Stock Markets Last Cheap Sector - Gold / Commodities / Gold and Silver Stocks 2018

The lofty stock marketssuffered a sharp selloff this week that may prove a major inflectionpoint.  There was one lone sector thatbucked the heavy selling to surge in the carnage, the gold miners’ stocks.  They are the last cheap sector in thesebubble-valued stock markets, long overlooked and neglected.  Wildly undervalued today, the gold stockshave great potential to soar dramatically even if stock markets keep weakening.

Just several weeks ago,the US stock markets hit new all-time record highs stoking universaleuphoria.  The flagship S&P 500broad-market stock index (SPX) closed at 2930.8 in late September, extendingits monstrous bull to 333.2% over 9.5 years. That made for the 2nd-largest and 1st-longest in US stock-market history!  It also left these markets dangerouslyovervalued, literally trading at bubblevaluations.

Exiting September, theelite stocks of the SPX sported an average trailing-twelve-monthprice-to-earnings ratio way up at 31.4x. Weighted by market capitalization, that was even more extreme at34.9x.  Over the past century and aquarter or so, bubble valuations start at 28x earnings.  So the stock markets were ripe for a fall,and the catalyst would prove surging 10-year Treasury yields along with a hawkishFed chairman.

While the SPX startedweakening last week as 10y yields blasted to a 7.3-year high, the serious selling finally erupted thisWednesday.  The SPX plunged 3.3% to2785.7, taking its total pullback from the peak to 4.9%.  Leading the way down were the market-darlingmega tech stocks, which have valuations much more expensive thanthe general markets.  Everything wassucked into that frenzied selling, with one exception.

The gold miners’ stocks were an island ofgreen in that roiling blood-red sea, their leading sector benchmark actuallyrallying 1.3%!  That is the GDX VanEckVectors Gold Miners ETF.  Thatseemingly-impossible divergence is exceedingly important for investors to understand.  It is the key to generating great wealth wheneverything else burns in what will likely snowball into the long-overdue next bear market in stocks.

The gold stocks are aunique sector because stock-market fortunes aren’t their primary driver.  Instead they mirror and amplify the trends in gold, which directlydrives their profitability in leveraged fashion.  Gold rallied 0.3% to $1194 Wednesday asinvestors finally started toreturn.  The major gold miners of GDXsurged 3.9x that much, despite the flaring stock-market fears.  Such contrary action is nothing new.

Weakening stock marketsmotivate investors to prudently diversify their bleeding stock-heavy portfolioswith gold.  Their buying bids goldhigher, which eventually fuels monstergold-stock bulls.  Within and afterthe last secular stock bear, the gold stocks skyrocketed.  GDX was born in the middle of that epic runin May 2006, so we need to use an older benchmark to remember why gold stocksare compelling in stock bears.

Between November 2000and September 2011, the HUI NYSE Arca Gold BUGS Index soared a truly-astounding1664.4% higher.  You read that right, theworld’s most-hated sector today multiplied wealth by nearly 18x across those 10.8 years!  The SPX actually slumped 14.2% in that span,but was down as much as 56.8% at worst when a mid-secular-bear cyclical bearclimaxed.  So investors returned to goldin a big way.

In roughly the samespan, it powered 638.2% higher in a massive secular bull.  The HUI leveraged those gains by 2.6x, rightin line with the usual 2x to 3x it has seen historically.  If the stock markets are finally on the vergeof another bear driven by recordFed tightening, this gold-stocks-to-the-moon cycle is going to repeat.  Gold will be bid for years as investors slowly rebuild normal portfolio allocations,so gold stocks will fly.

This leveragedrelationship between gold miners’ stocks and gold prices is deeply fundamentaland easy to understand.  While the majorgold miners of GDX will report their Q3’18 financial results over the nextmonth or so, their latest-available data is still Q2’s.  That quarter their average gold productioncost was $856 per ounce in all-in-sustaining-cost terms,which is way under even Q3’s low average gold price of $1211.

For easiercalculations, let’s round these to $850 AISCs at $1200 gold, which yieldsprofits of $350 per ounce.  If goldrallies 10% to $1320, the major gold miners’ profits surge 34% to $470.  A 20% gold upleg to $1440 boosts theseearnings to $590, a big 69% gain.  And a little30% gold bull to $1560 catapults the industry profits 103% higher to $710!  Gold-mining earnings have big leverage to prevailing gold prices.

The costs of goldmining are largely fixed during mine-planning stages, when engineers andgeologists decide which ore to mine, how to dig to it, and how to processit.  The actual mining generally requiresthe same levels of infrastructure, equipment, and employees quarter afterquarter with little changing in throughput terms.  Thus average AISCs don’t move around mucheven when gold prices climb far higher.

Gold-mining profits andthus gold-stock prices would double with a mere 30% gold bull!  And that’snot a stretch at all.  Back in early 2016gold investment returned tofavor in a major way after back-to-back SPX corrections spooked stockinvestors.  American stock investors inparticular buying shares in the leading GLD SPDR Gold Shares gold ETF drovegold 29.9% higher in just 6.7 months in essentially the first half of 2016!

The major gold minersof GDX reacted with a massive 151.2% bull upleg in that ETF’s share price injust 6.4 months in roughly that same span. That made for outstanding 5.1x upside leverage to gold.  So the idea that gold stocks soar when weakening stock markets spur gold investmentdemand is based on historical precedent. This week’s gold-stock rally on an SPX selloff is just a small foretasteof the feast to come.

If gold stocks werealready super-expensive like mega tech stocks, the psychology of rising goldprices would still drive them higher. But this small contrarian sector has been forsaken and left for dead forthe last couple years or so.  Investorswanted nothing to do with gold and its miners’ stocks as the general stockmarkets levitated on Republicans’ massive corporate tax cuts.  So gold stocks are swirling in the gutter.

Their valuationsrelative to gold are exceedingly low today, anextreme anomaly.  Because they are sodeeply out of favor, their stock prices are radically disconnected from theirunderlying profitability even at $1200 gold. That means their coming upside as investors return to gold is muchgreater than it would be normally.  Gold stocksneed to mean revert far higher to merely reflect today’s gold prices, let alonefuture ones.

Gold-stock valuationtrends can be understood and gamed through a simple proxy, the ratio betweentheir stock prices and the underlying metal which drives their profits.  Since American stock investors prefer to deploycapital in GDX for gold-stock exposure and GLD for gold, we can construct aGDX/GLD Ratio to analyze this key fundamental relationship.  This GGR reveals gold-stock prices are ridiculously low today.

This GDX/GLD Ratiorendered in blue simply divides the daily closes in GDX and GLD.  Charted over time, this reveals whether goldstocks are relatively cheap or relatively expensive compared to the metal theymine.  This Wednesday even after goldstocks’ counter-market surge, the GGR was still only running 0.165x.  That’s very low in secular terms,highlighting how undervalued gold stocks are relative to gold.

Gold itself remains inthat bull market ignited in mid-December 2015 immediately after the Fed’s firstrate hike of this cycle.  Gold soared in the first half of 2016 afterAmerican stock investors returned to GLD with a vengeance following the first stock-market corrections in years.  Once these guys remember stockmarkets can’t rally indefinitely because they are forever cyclical, they shiftsome capital back into gold to diversify.

Gold started fallingout of favor again after the SPX started climbing to new record highs inmid-2016.  And all that accelerateddramatically after Trump’s surprise election victory late that year.  Republicans controlled both sides ofCongress, so stock markets soared on hopes for big tax cuts soon.  Whilegold fell in a huge correction, it didn’t exceed the -20% new-bearthreshold.  Gold’s bull has consolidatedsince.

Because gold-stockfortunes are overwhelmingly dominated by gold’s own, this sector is stillconsidered to be in a bull market because gold is.  During the past 2.8 years of gold’s bull, theGGR averaged just 0.187x.  GDX’s shareprice tended to close at just under a fifth of GLD’s share price since gold’scurrent bull was born.  That is exceedingly low historically, not normalat all.  The GGR needs to mean revert farhigher.

Again GDX was launchedback in May 2006, when gold stocks were really in favor after rocketing higherin their young secular bull.  Over thenext 2 years, the GDX/GLD Ratio averaged 0.591x.  If the gold stocks fully mean reverted backup to those levels relative to today’s gold prices, GDX would have to soar 258% higher from here!  But late 2008’s first stock panic in acentury torpedoed this core fundamental relationship.

Gold stocks plummetedin that stock panic, with GDX collapsing 71.0% in just 7.5 months!  That’s a major exception to the rule thatgold stocks tend to thrive during stock weakness.  While episodes of epic extreme fear are mercifullybrief, free-falling general stock markets can suck in gold stocks and even goldfor a spell.  The baby gets thrown outwith the bathwater when investors’ fear reaches blinding peak levels.

At worst in October2008 after the SPX had plummeted 30.0% in a single month, the GGR bottomed at0.227x.  That highlights the sheerabsurdity of recent years’ gold-stock prices. Even in the most-extreme stock-market fear event we’ll likely witness inour entire lifetimes, the gold stocks were trading over a fifth higher relative to gold than their average over thepast few years!  They reboundedpowerfully from that anomaly.

Over the next 2.9 yearsafter that epic stock panic, GDX morethan quadrupled with a 307.0% gain! In the first couple years of that post-stock-panic mean reversion, theGGR averaged 0.422x.  Restoring thatfundamental relationship between gold miners’ stocks and gold prices wouldrequire a 156% GDX rally from here.  Inthe 4 years after that panic, the GGR averaged 0.381x which is 131% higher thanthis week’s levels!

But effectivelystarting in 2013, the Fed began radically distorting the markets with its thirdquantitative-easing campaign.  That ledto soaring stock markets whichmirrored the Fed’s ballooning balance sheet as it bought massive amounts ofbonds with money newly conjured out of thin air.  So gold fell deeply out of favor as stockmarkets rocketed higher on epic Fed QE, suffering a multi-year bear whichcrushed gold stocks.

That ultimatelyculminated in mid-December 2015 on the Fed’s first rate hike of this cycleending 7 years of its stock-panic-spawned zero-interest-rate policy.  The GGR hit an all-time low of 0.120x about amonth later as gold stocks bottomed before soaring in their new bull.  Just like after the stock panic, gold-stockupside was explosive after being pummeled to unsustainable lows relative to themetal which drives their profits.

GDX again skyrocketed151.2% higher over the next half-year or so in early 2016, but its young bullwas still tiny.  Ever since gold stockshave languished, grinding sideways to lower as investors forgot about them.  There was little demand for contrarianinvestments while the SPX surged dramatically on taxphoria since late2016.  But this week’s action warns thosestocks-higher gold-lower trends may be starting to reverse.

There are several keytakeaways from this long-term fundamental relationship between gold-stockprices and gold levels.  First, in thepast the gold stocks have surged sharply in strong bulls after their pricesfell too low compared to gold. Gold-stock prices as measured by GDX have doubled to quadrupled in recent years’ mean reversions out ofanomalous extremes.  Similar gains atleast should be expected in the next one.

Second, gold-stockprices can’t fall relative to gold forever. While this small contrarian sector can lapse out of favor at times,investors flood back in once the stock markets weaken and investors return togold.  Between 2008 to 2015, the GGR’strend was sharply lower.  It stabilizedand consolidated low from 2016 to 2018. Now gold stocks are due for a secular reversal where their gains outpacegold’s on balance for years.

No markets orrelationships between markets move in one direction forever!  American stock investors are being shockedinto remembering this core reality this week. Everything is forever cyclical. The longer any market is stuck in any particular trend, the bigger andlonger its proportional mean reversion will last.  Gold and especially gold stocks are likely toexperience years of plenty after suffering years of lean demand.

Third, all this GGRanalysis so far makes the unlikely assumption that gold prices don’t rallytoo.  But gold is likely to enjoy apowerful bull in the coming years as stock investors re-diversify smallfractions of their stock-dominated portfolios into counter-moving gold.  As gold prices are bid higher, the upside ingold stocks will leverage and amplify gold’s gains.  The higher GLD is bid, the higher GDX’s meanreversion will go.

As an example, assumethe most-conservative mean reversion of the GGR back to that 4-year post-panicaverage of 0.381x.  At today’s goldlevels, that implies GDX has to more than double from here with a 131%gain.  But if GLD is bid 10%, 20%, or 30%higher, the necessary GDX upside to regain that normal gold-stock pricingrelative to gold climbs to 154%, 177%, or 200%. And that’s actually quite conservative too.

After anomalous priceextremes, mean reversions don’t simply stop at the averages but tend to overshoot proportionally in theopposite direction.  So gold stocks aredue for a period where they outperform gold so greatly that the GGR soars tothe high side instead of mere normal levels! That portends far-larger gold-stock gains than anything discussed.  Run the numbers with a GGR mean-reversionovershoot and be amazed!

This last chart zooms into the past few years or so, essentially the current gold and gold-stockbulls.  The GGR was recently driven to a2.6-year low by the forcedcapitulation in gold stocks in August and the echo capitulation in earlySeptember.  So even in the context ofrecent years alone, the gold stocks are waytoo low relative to prevailing gold prices. The GGR is due for a sharp surge back above that meager mean.

At worst inmid-September, the GGR plunged to 0.155x. That was a breakdown from its downtrend of recent years, and 0.032xunder its past-few-years average of 0.187x. A full proportional mean-reversion overshoot out of this latest anomalywould drive the GGR back to 0.219x.  Justto normalize relative to gold in even that little way would require another 33%rally from this Wednesday’s close to $24.73 in GDX!

With gold stocks sowildly undervalued relative to the metal which drives their profits, theirupside is huge no matter how you slice it. The gold miners are truly the lastcheap sector in these entire lofty, euphoric stock markets!  And since their earnings are totallydependent on gold prices which tend to rally on big investment buying whenstock markets weaken, gold stocks have the unique ability to climb during stockbears.

We got a small previewof that this week, when GDX rallied 1.3% on Wednesday despite that sharp 3.3%SPX plunge.  Given the bubblegeneral-stock-market valuations and the Fed’s unprecedented now-full-steam quantitative-tightening campaign to destroy QE money, every investor needs to make portfolio allocations to gold and thestocks of its miners.  They tend to powerenormously higher when little else will.

And even if the stockmarkets again evade the hangman’s noose and somehow continue grinding higherstill, gold investment demand could still climb.  Once stock investors are spooked, they usuallyadd gold for a long time after to getsome semblance of portfolio diversification. So gold and gold stocks still soared from 2009 to 2011 and in the firsthalf of 2016 even as the SPX recovered from a panic and corrections.

Wall Street has longhated gold because it thrives when stock markets weaken.  So it’s essential for all speculators andinvestors to cultivate excellent contrarian intelligence sources.  That’s been ourspecialty at Zeal for decades now, we’ve long published acclaimed weekly and monthly newsletters.  They offer a unique and essential contrarianperspective to help offset and neutralize the endless stock-marketcheerleading.

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The bottom line is thegold miners’ stocks are the last cheap sector in these entire lofty stockmarkets.  They’ve languished deeply outof favor for years as investors forgot the wisdom of prudently diversifyingtheir stock-heavy portfolios with gold. But once stock markets weaken enough to spook them, traders startreturning to gold and gold stocks.  Thisclassical behavior started to play out again with this week’s selloff.

As capital flows backinto this forsaken sector, the gold-stock upside is truly extreme.  These gold miners’ stock prices are wildlyundervalued relative to the metal which drives their profits.  So they are overdue for a massive meanreversion and eventually overshoot.  Whenthis dynamic of gold stocks returning to favor after a long exile has playedout in the past, contrarians who bought in early and low really multipliedtheir wealth.

Adam Hamilton, CPA

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