2.4x so far this year, that’s right in line with precedent.
But this serious gold-stock weakness is a recent thing. Back in mid-June, gold and GDX were trading at $1302 and $22.66. Gold was dead flat in 2018 at that point, and GDX wasn’t much worse with a 2.5% loss. That was actually pretty resilient given the market backdrop. The US dollar was strengthening with its US Dollar Index up 2.8% YTD. The dollar’s fortunes heavily drive gold-futures speculators’ trading.
And gold investment remained decent then too despite the flagship S&P 500 stock index (SPX) climbing 4.1% YTD by mid-June. Gold investment demand wanes when stock markets are euphoric. Gold’s best investment proxy is the physical gold bullion holdings held in trust for shareholders of the leading GLD SPDR Gold Shares gold ETF. They were only down 1.0% YTD then, so investors weren’t materially selling.
Thus the gold-stock story today isn’t a 2018 one, but a past-few-months one. In July gold fell 2.3% on a big 2.3% draw in GLD’s holdings thanks to a strong 3.6% SPX rally. Why prudently diversify stock-heavy portfolios with counter-moving gold when stocks seem to do nothing but rally indefinitely? The weakness in gold that month forced GDX 4.6% lower, which made for 2.0x downside leverage which was on the light side.
But things really went pear-shaped in August. A mounting emerging-markets currency crisis centered on the plummeting Turkish lira goosed the USDX on safe-haven buying. So gold plunged 4.1% during that month’s first half on a sharp 2.2% USDX surge. The gold stocks, which are ultimately leveraged plays on gold, took it on the chin. GDX plummeted 14.7% in that short span making for serious 3.6x downside leverage!
That naturally devastated the already-fragile psychology in gold-stock land, leaving its traders despondent and super-bearish. So the gold stocks couldn’t muster a recovery in August’s second half with gold. While it rebounded 2.2% into month-end, GDX could only stage a pathetic 2.1% rebound. Overall in August, gold fell 2.0% while the gold stocks per GDX plunged 12.8%. That was the result of a forced capitulation.
With gold stocks so deeply out of favor, there aren’t many investors and speculators left in them who don’t want to be there. Only hardened contrarians remain, traders who aren’t spooked by mid-August’s gold low near $1174. But they still have to run stop losses, and lots of those were triggered as gold stocks fell exacerbating their plunge. That forced technical selling begot more selling, snowballing out of control.
I wrote a whole essay explaining gold stocks’ forced capitulation several weeks ago. That heavy-if-not-extreme gold-stock selling wasn’t voluntary or even sentiment-driven. But it stoked raging bearishness as GDX was pummeled to a deep 2.6-year low. It’s rare for major gold stocks to leverage gold’s downside by an extreme 6.4x, definitely not sustainable. But exceptional sentiment extremes still take time to dissipate.
So the bleeding gold stocks 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 started recovering after that odd event, ultimately ending September essentially flat at -0.2%. That was better than gold’s 0.7% loss.
Unfortunately all this carnage in recent months really wreaked havoc technically. This chart shows GDX since early 2016, a span still considered a gold-stock bull because gold’s own bull remains in force with no 20%+ bear-market declines. August’s cascading forced selling in gold stocks drove a major support breakdown, and ultimately snowballed to a deep multi-year low. But the gold stocks are now recovering.
Since GDX’s echo-capitulation low in mid-September, it has rebounded 8.4% at best as of earlier this week. That far outpaced gold’s little 0.5% rally in that span, for extreme upside leverage of 16.8x. That’s already proving that gold stocks’ anomalous forced capitulation and secondary echo capitulation weren’t righteous fundamentally. We are in the early weeks of a mean-reversion rebound likely to run at least a few months.
That portends major gains for contrarian speculators and investors willing to buy in low while sentiment still feels miserable. The gold stocks as rendered by GDX had been meandering in a consolidation basing trading range between $21 to $25 for 19.3 months before August’s breakdown. The gold stocks need to mean revert back up into that strong trend, which would require GDX rallies of 12% to 33% from current levels.
The former would merely return GDX to its lower support of $21, while the latter would carry it back up to its resistance of $25. The odds definitely favor a bigger-rather-than-smaller mean-reversion rally. When sentiment extremes force prices way outside of normal trading ranges, their inevitable rebounds tend to overshoot proportionally towards the opposite extreme. That ought to at least be high in GDX’s trading range.
Traders invariably make major mistakes in judgment at price extremes, the consequence of our very human nature. We tend to extrapolate current prices out into the indefinite future, assuming they are the new norm rather than a short-lived anomaly. And we also figure those price levels must be fundamentally justified since they happen to exist in the markets. Both are incredibly wrong, blinding traders to great opportunity.
Between mid-June to mid-September, GDX plunged 22.5% on an 8.1% gold drop. That 2.8x leverage is on the high side of normal, but it’s still rare to see such a big plunge in gold-stock price levels in such a short 2.9-month span. The last time anything remotely like this happened came in late 2016. Gold and gold stocks plunged after Trump’s surprise election victory ignited a massive taxphoria rally in stock markets.
That ultimately hammered GDX 39.4% lower over 4.4 months by mid-December that year. Then, just like now, traders got all wrapped up in the popular bearishness major lows always generate. They assumed the gold miners were faring so poorly they’d keep spiraling lower indefinitely. Yet as always around major lows, that extreme bearishness was dead wrong. GDX surged 34.6% higher to rebound in the next 1.8 months.
That’s right in line with what GDX needs to see in the coming months to regain the high side of its long consolidation trend. Continuing to extrapolate prices rarely works for long once they are driven to major extremes as evidenced by sentiment. When everyone waxes super-bearish on gold stocks after a big and fast plunge, that’s when to fight the crowd and start betting heavily for a sharp reversal and mean reversion.
The recent capitulation gold-stock levels are wildly unjustified fundamentally as well, which means they can’t last for long. I’ve been a hardcore contrarian speculator and investor for decades now, and run a small financial-research company specializing in contrarian trading. One of my projects every quarter just after earnings season finishes is digging deep into the latest results from the major gold miners of GDX.
While Q3’18 is in the books, most major gold miners won’t report how they are doing operationally and financially until 4 to 6 weeks after quarter-end. So the latest-available fundamental data remains Q2’s. In mid-August I explored that in depth for GDX gold miners’ Q2 results. The most-important fundamental metric for this sector is all-in sustaining costs, revealing how much it costs to mine and replenish each ounce of gold.
In Q2 the top 34 GDX gold miners representing nearly 92% of this ETF’s total weighting reported average AISCs of $856 per ounce. That was right in line with past-year precedent as well, with these GDX miners’ AISCs in the preceding 4 quarters running $867, $868, $858, and $884. For years now, the major gold miners have reported average AISCs usually between $850 to $875 or so. Those are far below gold prices!
At worst during mid-August’s capitulation climax, gold closed near $1174. Assuming Q2’s $856 average AISCs hold into Q3, which is very likely based on recent years’ history, the major gold miners of GDX were still earning $318 per ounce! That makes for hefty 27% profit margins even when gold was at its worst. This forsaken sector was still doing fine fundamentally at gold’s recent lows, there was no threat at all.
That’s why most contrarian speculators and investors didn’t sell out of fear in early August and again in early September, but simply because the trailing stops on their trades were hit. Risk management is very important for any portfolio, 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-mining costs remaining way under recent prevailing gold prices, Q3 will be a worse quarter for gold miners than Q2. Gold’s average quarterly price fell 7.2% from $1306 in Q2 to $1211 in Q3, which will definitely hit earnings. But again the major gold miners’ $856 average AISCs are still $355 under that weaker Q3 gold price! This sector’s stock prices should be 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, another gold-stock benchmark like the HUI NYSE Arca Gold BUGS Index has to instead be used. At worst in early September, the HUI closed at 134.0. That’s the same level the HUI first traded at way back in May 2002, when gold’s entire price was $316 which was as high as it had been in its young bull.
Consider the ludicrous absurdity of all this. At their recent echo-capitulation lows, the gold miners’ stocks were trading at prices first seen 16.4 years ago when the whole gold price was considerably smaller than their current profits! That makes no sense at all, it’s an extreme anomaly resulting from unsustainable extreme bearishness. Like any stocks, gold-stock price levels must ultimately reflect their underlying earnings.
So a major mean reversion higher is inevitable, as today’s gold-stock prices are fundamentally absurd. Its primary driver is going to be a powerful upleg in gold itself, which will bring speculators and investors back to the beaten-down gold stocks in droves. Two things are going to force gold dramatically higher in coming months, speculators and investors normalizing their own recent extreme bearish positions on gold.
Again GDX was pounded 22.5% lower during 2.9 months into mid-September where gold dropped 8.1% lower. The sharp USDX rally inside that span 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 epic shorts must soon be closed by buying offsetting longs to cover them. That means big gold buying that will propel gold sharply higher proportional to its shorting-driven drop. If you don’t understand this whole short-selling-driven gold dynamic of recent months, you can’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 was plunging in that most-extreme hyper-leveraged gold-futures short selling in history, the investors fled in sympathy. GLD’s holdings plunged by 10.1% over that span, a massive draw in just a few months. That left them at a deep 2.6-year low of their own in mid-September, and investment selling has continued modestly since pushing them lower still. Investors have to do big buying to reestablish positions.
I wrote another essay digging deeply into these gold-investment dynamics in late September, which is equally important to understand. The upshot is speculators and investors alike sold their gold exposure to exceedingly-low and abnormal levels in recent months. Thus when they inevitably start buying back in to unwind bearish bets and reestablish new long positions, it’s going to require really-large capital inflowsto do.
As of the latest data available this week, the gold-futures speculators would have to buy to cover a truly-staggering 147.2k short contracts to return to mid-June levels. That’s the equivalent of 457.9 metric tonsof gold. Meanwhile American stock investors would have to buy enough GLD shares to force its holdings back up another 97.1t or 13.3% to return to mid-June levels. Either alone would push gold dramatically higher!
Speculators will be forced to buy gold futures simply because gold starts rallying and their hyper-leverage leaves them very vulnerable. Any US-dollar weakness will also contribute to gold-futures buying. And the investors will return because speculators’ gold-futures buying drives gold higher or the stock markets start materially rolling over. Ominously the latter is getting more likely every day with the Fed’s QT now full-steam.
Gold stocks are already recovering. Their recent forced capitulations were extreme anomalies that aren’t sustainable. Cascading stop-loss selling battered gold-stock prices to exceedingly-low levels that are fundamentally absurd. The gold miners’ stocks must be bid much higher to reflect their underlying earnings in today’s gold-price environment. That portends an inevitable mean-reversion rally.
And it should overshoot dramatically as gold itself powers much higher. Gold suffered extreme selling in recent months from gold-futures speculators and GLD investors. The former will soon be forced to cover their still-near-record gold-futures shorts, while the latter will buy as gold rebounds and the stock markets weaken. Nothing attracts traders to gold stocks like higher gold prices, so major-to-massive buying is nearing.