Gold stocks turning up
The gold miners have seen impressive investor interest in their beaten-down stocks in this young new year, with capital inflows fueling a sharp rally. And this buying is likely just beginning, as major market changes are afoot that should catapult gold much higher. With gold stocks trading at fundamentally-absurd price levels relative to prevailing gold prices, this sector’s upside potential is vast and unequalled.
But after the gold miners suffered a miserable couple of years, it sure takes a contrarian to understand that. The leading gold-stock investment vehicle and metric is Van Eck Global’s Gold Miners ETF, which trades under the symbol GDX. It is an excellent well-constructed gold-stock benchmark that matches the traditional HUI gold-stock index very well. So it naturally reflected the extreme carnage ravaging this sector.
GDX dropped 13.0% in 2014, following 2013’s disastrous 54.5% plummet. With the general stock markets levitating endlessly higher thanks to the Fed’s aggressive QE3 campaign and associated jawboning, demand for alternative investments withered. These are led by gold, which often moves in the opposite direction of the stock markets. With stocks soaring, investors shunned it and prudent portfolio diversification.
And since gold stocks are ultimately just a leveraged play on gold, their prices cratered. Investors simply wholesale abandoned them, leaving an entire sector for dead. As they seemingly perpetually spiraled ever lower, all but the hardest-core contrarians capitulated and sold. But this extreme selling created an epic opportunity, as gold-stock prices plunged far below fundamentally-justified levels based on their profits.
As long as the Fed’s stock-market levitation continued, gold and thus its miners would remain deeply out of favor. But with the inflationist US central bank ending QE3 late last year and planning the first rate hikes since mid-2006 this year, the Fed has abandoned these lofty and overvalued stock markets. As they inevitably roll over without trillions of dollars of QE liquidity injections, gold will gradually return to favor.
All financial markets are forever cyclical, with periods of outperformance always following periods of underperformance and vice versa. So smart contrarian investors are well aware the stock markets are overdue to reverse lower while gold mean reverts higher. Thus they are starting to buy the dirt-cheap gold stocks in anticipation of these inevitable major reversals. And that’s why gold stocks are turning up this year.
Institutional investors including pension, mutual, and hedge funds control the vast majority of capital in the stock markets. And their performance is judged by current and prospective clients in calendar-year blocks. So as 2014 wound down, few funds wanted to show the despised gold stocks on their trading books. But 2015 brings an entire new year for gold stocks to rebound higher, so funds are migrating back in.
This is readily evident in gold-stock technicals, represented here by that flagship GDX gold-stock ETF. In this young new year’s first three trading days, GDX rocketed 11.4% higher! That nicely leveraged the also-excellent 3.1% gold rally over that same period. This outstanding gold-stock price action worked to solidify this sector’s nascent uptrend, while triggering a bullish breakout above GDX’s 50-day moving average.
Gold stocks have definitely been trending higher in recent months, defying the universal bearishness still plaguing this sector. GDX’s higher lows and higher highs have formed this nascent uptrend, which will probably grow into a major new upleg. This leading gold-stock ETF is already up 23.4% from its dismal early-November low. And such a strong breakout above its 50dma implies upside momentum is building.
To understand the significance of all this, some context is essential. After suffering an extraordinarily anomalous down year in 2013 thanks to the Fed’s stock-market levitation crushing gold demand, the gold stocks spent the large majority of last year performing quite well. GDX enjoyed a solid consolidation uptrend between January and September 2014, with uplegs fueled by big-to-massive gold-futures buying.
The Fed’s QE3 goosing the stock markets drove the epically bearish psychology that fueled the extreme gold and gold-stock selling of the last couple years. But those gold liquidations largely came from just two groups of traders, American futures speculators and American shareholders of the flagship GLD gold ETF. With investors missing in action, the futures traders in particular utterly dominated gold prices.
So when they covered some shorts and added new long positions in the yellow metal last January and February and again in June, the gold stocks shot up dramatically as gold itself recovered. Considering how low and out of favor gold remained last year, GDX’s pair of uplegs averaging 27.5% were certainly respectable. But unfortunately 2014’s consolidation uptrend failed in September on heavy gold-futures shorting.
That month American speculators got caught up in the frenzied hyper-bearish gold psychology to ramp up their short positions very aggressively. They borrowed and sold incredible amounts of gold-futures contracts, pushing their total shorts to near-record levels. This extreme and unsustainable selling was finally exhausted in early November, but it did serious technical damage to gold and its miners’ stocks.
GDX plunged 39.5% in less than several months, totally erasing the minor improvement in overall gold-stock sentiment generated by 2014’s modest uptrend before September. Facing such a brutal withering onslaught of futures selling, gold dropped 12.6% over that span. While that’s certainly not trivial, GDX more than tripling that gold selloff was wildly excessive. That reflected prevailing hyper-bearishness.
But short selling is the most bullish kind of selling since it is inherently self-limiting. Speculators have to effectively borrow gold to sell it short. And all that borrowed gold must soon be repaid, which means every ounce sold short has to reverse into buying in the near future. And with speculators’ gold-futures short contracts approaching crazy record levels, these traders finally reached selling exhaustion in November.
And the resulting gold-stock lows were ridiculous. GDX plunged to $16.59 in early November, which was almost a record low for this ETF. It only traded lower for a single day in late October 2008 in the dark heart of that once-in-a-century stock panic. Gold stocks had almost never been cheaper in GDX terms! And such price levels were truly fundamentally absurd compared to the prevailing gold prices.
Throughout the entire stock markets, stock prices ultimately reflect their core fundamentals which are underlying corporate profits. And in the gold-mining industry, the dominant driver of earnings is the price of gold. Costs for any particular mine are largely determined by its deposit, and fixed when that mine is designed and constructed. So gold-price changes flow directly to the bottom line, where they’re amplified.
Back in October 2008 when GDX briefly plummeted to $16.37 per share, gold traded at $732. But in early November 2014 when GDX was hammered to $16.59, gold was $1144. So even though gold’s prevailing price was 56.3% higher, GDX was merely 1.3% higher! It is supremely irrational for the gold stocks to be trading as if gold was far lower than it really was, as they were far too cheap relative to their profitability.
This next chart looks at the relationship between gold-stock price levels and gold as seen through the lens of the GDX/GLD Ratio. Dividing the leading gold-stock-ETF price by the flagship gold-ETF price, and charting the results over time, reveals how gold stocks are priced relative to the core fundamental driver of their earnings. And they had never been more undervalued and out of favor than late last year!
While gold stocks recently bottomed in early November at that 6-year low, the GDX/GLD Ratio sunk a little lower at their secondary bottom in mid-December. The miners’ selloff early last month was extremely disproportional to gold’s, forcing the GGR lower. A GDX share was trading at just 0.149x the price of a GLD share, the lowest levels ever seen in GDX’s history. For reference, this ETF was born back in May 2006.
Even during late 2008’s stock panic, which was the most-extreme market fear event most of us will ever witness in our lifetimes, the GGR merely fell to 0.227x at worst. And that was driven by GDX plummeting a truly nauseating 71.0% in just a matter of months! How on earth can gold-stock sentiment be worse in late 2014 after a consolidation year than it was in late 2008 after the first full-blown stock panic since 1907?
The GGR’s stock-panic levels were an extreme anomaly, and such massive deviations from norms in the markets never last. The epic levels of fear necessary to force such epic lows soon burn themselves out, then beaten-down prices dramatically mean revert higher. And indeed over the next several years after 2008’s stock panic, gold-stock prices would more than quadruple. Buying low in extreme fear pays big.
The contrarian investors moving into gold stocks in early 2015 expect a similar or better outcome this time around from this sector’s even-more-extreme low in late 2014. If the much-higher stock-panic gold-stock price levels weren’t sustainable, why should today’s far-more-extreme levels be? Smart investors study market history, so they understand that financial markets are forever cyclical. Great anomalies are short-lived.
And the cycles have never been more overdue to turn for gold stocks, as the GGR’s secular resistance line shows. Gold stocks’ performance relative to gold’s is reflected by this key fundamental ratio. When the GGR is rising, gold stocks are usually rallying faster than gold as they regain investors’ favor. But a falling GGR means the opposite, that gold stocks are losing favor among investors and dropping faster than gold.
Literally since late 2007, a long secular span of time, gold stocks have been underperforming gold on balance. Whenever gold retreated during the past 7 years or so, the gold stocks greatly leveraged its downside which forced the GGR lower. But whenever gold rallied, the gold stocks failed to sufficiently leverage its gains. So the GGR struggled to regain ground, except for that year following the stock panic.
No market trend can run forever, including gold-stock price levels relative to gold. And the longer that any trend runs, the more extreme it gets in price and sentiment terms, the greater the probabilities of an imminent reversal. Gold stocks not only can’t fall out of favor relative to gold forever, but they are certain to return to favor in the coming years as the market cycles shift. There is no surer bet in all the markets.
And that prospect is why contrarian investors started returning to this despised sector in early 2015. The gold stocks are probably the only super-cheap sector left in these lofty Fed-inflated stock markets. They are the only one that has the potential to at least quadruple again in the coming years no matter what the stock markets do. Their mean reversion higher relative to gold is way overdue, and it’s going to be massive.
The recent GDX/GLD Ratio extreme lows vividly illustrate gold stocks’ incredible upside potential in the coming years. Remember that 2013 and 2014 were extreme anomalies thanks to the Fed’s brazen and reckless manipulations of stock-trader psychology. So the last normal years in this post-stock-panic era were between 2009 and 2012. Over that span the GGR averaged 0.381x, GDX traded near 3/8ths GLD’s price.
Merely to return to those levels, assuming gold stays flat around today’s $1200, GDX would have to rally 156% higher from its mid-December low! That would catapult it back up around $44, and as of this week only 1/8th of that inevitable mean-reversion normalization higher has happened. With gold stocks pounded to such fundamentally-absurd levels in recent months, their upside is great even if gold does nothing.
But gold is exceptionally low and out of favor too, so it has massive potential to mean revert higher itself as the Fed-goosed stock markets roll over and alternative investments and prudent portfolio diversification gradually return to favor. Higher gold prices plugged into any GGR naturally portend higher gold-stock prices as well. For example, consider GLD’s price levels in 2012 before the Fed’s vast QE3 distortions.
GLD averaged $162 that year, and even that wasn’t particularly high since the yellow metal had just suffered a major correction out of a euphoric overbought topping in late 2011. If GLD merely returns to those pre-QE3 levels and the GGR simply mean reverts to its 2009-to-2012 normal-year average, we are looking at a GDX price target near $62! That’s 3.1x higher than this week’s levels, another quadruple.
And both gold and the ratio of the stocks of its miners to it should go a heck of a lot higher. In the post-panic years before gold’s correction, the GGR averaged 0.419x. And the last time gold stocks were remotely close to being in favor before 2008’s stock panic, the GGR averaged 0.591x! So much-higher numbers can be conservatively plugged into this key fundamental relationship to yield far-higher GDX targets.
But it gets even more bullish, because mean reversions out of sentiment extremes never just stop at the previous average levels. Instead they dramatically overshoot to the other side. Visualize sentiment as a giant pendulum with two extremes to its arc, universal greed and fear. The farther that pendulum gets pulled to one side’s sentiment extreme before that emotion burns itself out, the higher the velocity of its back swing.
All that momentum carries the sentiment pendulum to a similar extreme on the opposite end of its arc. So the odds are excellent that gold stocks will regain favor to a great-enough degree to temporarily force the GGR up to very high levels. Thus the upside potential in this left-for-dead sector is extraordinary. The wealth that’s going to be created as gold stocks mean revert higher and multiply will be life-changing.
The contrarian investors returning to gold stocks in early 2015 certainly understand that. They realize that the Fed-levitated stock markets are on the verge of rolling over decisively, which will rekindle gold investment demand. And as gold itself recovers, the radically-undervalued and wildly-oversold gold stocks are going to rocket higher. They will very likely be this year’s best-performing sector in all the stock markets.
Another major bullish factor coming into play is the utter collapse in energy prices. Gold mining is an incredibly energy-intensive industry. It takes vast amounts of energy to dig up heavy rock, haul it, crush it, and extract the relatively tiny quantities of gold out of that ore. Energy is often the largest variable cost for gold miners. So the brutal collapse in energy prices in recent months is also going to really boost profits.
And that will make gold stocks look even more ludicrously undervalued than they already do, which is hard to believe. After falling out of favor for so long, after suffering an unbelievably anomalous year (2013) and its aftermath (2014), gold stocks are overdue to soar this year. The smart contrarians buying in early before the rest of the herd starts understanding gold stocks’ vast upside potential are going to earn fortunes.
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The bottom line is gold stocks are already turning higher in this young new year. Contrarian investors realize they are radically undervalued compared to the prevailing gold prices that drive their profits. And they are the greatest bargains in the entire stock markets, the only sector with the potential to easily at least quadruple in the coming few years while the rest of the Fed-goosed stock markets stall out and drop.
And the upside potential for the beaten-down gold stocks is extraordinary. As they inevitably start to return to favor as gold mean reverts higher, the upside targets are multiples of current price levels. And after such an extreme stint of bottom-feeding, the resulting mean reversion and overshoot should be proportionally extreme to the upside. Prudent investors who buy in early are destined to earn fortunes.
Adam Hamilton, CPA