Gold Stocks Remain Cheap

Adam Hamilton     December 20, 2019     2800 Words


The gold minersí stocks have suffered a lackluster few months.  Thatís a disheartening contrast to their powerful summer upleg on goldís bull-market breakout.  While this healthy gold-stock correction likely isnít over yet, the gold miners remain very undervalued relative to the metal they produce.  That means they still have massive upside left in this secular gold bull.  Sentiment just needs rebalancing before its next upleg.


In recent months Iíve written a lot about goldís correction, which is naturally driving a parallel one in the gold minersí stocks.  Iíve explained why speculatorsí positioning in gold futures, goldís dominant primary short-term driver, remains bearish with potential selling vastly outweighing likely buying.  Iíve shown how shallow and short goldís recent correction is compared to bull-market precedent, implying it isnít mature yet.


This hasnít changed, goldís correction is alive and well.  Based on their gold-bull-to-date trading ranges, the latest weekly read on specsí gold futures revealed they have room to buy 59.4k contracts.  But that is dwarfed by 6.3x with their potential selling at 372.3k!  And at worst so far, gold has only retreated 6.4% in 2.8 months.  This secular bullís prior two corrections following uplegs averaged 15.5% selloffs over 6.0 months.


If gold continues grinding lower as specsí collective bets are normalized, it will drag down the gold stocks with it.  The major gold miners tend to leverage goldís material moves by 2x to 3x.  That is evident in their leading benchmark GDX VanEck Vectors Gold Miners ETF.  Discussing this gold-stock correction in last weekís essay, I pointed out GDX has only lost 15.4% over 1.3 months at worst.  Thatís 2.4x downside leverage.


But this gold-stock bullís prior couple corrections directly driven by goldís averaged 35.4% GDX losses in 11.8 months.  That made for 2.3x downside leverage to gold.  If goldís correction isnít over yet, neither is the gold stocksí.  That being understood, speculators and investors need to look past this valley and start preparing for the next ascent.  Uplegs and corrections meander in perpetually-alternating cycles in markets.


The major corrections inevitably following major bull-market uplegs are mostly driven by sentiment.  The excessive greed generated late in bull uplegs has to be bled away before the next upleg can follow.  The only way to kill major-high exuberance is through subsequent selloffs, which ultimately spawn fear.  But the broader bull markets containing those individual uplegs and corrections are fueled by fundamentals.


Thatís how much profits gold miners are earning compared to their prevailing stock prices.  And they are looking fantastic.  In mid-November as the latest earnings season ended, I dug into the GDX gold minersí Q3í19 results.  These fundamentals are the strongest theyíve been in years, thanks to goldís bull-market breakout rally this past summer.  Q3ís average gold price of $1474 soared a colossal 21.7% year-over-year!


That drove explosive profits growth unparalleled in all the stock markets.  Based on the average all-in sustaining costs of the GDX miners, their earnings catapulted an astounding 68.9% higher YoY!  That was awesome 3.2x upside leverage to goldís gains.  And that stupendous earnings growth is likely to persist.  With goldís correction tarrying, Q4ís average gold price so far at $1481 is even a bit better than Q3ís.


Iíve done deep bottom-up analysis on many individual gold miners every quarter for years, which is very data-intensive both to do and explain.  That proves the strong relationship between gold-mining profits and prevailing gold prices.  Gold stocks are essentially leveraged plays on gold.  Thankfully thereís a simple proxy to visualize gold stocksí valuations relative to gold, the ratio between stock prices and goldís own price.


The gold stocks as a sector can be measured by GDX.  Its daily closes can then be divided by those of the worldís dominant gold ETF, the GLD SPDR Gold Shares.  The result is the GDX/GLD Ratio, or GGR for short.  Charting it over time shows whether gold stocks are gaining or losing ground relative to gold, and more importantly whether they are richly-valued or undervalued compared to the metal they bring to market.


The latter is true today, gold stocks remain very cheap relative to gold.  Again that doesnít mean that their healthy and necessary correction is over.  But it does greatly boost the odds the coming gold-stock uplegs in this secular gold bull are going to be outsized.  The gold stocks have to power far higher to reasonably reflect these higher prevailing gold prices.  The biggest gains of their bull market are almost certainly yet to come.


At best in this entire bull so far, GDX had blasted 151.2% higher by early August 2016.  Thatís actually still tiny by gold-stock-bull standards!  This sectorís last secular bull ran for 10.8 years from November 2000 to September 2011, straddling the birth of GDX.  The older benchmark HUI NYSE Arca Gold BUGS index skyrocketed 1664.4% higher over that span!  Gold stocks were that decadeís top-performing stock sector.


Like most other indicators, the GGR is still bearish over the near-term.  It joins the chorus suggesting this gold-stock correction isnít finished yet.  This first chart superimposes the GGR in blue with its technicals over GDX itself in red during this gold-stock bull.  The GGR hasnít yet retreated low enough to signal a likely bottoming in gold stocks.  This key gold-stock valuation metric remains high for a gold-stock correction.



The GGRís primary value over the short-term is highlighting trends in gold-stock performance versus the metal they mine.  When this ratio is rising, the gold stocks are outperforming gold.  That usually happens during gold uplegs, when the major gold stocks of GDX again amplify goldís gains by 2x to 3x.  All 3 of this gold-stock bullís major uplegs saw big GGR gains.  Gold stocks were advancing much faster than gold.


But gold stocksí leverage to gold is a double-edged sword, working equally as well on the downside when gold corrects.  So the GGR has retreated during this gold bullís prior couple corrections, showing the gold stocks as measured by GDX were falling faster than gold as measured by GLD.  So in other words, gold outperforms its minersí stocks during corrections by not selling off as much.  The GGR nicely quantifies this.


Heading into this gold-stock bullís initial correction in mostly the second half of 2016, the GGR peaked at 0.244x.  A share of GDX was worth almost a quarter of a GLD share.  By the time the dust settled, GDX had plummeted 39.4% compared to goldís milder 17.3% correction!  That crushed the GGR back down to 0.176x.  This key fundamental indicator plunged by 27.9% or 0.068x absolutely in that utterly brutal selloff.


This gold-stock bullís second correction began in early 2017, but dragged on way into summer 2018.  It hammered GDX 31.1% lower, again much worse than goldís own 13.6% correction that drove those gold-stock losses.  The GGR peaked at 0.216x in the preceding upleg, before plunging to 0.155x by that next correction bottoming.  Thatís a 28.1% or 0.061x gold-stock-correction GGR retreat, similar to the earlier correction.


So this bullís previous corrections averaged tight 28.0% or 0.065x GGR slumps.  Contrast that to the gold stocksí current correction.  The latest GGR peak hit 0.211x in early September, and at worst so far merely fell back to 0.188x in mid-October.  That makes for only an 11.1% or 0.023x GGR retreat at most.  Thus odds are the gold minersí stocks havenít fallen far enough yet relative to gold to rebalance their sentiment!


Past gold-stock corrections saw the minersí stocks drop far enough compared to gold to force the GGR under both its 200-day moving average and gold-bull average.  Neither has happened yet in this current correction, with these metrics now running 0.191x and 0.186x.  The gold stocks arenít likely to finish their crucial sentiment-rebalancing selloff until this GGR retreat grows larger, more in line with bull-to-date norms.


Given the better prevailing psychology now after goldís summer bull-market breakout, thereís probably no need for this gold-stock correction to snowball to much-higher bull averages.  Thatís both in terms of GDX itself and its fundamental relationship to gold as quantified by the GGR.  But this gold-stock selling still has to persist long enough and be big enough to largely eradicate greed, which really hasnít happened yet.


The reason gold-stock prices have stayed relatively high absolutely and compared to gold since their latest upleg toppings in early September is residual greed.  Major uplegs generate great greed, complacency, and euphoria as they go terminal.  These can only be eradicated and turned to fear, worry, and despair through sizable correction selloffs.  That has yet to happen after this latest topping, the downside has been mild.


Regardless of this near-term bearish outlook on gold-stock prices, their longer-term prospects driven by fundamentals instead of sentiment look awesome.  An analogy is a spring snow storm.  As spring progresses, temperatures are generally warming and daylight lengthens.  Thatís similar to a secular-bull uptrend in the markets.  Spring and summer are coming in gold stocks, after their long winter bear ending in early 2016.


Yet even in the warmest of springs, strong snow storms are always possible.  Temps plunge in those, and they make it look like winter is returning.  Yet no matter how severe they get, they can only last for short spells.  The spring warming trend driven by far-larger factors persists, despite any temporary reversals.  Thereís no contradiction inherent in expecting near-term gold-stock weakness before a resuming secular bull.


This next chart uses this same GGR data but zooms out to a longer time horizon, since 2007.  As GDX was birthed in May 2006, that encompasses nearly its entire lifespan.  Despite their near-term correction risks, the gold minersí stocks remain deeply undervalued relative to the metal they mine.  Thus they have massive upside as this gold bullís future uplegs unfold.  Gold stocks still need to mean revert radically higher!



This current young gold-stock bull that has enjoyed some powerful uplegs in recent years still looks tiny in big-picture context.  Incredibly its average GGR of 0.186x is so darned low that it is still below the wildly-extreme stock-panic levels from late 2008!  That first true stock panic in a century was the biggest market fear event of our lifetimes.  Itís crazy that nearly this entire gold-stock bull has drifted below that miserable metric.


Gold stocks traded far higher relative to prevailing gold prices before that panic, with the GGR averaging 0.591x in the preceding 2 years.  While that drooped to 0.422x in the 2 years after that panic, that was still far higher than todayís gold bull.  For GDX merely to regain those levels relative to GLD, it would have to soar another 114% higher from this weekís levels!  Gold stocks remain radically undervalued compared to gold!


A more-conservative post-stock-panic GGR average is the 4-year one from 2009 to 2012.  That was after that stock panic, but before 2013 where the Fed epically distorted markets.  That year was when its third quantitative-easing bond-monetization campaign peaked.  The Fedís balance sheet skyrocketed 38.7% or $1125.3b higher that year alone, far beyond any precedent!  The US stock markets soared 29.6% on that.


Such astounding stock-market gains killed demand for alternative investments led by gold.  So the yellow metal plummeted by 27.9% in that peak-QE year, crushing GDX a gut-wrenching 54.5% lower in 2013!  Thus the 4 years between those wild events were arguably the last quasi-normal years in the markets.  During that span, the GGR averaged 0.381x.  GDX would have to soar 93% higher to regain those levels today.


Gold stocks are still super-cheap relative to the metal they mine which drives their profits.  That anomaly has to be rectified before this gold bull runs its course.  GGR extremes never last, but see sharp mean reversions and subsequent overshoots eventually.  That will happen as todayís secular gold bull matures in future years.  The gold stocks will far outperform goldís coming uplegs, regaining much lost ground.


No one knows how big goldís bull market will ultimately prove, but itís likely to be very large given the vast monetary inflation the worldís major central banks are spewing into the markets.  But even considering the next upleg alone shows how compelling the gold-stock opportunities are.  This gold bull has enjoyed 3 major uplegs so far, up 29.9%, 20.4%, and 32.4%.  Goldís next major upleg should prove relatively in-line.


While these bull-to-date upleg gains averaged 27.6%, letís conservatively assume 20% for the next one.  If goldís correction extends to 10%, much smaller than that 15.5% bull-to-date average, gold will bottom near $1400.  A 20% upleg from there would carry gold near $1680.  At the current gold-stock bullís super-low GGR of 0.186x, that implies GDX would rally near $29.50.  The gold-price-to-GLD conversion loses 5.8%.


GLDís managers have big costs storing gold bullion, so they charge investors 0.4% of its net assets each year.  Cumulatively since GLDís late-2004 launch, that adds up to about 5.8%.  GDX $29.50 isnít very exciting though, just 7.5% above this weekís levels.  Thatís because GDX would leverage a 10% gold correction by 2x to 3x, extending its own correction to 20% to 30%.  So GDXís next upleg would start off lower.


But on balance during secular gold bulls, gold stocks regain ground relative to gold.  The longer theyíve generally powered higher in a bull uptrend, the more capital speculators and investors deploy in them to chase this sectorís gains.  That leads to much-higher prevailing gold-stock prices.  The gold minersí upside over the coming year if the GGR mean reverts back up to that post-panic 0.381x average is impressive.


At $1680 gold and a 0.381x GGR, GDX would soar near $60.25!  Thatís about 120% higher from this weekís levels, and a whopping 160% higher than where GDX would bottom if its total correction extends to 25% before goldís next upleg starts marching.  With gold stocks remaining so cheap relative to gold today, their upside potential remains massive.  And even these targets are conservative on multiple fronts.


Goldís secular bull is likely to see at least several more major uplegs in coming years, not just one.  And gold stocks not only mean revert in GGR terms, but overshoot proportionally to the high side as euphoria builds late in secular gold bulls.  So if you plug in higher gold prices, and higher GGRs, the potential gold-stock upside targets get astoundingly high.  Remember gold stocksí last secular bull saw epic 1664% gains!


So itís exceedingly important not to make the big mistake most traders do during major corrections.  As gold and gold prices grind lower over a few months or more, traders gradually lose interest.  Apathy mounts leading to gold-stock selling, which is whatís necessary to rebalance sentiment after a major upleg.  By the time gold and gold stocks have bottomed, traders have either moved on or given up on those bulls.


That means they wonít buy low as corrections end, greatly limiting their potential gains in the following uplegs.  The only way to overcome these natural human tendencies is to always follow the markets, to keep the big picture in mind no matter what short-term trends are.  And while todayís remain bearish for gold stocks over the near-term, their deep undervaluation relative to gold implies their bull is still young.


To multiply your capital in the markets, you have to trade like a contrarian.  That means buying low when few others are willing, so you can later sell high when few others can.  In the first half of 2019 well before gold stocks soared higher, we recommended buying many fundamentally-superior gold and silver miners in our popular weekly and monthly newsletters.  We later realized big gains including 109.7%, 105.8%, and 103.0%!


To profitably trade high-potential gold stocks, you need to stay informed about whatís driving broader gold cycles.  Our newsletters are a great way, easy to read and affordable.  They draw on my vast experience, knowledge, wisdom, and ongoing research to explain whatís going on in the markets, why, and how to trade them with specific stocks.  Subscribe today and take advantage of our 20%-off sale!  Get onboard now so you can mirror our coming trades for goldís next upleg after this correction largely passes.


The bottom line is gold stocks remain very undervalued relative to gold.  Theyíve spent most of this bull languishing under stock-panic extremes, which means they still have vast room to mean revert higher.  Such low gold-stock prices compared to prevailing gold levels virtually guarantee the miners will enjoy seriously-outsized gains during future gold uplegs.  They can way-outperform gold for years before normalizing.


But that longer-term super-bullish fundamental outlook doesnít negate the need for periodic corrections to rebalance sentiment.  The recent one is likely still underway today, as key gold and gold-stock indicators have shown no signs of bottoming yet.  Thatís wonderful news if youíre looking to deploy capital in this highest-potential sector, as the next big mid-bull buying opportunity before goldís next upleg is likely still coming.


Adam Hamilton, CPA     December 20, 2019     Subscribe