Gold stocks coiled spring 2

All year long, the extreme stock-market rally driven by hopes for big tax cuts soon stole the limelight from gold. The flagship S&P 500 stock index has blasted 19.7% higher year-to-date, stoking incredible levels of euphoria. That sucked all the oxygen out of the investment world, overshadowing everything else. So investors have largely shunned gold this year, since it is normally the anti-stock trade moving counter to stocks.

Usually soaring stock markets crush gold, like back in 2013. That year the Fed’s new third quantitative-easing campaign conjured $1020b out of thin air to monetize bonds. The resulting artificially-low interest rates fueled a stock-buyback boom, catapulting the S&P 500 29.6% higher. So investors felt no need to prudently diversify their stock-heavy portfolios with gold, thus this metal plummeted 27.9% lower that year!

Considering gold is often hostage to stock-market fortunes, it performed remarkably well in 2017 despite the endless record highs in major stock indexes. Gold was up 10.0% YTD as of the middle of this week, very impressive considering the circumstances. Gold miners’ inherent profits leverage usually enables their stock prices to amplify underlying gold rallies by 2x to 3x, so they should be up 20% to 30% this year.

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. Unfortunately its performance this year has been utterly dismal compared to gold, with the HUI up just 1.8% YTD! That makes for horrendous leverage of 0.2x, wildly unacceptable considering gold miners’ big additional risks compared to the metal they bring to market.

There have been exceptions, with some miners far outperforming their languishing peers. This Tuesday in our weekly newsletter, we just realized 184% gains on a year-old trade in a leading mid-tier gold miner! The gold stocks have been tradable this year, seeing sizable rallies within their consolidation grind. But overall they’ve been drifting listlessly on balance, naturally wreaking great damage on sector sentiment.

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 obviously happened in the stock markets this year, despite the Fed and the ECB on the verge of radical tightenings that will strangle this stock bull. The parabolic bitcoin mania is another wild case in point. But when stocks are down, traders naturally wax sullen and bearish.

As at all sentiment extremes, traders assume gold stocks are doomed to suffer this frustrating weakness indefinitely. But that’s a bad bet, as sentiment perpetually meanders back and forth between excessive greed and fear. The longer psychology remains 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. Those tend to overshoot proportionally.

The last time gold stocks were this out of favor drifting near lows was the second half of 2015. The gold miners were left for dead, with nearly everyone predicting they would spiral lower forever. Yet sentiment shifted out of that bearish echo chamber, and the gold stocks skyrocketed like North Korean ICBMs. In merely 6.5 months, the HUI soared 182.2% higher! That amplified gold’s concurrent 25.2% rally by a big 7.2x.

2017’s painful consolidation is the perfect breeding ground for another monster gold-stock upleg in 2018. After spending a year basing at deeply-undervalued prices relative to today’s gold levels, it shouldn’t take much of a sentiment shift to catapult gold stocks way higher. From a contrarian standpoint this unloved sector’s technicals are actually quite bullish today, with the gold miners’ stocks wound up like a coiled spring.

Last year’s colossal 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 a half-year! Once this sector starts moving, the resulting uplegs tend to be massive. The key is bucking popular bearish sentiment to get invested early before the crowd rushes back in.

That enormous upleg birthing a mighty new gold-stock bull last year was followed by a huge drop driven by gold. Since prevailing gold prices directly drive miners’ profits, 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. That was super-anomalous, thus gold bounced back this year despite the record stock markets.

First gold was hit by gold-futures stop losses being run, then slammed by the Trumphoria stock-market surge in the wake of November 2016’s 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 suffering three in a row back-to-back is unheard of! I explained each anomaly in depth in an April essay if you’re interested in getting up to speed.

Gold dropped 17.3% in 5.3 months, certainly a massive correction but 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 the second half of 2016 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 earnings 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 Q3’17, the major gold miners of GDX reported average all-in sustaining costs of just $868 per ounce. At this week’s $1265 gold levels, that yields major-gold-miner earnings of $397 per ounce. This makes for hefty operating margins of 31%, levels most industries would kill for. Yet the markets are pricing gold stocks today as if they were running catastrophic losses. At the middle of this week, the HUI was near 185.6.

The first time this leading gold-stock index hit these levels in August 2003, gold was only trading in the $360s. Now it is 3.5x higher, the gold miners are far more profitable, yet their stocks are still ludicrously languishing at 14.3-year-old levels! This makes zero sense fundamentally, revealing the gold miners’ radical undervaluations today. Such extremes can only be driven by sentiment, and never last for very long.

The catalyst that will shatter this bearish-sentiment curse is gold rallying. At the GDX major gold miners’ latest average AISC of $868 in the third quarter, a mere 10% gold advance would boost mining earnings by 32% to $524 per ounce. That will rapidly shift psychology back to bullish. Just like in the first half of 2016, these ridiculously-low gold stocks will take off like rockets once gold starts decisively moving higher again.

And that’s likely very soon thanks to major central banks. This quarter the Fed just started quantitative tightening for the first time ever, to begin unwinding the trillions of dollars evoked into existence during its long years of QE. While QT only ran $10b per month in Q4’17, it will gradually ramp up next year to its terminal $50b-per-month pace in Q4’18! QT is exceedingly bearish for these surreal QE-inflated stock markets.

On top of that the European Central Bank will slash in half its own massive QE campaign from €60b per month to €30b monthly starting in January 2018. Between the Fed’s new QT and the ECB’s new QE tapering, 2018 is going to see the equivalent of $950b less central-bank capital injections than enjoyed in 2017! And in 2019 that will keep growing to another $1450b of central-bank tightening compared to this year.

With the Fed and ECB strangling this anomalous QE-levitated stock bull, gold will really shine again. As stock markets grind lower, investors will remember the wisdom of prudently diversifying their stock-heavy portfolios with counter-moving gold. Gold investment demand will soar again like in early 2016 after the last stock-market correction. Once gold resumes powering higher, capital will flood back into its miners’ stocks.

Gold’s potential upside next year is likely much greater than most think possible. This week the famous hedge-fund investor Doug Kass of Seabreeze Partners Management wrote about the 15 surprises that he expects in 2018. He sees these red-hot stock markets steadily declining all year long partially due to extreme overvaluations today. Kass writes, “Dip buying is not rewarded, but shorting the rips is rewarded next year.”

That will help reignite massive investment capital inflows into gold. Kass is forecasting, “Interest in gold, which has been sidelined for months amid the cryptocurrency frenzy, regains popularity, reverses direction from the lower left to the upper right and moves higher in price. In an abrupt and swift flight to alternative safety, gold makes new all-time highs and becomes the single best-performing asset class in 2018.”

That’s a major gold rally next year, as gold’s existing all-time high in nominal terms is $1894 which came in August 2011. That would require a 50% gold surge in 2018, which wouldn’t be outside the realm of plausibility if the stock markets roll over into a new bear market on central banks’ unprecedented radical tightening. Again after that last stock-market correction in early 2016, gold blasted 29.9% higher in just 6.7 months.

Of course the gold-stock upside in such a banner year for gold would be epic, especially starting with this sector so wildly undervalued fundamentally today. While I’m not as bold as Doug Kass to predict new all-time gold highs in 2018, it wouldn’t surprise me one bit to see this metal power 20% to 30% higher next year. That seems fairly conservative if the long-central-bank-delayed stock bear finally starts awakening.

The potential gains in the gold miners’ stocks during such a major new upleg are actually quite easy to estimate fundamentally. This last chart looks at the HUI/Gold Ratio, which simply divides 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. This really drives home the coiled-spring nature of gold stocks today.

This week the HGR was way down near 0.147x, meaning the HUI was running at just over 1/7th of gold’s prevailing price. While that means nothing in isolation, the context provided by this long-term HGR chart reveals 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 per the HUI yardstick slumped to a fundamentally-absurd 13.5-year secular low as I pointed out in real-time. Though gold was trading near $1087, still 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! Such an extreme anomaly couldn’t and didn’t last, resulting in the battered gold stocks nearly tripling in only 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 was actually righteous, it would’ve been seen plenty of times in modern history. But it wasn’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, this key fundamental ratio for gold-stock valuations averaged 0.346x.

To simply mean revert back up to those last normal levels relative to today’s gold prices, the major gold miners dominating the HUI and GDX would have to power 136% higher from here. To merely restore some semblance of normalcy fundamentally, the gold stocks literally need to more than double even at this week’s prevailing $1265 gold levels! Their prices can’t stay disconnected from their earnings forever.

But if gold indeed powers higher in a major new upleg next year as central-bank tightening drags stock markets lower, the gold-stock upside is far greater. At my conservative 20% to 30% gold rally in 2018, this metal would climb to $1518 to $1644. That yields HUI targets from 525 to 569, which are 183% and 206% higher than this week’s low levels. The gold stocks easily have the potential to triple in 2018 alone!

But that’s pretty conservative because it’s purely fundamentally-based, ignoring the impact of sentiment. 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 just stop in the middle at neutral sentiment. Their momentum leads them to overshoot to the opposite extreme.

This natural cyclical reaction makes gold stocks’ potential upside far more impressive. A proportional overshoot in HGR terms heralds radically-higher gold-stock prices ahead. This week the HUI is 0.20x under its post-panic-average 0.346x HGR. As trader psychology gradually swings from extreme fear back to extreme greed as gold stocks climb, it wouldn’t be a stretch at all to see the HGR shoot 0.20x over to 0.546x.

That would likely mark a major topping, not lasting long. But such an overshoot HGR at 20% to 30% higher gold prices would yield gold-stock-bull peak targets of 829 to 898 on the HUI. That’s a staggering 346% to 384% higher than this week’s levels! Where else in all the stock markets does a sector have the potential to quadruple or quintuple in the coming years? Gold and gold stocks climb even during stock bears.

If Doug Kass’s 2018 surprise proves correct and gold regains its all-time high of $1894 with a 50% rally, gold stocks’ probable upside is wealth-multiplying. It yields a neutral-sentiment HUI target at that 0.346x HGR of 656, and a crazy 1036 on a sentiment mean reversion to a 0.546x greed-drenched HGR! These make for respective potential gains of 254% to 458% in the major gold miners’ stocks, dwarfing all other sectors.

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 wildly 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.

Once gold starts powering higher decisively enough to catch investors’ attention, the gold stocks will be off to the races like in early 2016. Like bitcoin this year, the more gold stocks rally the more traders will take notice and deploy capital. This process will soon become self-feeding, with more buying fueling higher prices leading to still more buying. That will yield massive gains to early contrarians who bought in low.

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.

While investors and speculators alike can certainly play gold stocks’ coming breakout rally with the major ETFs like GDX, the best gains by far will be won in individual gold stocks with superior fundamentals. Their upside will trounce the ETFs, which are burdened by over-diversification and underperforming gold stocks. A carefully-handpicked portfolio of elite gold and silver miners will generate much-greater wealth creation.

At Zeal we’ve literally spent tens of thousands of hours researching individual gold stocks and markets, so we can better decide what to trade and when. As of the end of Q3, this has resulted in 967 stock trades recommended in real-time to our newsletter subscribers since 2001. Fighting the crowd to buy low and sell high is very profitable, as all these trades averaged stellar annualized realized gains of +19.9%!

The key to this success is staying informed and being contrarian. That means buying low when others are scared, like late in this year’s vexing consolidation. An easy way to keep abreast is through our acclaimed weekly and monthly newsletters. They draw on our 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. For only $12 per issue, you can learn to think, trade, and thrive like contrarians. Subscribe today, and get deployed in the great gold and silver stocks in our full trading books!

The bottom line is the gold stocks still look like a coiled spring today despite the extreme bearishness plaguing them. Following its long drift in 2017, this battered sector is ready to stage a massive breakout upleg in 2018. The gold miners’ stocks remain deeply undervalued relative to current gold prices, let alone where this metal is heading. And gold will likely power much higher next year as stock markets roll over.

These bubble-valued stock markets artificially levitated by the central banks are about to face the largest monetary tightening in world history, literally trillions of dollars in the next couple years alone. Gold will quickly return to favor as usual when stocks materially weaken. The resulting investment capital inflows will lift gold, really boost gold miners’ profits, and motivate traders to return en masse to this abandoned sector.

Adam Hamilton, CPA

December 22, 2017

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