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Contrarian Gold Stocks

Adam Hamilton
Jan 18, 2013

Before investors can sell high and multiply their wealth, they first have to buy low. The lower any trade's entry price, the greater its ultimate profits. The best time to buy low is when stocks are deeply out of favor, when few others are willing to buy. And that certainly describes gold and silver stocks today. This sector is universally loathed despite fantastic fundamentals, offering vast opportunities for brave contrarians.

Contrarian investing is simple in concept, yet very difficult in execution. The fortunes of stocks flow and ebb, their prices rising and falling. After they've risen, they quickly become popular. Everyone wants them and bids up their prices. That's when it feels the best to buy, so that's when the great majority of investors rush in to chase the rally. But following the herd leads to buying high, the recipe for failure.

Contrarians seek to buy low, which is only possible after stocks have fallen. The very definition of contrarian is "an investor who makes decisions that contradict prevailing wisdom, as in buying securities that are unpopular at the time". But this is very hard psychologically, as fighting the crowd is never easy. All our instincts scream against buying into a sector that the great majority is utterly convinced is doomed.

Nevertheless, that's the surest and safest way to grow your capital as history has proven countless times. Stock prices are the lowest in unpopular left-for-dead sectors. And if their fundamentals remain bullish, there is no doubt they will recover. Contrarians buy low when few others want to, wait for the rest of investors to recognize the value they saw early, and then sell into the subsequent rally for huge profits.

I know fighting the crowd works because I've walked the walk, gradually forging myself into a contrarian through decades of trading. And the results speak for themselves. Since I founded my financial-research company in 2000, we've formally recommended 637 stock trades in our pair of newsletters. Their average annualized realized gains are +33.9%! This includes all losers, in a secular stock bear no less.

And after dedicating much of my life to contrarian trading, I'm marveling at the opportunity in gold and silver stocks today. It is one of the best I've ever seen! This small mining sector wrests precious metals, which remain in high demand globally by investors, from the bowels of the Earth. Gold miners' profits are a direct function of the gold price, and universally in the stock markets profits ultimately determine stock prices.

Yet gold stocks are trading today as if gold was far lower, as if they had little hope of ever earning big future profits. There is a vast fundamental disconnect between these miners and the price of the metal that drives their profitability. This critical point is easily illustrated through a simple construct known as the HUI/Gold Ratio. It divides the premier gold-stock index, known as its symbol HUI, by the price of gold.

Charted over time, this HGR chronicles gold-stock prices relative to the price of gold. Sometimes gold stocks outperform gold pushing this ratio higher, and other times gold outperforms its miners' stocks forcing the HGR lower. The best time to buy gold stocks low and cheap in fundamental terms is when they slump dramatically relative to gold. And today the HGR is actually languishing near stock-panic levels!

Incredibly, the main reason gold stocks are so beaten down today remains 2008's stock panic! That epic fear superstorm was a psychological juggernaut that eviscerated this entire sector, scarring most gold-stock investors of the time so deeply that they would never come back. And so far, not enough new investors have stepped up to take their place. So this sector's constituency remains woefully small.

Before that once-in-a-lifetime stock panic, the HUI spent 5 full years meandering in a tight secular trading range relative to gold. You can see it above, bound by the HGR's lower support line of 0.46x and upper resistance line of 0.56x. The HGR average between mid-2003 and mid-2008 was 0.511x. In other words, the HUI tended to trade at just over half the prevailing gold price. But the panic shattered that norm.

While gold was hit hard too, the gold stocks plummeted far faster than the metal that drives their profits. So the HGR ultimately bottomed in the unbelievable 0.21x range in late October 2008. The HUI had plunged 71% in less than 8 months since its all-time high, so it isn't hard to understand why the gold-stock investors of the time were so demoralized. It was the biggest disaster imaginable psychologically.

But just because stocks are low doesn't mean their prices are justified fundamentally. The heart of contrarian trading is recognizing that popular sentiment swings between extremes like a great pendulum. Near major highs, greed reigns supreme. But near major lows, and the ones in the panic went far beyond major, fear dominates everything. Fear leads to excessive selling, driving stock prices far below where profit fundamentals merit.

If you weren't paying close attention to gold stocks in late 2008, believe me the depth of despair then made today's bearishness look like a picnic. The great majority of investors truly believed this sector was so catastrophically damaged in the stock panic that it would never rise again. But as a battle-hardened contrarian, I sure didn't. Using this same HGR analysis then, we started buying and recommending gold stocks aggressively.

And the resulting profits were mind-boggling. Between October 2008 and the HUI's latest bull-market high in September 2011, this index rocketed 319% higher! Gold stocks more than quadrupled over that post-panic span, more than doubling the underlying gains in gold itself. The very time that gold-stock pessimism was the highest ever seen proved to be the greatest buying opportunity of their secular bull!

The post-panic gold-stock rally was so fast initially that these miners regained much ground relative to the gold price that drives their profits. By late 2009, the HGR was back up near 0.44x. After that it stabilized, consolidating sideways for the next year and a half or so. The gold stocks as measured by the HUI kept on advancing to new all-time highs, rewarding the brave contrarian investors who bought low after the panic.

But psychology was starting to shift again. Gold had soared dramatically in an anomalous summer rally in mid-2011 during the US government's last debt-ceiling debate. Afterwards it was very overbought and a correction was due. As gold started correcting, the still-fragile post-panic gold-stock sentiment crumbled. The gold-stock investors were really worried, and pushed the HUI down faster than gold itself was being sold off.

This bearish psychology ultimately culminated in this past spring's gold-stock capitulation. The HUI was hammered down to 376 as the great sentiment pendulum pegged itself on the extreme fear end of its arc. The emotional selling was so overwhelming that it battered the HGR back down to 0.24x. Gold stocks were back down at levels relative to gold only seen before during 2008's once-in-a-century stock panic!

And that's where today's amazing contrarian buying opportunity in gold and silver stocks was born. The anomalous stock-panic lows led to the biggest gold-stock rally by far of their entire secular bull. And with gold stocks once again at panic levels relative to gold, with fear at a similar extreme, shouldn't they have similar upside potential in the coming years? I certainly think so, and have been hammering home that point since May.

But being bullish on this hated sector is a hardcore contrarian stance. And as the investment world's rebels, contrarians are always ridiculed when we buy low. The great majority of investors want to give in to the excessive fear that spawns fundamentally-unjustified lows, so they look for rationalizations. Mainstream non-contrarian commentators rush to fill this void, dutifully arguing that gold stocks will never rally again.

If you are already a gold-stock investor, you are well aware of the anti-gold-stock arguments permeating this sector. Gold stocks are dead because stock investors are all switching to the GLD gold ETF instead. Gold miners are doomed because they can no longer earn sufficient profits with global mining costs rising. Gold stocks will never regain favor because they can't attract any investors to bid them higher.

The problem is none of this stuff is true! It is all rationalizations, contrived attempts to justify the popular fear and despair plaguing gold-stock investors who crave being accepted by the crowd. As a contrarian speculator running my own financial-research company, I've had lots of time to extensively investigate each major anti-gold-stock argument. And they all quickly crumble, as their roots are fear instead of fundamentals.

On the GLD front, that awesome flagship gold ETF was born in November 2004. Between that day and the HUI's pre-panic all-time high years later in March 2008, the premier gold-stock index surged 115% higher even while GLD's bullion holdings soared around 8000%! Their gains are not mutually exclusive. GLD is great for stock-investor portfolio diversification, but it doesn't leverage gold like gold stocks. It was created for an entirely different constituency.

And on the profits front, our extensive research proves those fears false. After this past May's capitulation, conventional gold-stock valuations as measured by HUI components' price-to-earnings ratios fell to their lowest levels of the entire secular bull. They were much lower than during the stock panic, and even lower than broad general-market valuations as measured by the S&P 500 components!

Gold and silver stocks are earning big profits with prevailing gold and silver prices so high. We've been buying high-potential small miners in recent months that actually had P/E ratios around 10x earnings! All the anti-gold-stock arguments emotional investors are using to attempt to justify their own fear are unfounded rationalizations. The majority always hates and argues against heavily beaten-down sectors.

But contrarians don't blindly buy into conventional wisdom, we have to do our own research in order to be brave and tough enough to buy low when few others will. And not only does the HGR now reveal one of the best contrarian gold-stock buying opportunities since 2008's crazy stock panic, the gold-stock performance trends are already subtly improving. This final HGR chart zooms into just the post-panic period.

After the HGR plunged to panic levels during this past spring's brutal gold-stock capitulation, it has since been bottoming and climbing. There is a new support line buttressed in the last couple months, an HGR uptrend that is holding despite the rotten psychology plaguing gold since late November. Even with the incredible bearishness permeating this sector, the HGR has risen on balance for over 8 months now.

Note above that this is easily the longest period of gold-stock outperformance relative to gold since the HGR's post-panic uptrend failed back in mid-2011. Psychology is stealthily changing in gold-stock land. The vast majority of the older emotional investors who drove this sector's recent capitulation are gone, leaving newer stronger investors who better understand the bullish fundamentals of gold and gold stocks.

So even as gold weathered heavy fund selling in recent months triggered by fiscal-cliff tax-hike fears, the beaten-down HUI largely held its own. Gold stocks have certainly been weak, but nowhere near as weak as they could have been in light of the relentless gold selling. A new cadre of contrarian investors has been establishing positions in gold stocks with their recent panic-like prices, buying low and holding.

And we are certainly among them. It isn't easy psychologically buying gold stocks near panic levels relative to gold, but that is the contrarian path to huge future gains. It is kind of funny too, as the anti-gold-stock crowd often looks no farther than the HUI to claim gold stocks are garbage. But we are already enjoying solid gains in many of our trades despite the headline HUI lollygagging along near support.

Even this week with the HUI merely near 430, we are seeing great gains in some of our elite gold and silver stocks. A silver stock we bought in May had 57% unrealized gains. A gold stock we bought in late July was already up 125%. And a couple silver juniors we only bought in mid-December were already both up over 40%. Buying low when stocks are wildly unpopular starts yielding gains well before the crowd catches on!

If gold-stock fundamentals reassert themselves as they ought to, if the gold-miner stock prices ultimately reflect their underlying profits streams driven by prevailing gold prices, then sooner or later enough new investors will enter this sector to catapult the HUI back to its pre-panic relationship relative to gold. That was that 5-year secular-average HGR. This second chart shows where the HUI would be at 0.511x the price of gold.

It's the yellow line above. At today's gold prices, which most investors have conditioned themselves to believe aren't that great, the HUI would need to soar to 859 to trade at its pre-panic-average relationship with gold. That is a double from current levels, a staggering gain! Interestingly the gap between where the HUI is trading today and where it would be at this bull's pre-panic-average HGR is back near panic extremes.

And that panic anomaly happened to be the best gold-stock buying opportunity of this entire secular bull, leading the HUI to more than quadruple in the subsequent years. Could that happen again from the recent spring lows? Absolutely! Universally in the stock markets, stock prices are ultimately bid up to reflect their underlying profits. And high gold prices drive big profits for the best gold-mining companies.

Importantly for this loathed sector, underlying profit fundamentals always trump sentiment in the end. Even if most investors who once owned gold stocks are too discouraged today to ever come back, other investors will gradually learn about this sector and deploy capital in it for the first time. New investors, led by the vanguard of brave contrarians chasing this extraordinary opportunity, will more than replace the fallen.

And it's not like the gold price will be static in the coming years, its secular bull will continue powering higher on great fundamentals. This will both accelerate the migration of new capital into gold stocks and expand their profits so they are ultimately bid to much higher levels than today's gold prices would support. And the elite hand-picked miners with the best fundamentals will see gains dwarfing those of the headline HUI.

Gold stocks today are an incredible contrarian opportunity. I don't know of any other sectors that are so radically undervalued, unpopular, and ripe for discovery by mainstream investors. Sooner or later their stock prices will be bid up to reflect the large profits the high prevailing gold prices drive. And the early contrarian investors will see massive gains, just like we did after the last time gold stocks fell so deeply out of favor.

If you have cultivated the mental toughness necessary to be a contrarian, you ought to join us. At Zeal we've been buying elite gold and silver stocks aggressively since the spring capitulation. We are already seeing big gains on some, even with the HUI languishing near lows. And as the great sentiment pendulum gradually swings back from extreme fear towards extreme greed, gold-stock prices will explode higher.

You too can easily share in the profitable fruits of our research. We spend months at a time researching the entire population of certain groups of stocks, like silver juniors most recently. Then we whittle them down to our dozen fundamental favorites and profile each winner in fascinating reports. If you want to quickly get up to speed on the high-potential gold and silver stocks with the best fundamentals, buy some reports today!

We also publish acclaimed weekly and monthly subscription newsletters for speculators and investors. In them I draw on our vast experience, knowledge, wisdom, and ongoing research to explain what is going on in the markets, why, and how to capitalize on it with specific contrarian stock trades as opportunities arise. Subscribe today and bring decades of proven contrarian acumen into your corner!

The bottom line is gold and silver stocks now offer one of the greatest contrarian opportunities seen in years. Sentiment has swung so far to the fear extreme that even in the midst of a powerful secular gold bull the gold miners' stocks have been left for dead. A whole cottage industry has sprung up to rationalize these fears, trying to convince investors they are right in believing gold stocks are doomed.

But contrarians know the best times to buy low are when sectors with outstanding fundamentals slump to great unpopularity. The markets are ever-cyclical, so sentiment extremes never last for long. As the fear washes out old investors, new investors soon flood in to chase the resulting bargains. This ignites major rallies that ultimately attract in mainstream investors, leading to huge gains as contrarians sell high.


Jan 18, 2013
Adam Hamilton, CPA

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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