The gold miners’ stocks have largely ground sideways this year, really lagging gold’s strong rally. That lack of upside has decimated sentiment, leaving a bearish wasteland bereft of hope. But this deeply-out-of-favor sector is actually a coiled spring, ready to surge dramatically as psychology shifts. Sentiment, technicals, and fundamentals all point to much-higher gold-stock prices even at today’s prevailing gold levels.
The main appeal of gold-mining stocks is their underlying profits’ leverage to gold. The gold stocks are much riskier than gold, due to many operational, geological, and geopolitical risks the metal itself doesn’t share. So investors and speculators alike must be compensated for these big added risks with superior returns to gold. That hasn’t happened so far in 2017, which is why gold stocks are so widely despised today.
All year long, the extreme Trumphoria-fueled stock-market rally has stolen the limelight. The flagship S&P 500 stock index is up 10.5% year-to-date as of this week. That’s sucked all the oxygen out of the investment world, overshadowing everything else. So investors have shunned gold this year, while the futures speculators have shorted it at near-record extremes. Gold has often been mocked on CNBC all year.
That’s pretty ironic though, as gold’s YTD performance is +10.9%! That’s a little better than the general stock markets. That should be enough to garner some attention, but gold can’t escape from the stock markets’ eclipsing shadow. Gold miners’ inherent profits leverage to gold usually enables their stock prices to amplify an underlying gold rally by 2x to 3x. Thus the gold-stock sector ought to be up 20% to 30% YTD.
The dominant gold-stock index is the HUI NYSE Arca Gold BUGS Index, which is closely mirrored by the leading GDX VanEck Vectors Gold Miners ETF. So far in 2017, its performance has been dismal relative to gold. As of this week the HUI was only up 6.6% YTD! That makes for mere 0.6x leverage to gold, unacceptable given gold stocks’ big additional risks. That’s why psychology is exceedingly bearish today.
Gold stocks are underperforming so massively this year due to sentiment. Because this small contrarian sector is languishing, traders want nothing to do with it. And because they are widely avoided, the gold stocks are trapped in consolidation hell. The only thing able to start shifting sentiment back to bullish is a meaningful gold rally igniting material gold-stock buying. The resulting gains would win back capital inflows.
Sentiment and technicals are inexorably intertwined. No matter what else is going on, when stocks are high traders get excited and bullish. That’s happening in the general stock markets today, despite their bubble valuations and the Fed’s quantitative tightening ominously looming. But when stocks are down, traders wax sullen and bearish. The markets work this way universally, the gold stocks are no exception.
As at all sentiment extremes, traders have assumed this vexing gold-stock weakness will last indefinitely. But that’s a bad bet, as sentiment perpetually meanders back and forth between excessive greed and fear. The longer sentiment stays on one side of that arc, and the more extreme it gets, the greater the odds for an imminent mean-reversion swing back the other way. And those tend to overshoot proportionally.
The last time gold stocks drifted near lows like so far this year was in the second half of 2015. They were hated, with nearly everyone predicting they were doomed to spiral lower forever. Yet sentiment shifted out of that bearish echo chamber, and the gold stocks took off like North Korean ICBMs. In merely 6.5 months, the HUI skyrocketed 182.2% higher! That amplified gold’s 25.2% concurrent rally by a breathtaking 7.2x.
Gold stocks have long exhibited a drift-surge pattern. Long consolidations bleeding away all bullishness are soon followed by massive uplegs. They ignite just as traders are capitulating and walking away. The best time to buy is late in one of these grating drifts, because the next major upleg is just around the corner. And that’s exactly where the gold stocks are today technically, as this HUI consolidation chart reveals.
Last year’s monster gold-stock upleg that has already been forgotten is crystal-clear here. Contrarians willing to fight the herd and buy low in late 2015 when gold stocks were shunned made out like bandits. They nearly tripled their capital in about a half-year! Once this sector starts moving, shifting from drift to surge, its resulting uplegs tend to be massive. The trick is bucking bearish sentiment to get invested early.
That enormous upleg birthing a new gold-stock bull last year was followed by a gigantic drop driven by gold. Since prevailing gold prices directly drive their earnings, the gold stocks follow and amplify moves in the metal they mine. In the second half of 2016, gold plunged sharply thanks to a highly-improbable series of events. Gold’s resulting freakish drop was incredibly anomalous, which is why it bounced back this year.
First gold was hit by gold-futures stop losses being run, then by the Trumphoria stock-market surge in the wake of the surprise election results, and finally by the Fed’s second rate hike of this cycle. Seeing an isolated event-driven selloff isn’t unusual, but three in a row back-to-back is unheard of. I explained all of them in depth in past essays if you want a deeper understanding of why they were unrepeatable one-off events.
Gold fell 17.3% in 5.3 months, certainly a massive correction but well shy of new-bear-market territory at -20%. Gold stocks as measured by the HUI amplified gold’s downside by 2.5x, smack in the middle of that historical 2x-to-3x leverage range. So the huge gold-stock selloff in last year’s second half wasn’t outsized at all compared to the anomalous carnage in gold. That’s the way this sector has always worked.
Once again gold miners’ profits leverage to gold explains their price action. Consider an example, a gold miner producing gold at all-in sustaining costs of $1000 per ounce. At $1250 gold, that yields profits of $250 per ounce. If gold rallies or falls 10% to $1375 or $1125, this miner’s profits literally soar or plunge 50% to $375 or $125 per ounce! The higher any miner’s costs, the greater its profits leverage to gold prices.
In the last quarter fully reported, Q1’17, the major gold miners of GDX reported average all-in sustaining costs of $878. Q2’17 results haven’t been fully released yet, but should be by next week. At $878 AISC, $1250 gold yields profits of $372 per ounce. If gold rallies or falls 10%, these per-ounce profits change to $497 or $247. That’s up or down 34% on a 10% gold move! That’s where gold stocks’ leverage to gold comes from.
So seeing this sector largely drift sideways this year despite gold’s strong 10.9% YTD gain is anomalous, it shouldn’t have happened. And it wouldn’t have happened without stock markets’ extreme Trumphoria rally monopolizing traders’ attention. They’ve been so captivated that they’ve ignored gold’s superior gains in 2017, and that lack of interest has slaughtered the gold stocks dependent on gold being in favor.
The result technically is the major triangle consolidation rendered above. Since gold stocks’ deep low in December on a Fed rate hike, their lower support has been slowly climbing. But meanwhile their upper resistance has been trending lower. This has slowly and inexorably compressed this sector technically, tightening the gold stocks into a coiled spring. These converging trendlines guarantee an imminent breakout.
And odds overwhelmingly favor an upside resolution to this triangle consolidation pattern. Gold stocks’ resistance line is paralleling their key 200-day moving average. A decisive move above their 200dma will unleash all kinds of buying from technically-oriented traders. And that 200dma breakout will result in the simultaneous breakout from this year’s vexing consolidation. That will rapidly shift psychology away from bearish.
There are two major reasons why gold stocks are heading much higher rather than lower soon. Gold has long enjoyed a major autumn rally which tends to catapult the gold stocks higher in the coming months. I wrote about this in depth last week, explaining why it happens and quantifying it. With gold seasonals so strong in the coming months, it would be super-unlikely for gold stocks to break down from already-low levels.
On average in bull-market years, gold powers 6.9% higher between mid-June and late September. That fuels an 11.2% HUI rally on average in that same general timeframe. As gold continues powering higher over the next month, the gold stocks will almost certainly amplify its gains. This isn’t an academic point, as this year’s autumn rally is already well underway. Gold’s summer-doldrums low came in early July.
Since then gold and the HUI have climbed 5.2% and 8.6% higher as of this week. That resulting 1.7x leverage is still on the low side, but rapidly improving from the 0.6x year-to-date metric. Gold stocks are starting to outperform their profits-driving metal again, a major sign sentiment is already shifting away from extreme bearishness. But there’s a far-better reason to be bullish on gold stocks than their autumn rally.
While these coiled-spring technicals are exciting, they pale in comparison to the immense fundamental disconnect between gold-miner stock prices and gold levels. Ultimately all stock prices eventually reflect some reasonable multiple of their underlying corporate profits. But the gold stocks are now collectively trading as if gold was far under current prices, which is supremely irrational. This anomaly has to mean revert.
This last chart offers the most-compelling fundamental justification to be heavily long gold stocks today. It looks at a construct called the HUI/Gold Ratio, calculated simply by dividing the daily HUI close by the daily gold close. This HGR acts as a proxy for that core fundamental relationship between gold, miners’ profits, and their stock prices. Gold stocks have rarely been as undervalued relative to gold as they are now.
This week, the HGR was trading near 0.152x. The HUI was running at 15.2% of gold’s price. Of course like all indicators that means nothing in isolation. But the context provided by this long-term HGR chart shows how absurdly cheap the gold stocks remain relative to the metal which drives their earnings. The only year in modern history where gold stocks were cheaper was 2015, the end of an exceptional secular bear.
Early in 2016 gold stocks as measured by the HUI slumped to a fundamentally-absurd 13.5-year secular low. It made no sense whatsoever. Though gold was trading near $1087, way above this industry’s all-in sustaining costs, the HUI was trading at levels last seen when gold was near $305 in July 2002! That anomaly couldn’t and didn’t last, resulting in battered gold stocks nearly tripling in only about a half-year.
That coiled-spring reaction perfectly illustrates how explosive gold-stock upside is after this sector suffers a long, low drift resulting in extremely-bearish psychology. If today’s 0.15x HGR is actually righteous, it would’ve been seen plenty of times in modern history. But it hasn’t. Such extremely-low gold-stock price levels relative to gold were only able to persist briefly after a long secular bear. They weren’t sustainable.
Remember the Fed started aggressively levitating the US stock markets in early 2013, wreaking havoc on alternative investments led by gold. The gold market’s last normal years were sandwiched between 2008’s stock panic and 2013’s radical Fed distortions. That’s the best recent baseline for where the HGR ought to trade. And between 2009 to 2012, it was running way up at 0.346x. That’s over double today’s levels!
To simply mean revert back up to those last normal levels relative to gold, the big gold stocks dominating the HUI would have to power 127% higher from here to 441! To restore some semblance of normalcy fundamentally, the gold stocks need to more than double from here even at this week’s $1276 prevailing gold levels! The gold stocks certainly can’t stay disconnected from their own earnings realities forever.
All markets are cyclical, including gold stocks. Extreme undervaluations relative to gold are followed by overvaluations as the pendulum swings back the other way. Mean reversions after extremes never stop in the middle. Their momentum leads them to overshoot to the opposite extreme! That makes gold stocks’ coming upside far more impressive. A proportional overshoot heralds radically-higher gold-stock prices ahead.
At worst in mid-January 2016, the HGR fell to an all-time low of 0.093x. That was a staggering 0.253x under that post-panic normal-year average HGR of 0.346x. So a proportional overshoot would briefly boost the HGR 0.253x above that mean, to 0.599x. That upside extreme wouldn’t last long, as greed wouldn’t be sustainable. But it could happen in a blowoff top after gold stocks are popular following a bull.
At $1276 gold, that yields a potential HUI topping target of 764! That’s a stupendous 293% above this week’s levels. Is there any other stock sector with the potential to quadruple in the coming years? No way. Gold stocks are the only severely-undervalued sector left after this Trumphoria stock rally, so their upside is unparalleled. And incredibly these simple HGR-derived gold-stock targets are actually conservative.
They assume gold is static, stuck at $1276. That’s exceedingly unlikely. As these Fed-levitated stock markets inevitably roll over with Fed quantitative tightening dawning, gold itself will catch a major bid as investment capital returns. As a rare asset that generally moves counter to stock markets, gold is hostage to them. So when the stock markets suffer their long-overdue major selloff, gold will soar on capital inflows.
10%, 20%, and 30% gold uplegs from here would take this metal to $1403, $1531, and $1658. Plug in the HGR of your choice, the post-panic average or the mean-reversion overshoot, and you get some potential HUI targets so high they defy belief. And don’t think a 30% gold rally is out of the question. In response to the last stock-market correction, gold powered 29.9% higher in just 6.7 months in early 2016!
Don’t get bogged down in HUI upside targets, they only serve to illustrate a critical point for investors and speculators today. Gold stocks are not only radically undervalued at today’s gold prices, but even more so compared to where gold is heading in its own still-very-much-alive bull market. Even if you think gold stocks only have 50% to 100% upside, that’s vastly better than everything else in these overvalued stock markets.
Gold stocks’ leverage to gold’s gains is already accelerating in their early autumn rally. That is gradually starting to shift sentiment, pushing that pendulum away from being pegged at hyper-bearish. The more gold stocks rally, the more traders will take notice and deploy capital. That process will soon become self-feeding, and gold stocks will be off to the races again like in early 2016. That will yield massive gains.
That begs the question what are you going to do about it? Are you tough enough mentally to invest like a contrarian, to buy low and out of favor when few others are willing? Can you handle fighting the crowd, making unpopular investments? Or will you take the mainstream approach, which is waiting to buy gold stocks until they’ve already doubled from here? The biggest gains are won by the early birds who buy the lowest.
Gold stocks look like a coiled spring today despite the extreme bearishness plaguing them. Following its long drift so far this year, this sector is ready to stage a massive breakout surge in the coming months. Technically gold stocks’ triangle consolidation has nearly converged, guaranteeing an imminent breakout. But far more bullish are gold stocks’ deeply-undervalued fundamentals relative to gold.
Gold-mining profits are heavily dependent on prevailing gold prices. And with this industry’s costs way under gold’s current levels, the gold miners are already earning hefty profits today. Sooner or later their stock prices must reflect fundamental reality. That mean-reversion process is already underway, with gold stocks’ early-autumn-rally gains increasingly outpacing gold’s. Their upside leverage should only accelerate.