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Gold-Miner Valuations

Adam Hamilton
Jan 24, 2020

The gold miners' stocks have spent the past half-year mired in a high consolidation. They haven't been able to break out, but aren't breaking down either. This technical purgatory is working to slowly bleed off overboughtness and rebalance sentiment. This necessary process to eradicate greed from the last upleg peak is never exciting. But today's low gold-miner valuations reveal great upside potential in their next upleg.

The world's leading and dominant gold-stock trading vehicle and benchmark is the GDX VanEck Vectors Gold Miners exchange-traded fund. It commanded $13.2b in net assets in the middle of this week, 2.7x larger than its next-biggest competitor GDXJ. The major gold miners' stocks included in GDX soared this past summer, blasting higher after gold's decisive breakout to its bull market's first new highs in several years.

GDX's strong 29.0% surge over the next 2.5 months into early September capped a larger 76.2% upleg over 11.8 months. Naturally last summer's sharp rally generated much excitement and greed in this small contrarian sector. So the gold stocks needed to correct or consolidate, either selling off deeply enough or drifting sideways long enough to restore sentiment balance. Excessive greed is inherently unsustainable.

So after peaking at a 3.1-year high of $30.95 in early September, GDX initially started correcting with a 15.4% retreat over the next 1.3 months. That's really small as far as gold-stock corrections go, as this bull's prior two averaged 35.4% GDX losses over 11.8 months! And this sector as measured by GDX had shown no major technical bottoming signals, like falling back to or under its key 200-day moving average.

But since then that proto-correction morphed into a high consolidation. After that mid-October correction low, GDX spent the next couple months meandering between $26 to $28. Gold breaking out of its own correction downtrend on Christmas Eve unleashed enough gold-stock buying to fuel a parallel breakout by the miners. GDX surged as high as $29.50 on close, and since then has mostly drifted from $28 to there.

This chart shows the past half-year's correcting and consolidating price action within the context of this broader gold-stock bull. This sector remains in a technical no man's land, neither correcting far enough nor drifting long enough yet to signal all-clear. This leaves a glass-half-full-or-half-empty thing, with gold-stock outlooks something of a Rorschach Test for traders. This setup can be used to argue their own biases.

The bulls rightfully point to impressively-resilient major gold stocks holding most of last summer's massive gains. The bears highlight the equally-valid fact GDX has totally stalled out for nearly 5 months, failing to advance despite gold's recent major new secular highs. Odds are goldis going to prove the arbiter of what this sector does next. The gold stocks are ultimately leveraged plays on gold, amplifying its fortunes.

Gold itself has two dominant primary drivers, speculators' gold-futures trading and investment buying. In recent weeks I've written extensively about both. Specs' collective positioning in their hyper-leveraged gold futures is effectively all-in. Their long bets are way up at all-time-record highs, while their short-side bets are down near gold-bull lows. Thus their capital firepower for buying more is effectively exhausted.

These influential traders remain far more likely to sell big to unwind these excessively-bullish bets than to buy materially more. Identifiable gold investment demand has been mostly weak on balance too ever since September when gold's last upleg initially crested. While gold powered to new highs earlier this month on that flaring conflict between the US and Iran, they didn't hold since specs and investors weren't buying much.

Whatever gold does next is absolutely critical for gold stocks' near-term outlook. Over 80%of individual gold-stock price moves are driven by gold's own trends. Gold is the tide the gold-mining boats rise and fall on as a fleet. Fundamentally-superior gold stocks can outperform their sector when gold is rallying in uplegs, but they still fall with their peers when gold is correcting. Gold stocks need gold buying to advance.

Gold-futures speculators need to somehow keep adding bullish bets even from near-record levels where they are tapped out. Gold investors need to flood back in despite the general stock markets levitating to all-time-record highs spinning off great euphoria. These are both tall orders, with major selling from both key camps much more likely than material additional buying. So it's prudent to stay wary on gold stocks here.

That caveat understood, the major gold miners' fundamentals look excellent. From a high level this is a simple business financially. The miners wrest all the gold they can from the bowels of the Earth, then sell it at whatever the markets offer. The difference between prevailing gold prices and their total extraction costs is their profits. The more gold they can produce, and the higher they can sell it for, the better their earnings.

The best widely-adopted measure of gold-mining expenses is all-in sustaining costs. AISCs include all direct cash costs, as well as everything else necessary to maintain and replenish operations at current gold-production levels. After every quarterly earnings season, I dig deeply into the AISCs of the major and larger-mid-tier gold miners included in GDX. The latest read came from Q3'19 results in mid-November.

The top 34 GDX gold miners collectively commanding 94.1% of this leading ETF's overall weighting had average AISCs of $910 per ounce in that latest reported quarter. Q3's numbers will remain the most recent for some time yet. Q4 results typically take an additional month or so to release, since they included audited full-year numbers. So the next round of gold-miner AISCs won't be fully out until mid-March.

The last 4 reported quarters of GDX average AISCs ran $889, $893, $895, and $910. That averages out to $897 per ounce, which we may as well round to $900. Gold-miner valuations, how cheap or expensive their stock prices are, are partially determined by their mining costs relative to prevailing gold price trends. This spread drives their earnings, and ultimately their stock prices gravitate to some reasonable multiple of those.

In Q3'19 gold averaged $1474 per ounce, while again the GDX gold majors' AISCs averaged $910. That implies industry earnings of $564 per ounce! That makes for massive 38% profit margins, very-high levels most other industries would kill for. That was a radical increase thanks to gold's powerful bull-breakout surge into that quarter. In Q2'19, gold's far-lower $1309 average price yielded much-lower earnings.

That quarter the GDX majors' AISCs averaged $895, implying $414 profit margins. Thus Q3's soared a massive 36.2% sequentially on 12.6%-higher average gold prices quarter-on-quarter! There's no doubt gold stocks' strong upleg ending in early September was fundamentally-righteous. The year-over-year comparisons are even more stunning. Back in Q3'18, gold was averaging just $1211 emerging from major lows.

The GDX gold miners' average AISCs that quarter ran $877, implying industry profit margins of $334 per ounce. So year-over-year the major gold miners dominating GDX saw their earnings skyrocket 68.9% on 21.7%-higher average gold prices! Yet despite gold stocks' strong upleg, they still didn't rally enough to reflect such amazing profits growth. GDX's average price from Q3'18 to Q3'19 merely climbed 40.1%.

The gold miners' stocks arguably didn't climb high enough in their latest upleg to adequately reflect their radically-better fundamentals. That certainly left them undervalued at early September's GDX peak. And that trend has persisted. Gold largely consolidated high in Q4'19 instead of correcting following its own mighty upleg, the strongest of its bull so far. That made for even-higher average gold prices of $1483 last quarter.

Assuming GDX AISCs remain around their average $900 level, that implies the gold miners ought to be reporting profits around $583 per ounce in Q4. That's even better than Q3's despite gold stalling out, and a staggering 72.0% higher YoY from Q4'18's levels! And while Q1'20 remains very young, thanks to that US-Iran geopolitical spike gold is averaging a much-higher $1554 so far. Gold-mining earnings are strong.

Obviously if gold rolls over into a correction this quarter, these hefty profits will fade fast. The major gold stocks of GDX generally leverage material gold moves by 2x to 3x, because their earnings have similar leverage to gold prices. Another important factor to consider is gold-production levels. Overall earnings depend not just on the spread between prevailing gold prices and AISCs, but how much gold the miners harvest.

In such a capital-intensive industry where mines are nearly always operating 24x7x365, you'd think their collective output would be fairly constant. Interestingly enough, it's not. The major gold miners' outputs vary considerablyquarter to quarter! This is readily evident in the global gold production data from the venerable World Gold Council. Each quarter it publishes the best fundamental data available on gold.

The new Q4'19 Gold Demand Trends report hasn't been released yet, they are typically published just over a month after quarter-ends. But the decade of quarterly GDTs before that reveals fascinating gold-production trends. Sequentially from the prior quarter, Q1s, Q2s, Q3s, and Q4s have averaged global gold output growth of -7.5%, +5.1%, +5.0%, and +0.5%! That variability is enormous and unexpected.

Q4s' gold production dominated by the major gold miners tends to only rise slightly. That's good news for the upcoming Q4'19 results. With mostly-flat production, the earnings picture painted by the gold-AISC spread remains valid. The major gold miners dominating GDX should report outstanding earnings in their Q4 results. That will contribute to gold stocks looking better fundamentally, more undervalued, in coming months.

But their Q1'20 production, which will be fully reported by mid-May, is far more problematic. That is likely to drop sharply from Q4'19's, with Q1s averaging -7.5% QoQ! And that Q1 plunge over the past decade or so isn't the result of outliers. The raw data since Q1'11 shows Q1 sequential global-gold-mining-output drops of -7.2%, -6.9%, -7.4%, -11.0%, -9.4%, -3.5%, -8.7%, -6.2%, and -6.8%! That's certainly a tight grouping.

Last summer I explained what's likely driving this Q1-drop phenomenon in another essay. In a nutshell mine managers are choosing Q1s to take production hits from running lower-grade ores through their mills, and scheduling temporary shutdowns then for maintenance and expansions. Winter weather creates operational challenges too, with the majority of the world's land masses and gold mines in the northern hemisphere.

Another Q4-to-Q1 production slump is almost certain this year, which will push down gold-miner earnings and thus raise valuations. While the miners won't report any Q1 production results until early April at best, there could be selling in anticipation of this slump. That could exacerbate any gold-stock correction driven by gold rolling over into its own correction, temporarily tarnishing perceptions of gold-stock valuations.

Gold-stock price levels are ultimately dependent on underlying corporate earnings. And they in turn are driven by prevailing gold prices. The higher those are, the bigger the profit margins after all-in sustaining costs are paid. So the core valuations of gold miners' stocks can be distilled down into their relationship with gold prices. This shortcut bypasses the voluminous and tedious research work analyzing quarterly results.

The ratio between gold-stock price levels and prevailing gold prices can be expressed in the GDX/GLD Ratio, or GGR. It simply divides the daily close of this leading GDX gold-stock ETF by the daily close in the massive and dominant GLD SPDR Gold Shares gold ETF. Charted over time, this valuation proxy reveals whether gold stocks are getting more expensive or less expensive relative to the metal they mine.

This chart superimposes the GGR over the raw GDX through this entire secular gold-stock bull. When the GGR is rising, the gold stocks are outperforming gold. After spending the better part of 2017 and 2018 stuck in a downtrend where relative gold-stock valuations were falling, they finally started recovering in this latest upleg. It began back in mid-September 2018, when the GGR fell to 0.155x which was a 2.6-year low.

As GDX powered 76.2% higher over the next 11.8 months, gold stocks regained much lost ground relative to the metal which drives their profits. That's normal during gold uplegs. The GGR peaked the same day GDX did in early September 2019, hitting 0.211x. Ever since it has ground sideways to lower, just like the gold stocks. This gold-stocks-to-gold ratio offers some important insights on today's gold-stock valuations.

While GDX's last upleg peaked in early September, the gold miners' advance relative to gold stalled out nearly 7 weeks earlier in mid-July! From then on, the gold stocks were just pacing gold's gains rather than amplifying them by 2x to 3x like usual. A couple factors likely contributed. This summer's powerful gold-stock rally started in late May, but GDX didn't break out above its multi-year $25 resistance until late June.

Gold-stock speculators and investors remained skeptical of that surge initially, which is understandable after GDX failed multiple times at $25 since late 2016. Just 2.5 months elapsed between gold's decisive bull-market breakout in late June and its upleg topping in early September. That's not enough timeto reverse great apathy and lingering doubt fueled by several years of gold stocks grinding sideways to lower.

Although gold-stock psychology was rapidly improving in July and August, it hadn't shifted deep enough back into greed yet to fuel outsized gold-stock gains. That gold breakout happened at an unfortunate time too. Summers tend to be weak for gold seasonally, leaving prudent gold-stock traders more wary of that upleg than they'd be at other times of the year. And July and August are peak summer vacation months.

So the gold miners didn't have their full constituency watching and joining in during that usually-lethargic summer-doldrums span. Had that same GDX rally happened in October or November, it would've grown much larger with multiples more traders paying attention and chasing it. That gold-stock surge happened at the wrong time to attract enough capital to get really big. And then it was truncated prematurely by gold.

Gold faced a massive gold-futures-selling overhang in early September, which I warned at the time. The gold-futures speculators who dominate its short-term price action were effectively all-in, with longs near record highs and shorts very low. Their buying firepower was exhausted, their finite capital fully deployed. So they couldn't keep piling in even if they wanted to. Thus gold's upleg stalled and peaked, and GDX followed.

Ominously the spec gold-futures situation in recent weeks is even more extreme than early September's! That's the highest-octane argument for gold and gold stocks to correct deeper from here rather than continuing to consolidate high. But back to the last upleg peak, the major gold miners' stocks never got to overvalued levels relative to gold. Last summer's 0.211x GGR high was really low for a major upleg topping.

Back in early August 2016 when this gold-stock bull's maiden upleg peaked, the GGR blasted higher to 0.244x. Had this latest upleg seen a similar gold-stock valuation, GDX would've soared to $35.78 instead of $30.95! That probably would've happened if that gold-stock surge had occurred in a better time of the year and lasted a few months longer. Gold stocks never getting overvalued supports this high consolidation.

But if the massive pent-up gold-futures selling forces gold to deeper correction lows in the coming weeks or months, the gold stocks have plenty of room to fall. This week's GGR of 0.196x isn't high at all in an absolute sense, but it remains above this 4.1-year-old gold bull's 0.187x average. The GGR could very well see a support approach before the next gold-stock upleg, and that's running down near 0.183x now.

In order to return to those kinds of GGR levels at this week's gold prices, GDX would have to retreat 6.9% from here. That's material downside. And if gold itself corrects, the GGR-support target naturally gets proportionally lower. At worst after its latest upleg, gold had only corrected 6.4% over 2.7 months by late November. This gold bull's prior couple corrections averaged much-larger 15.5% selloffs over 6.0 months!

So if the massive gold-futures-selling overhang forces gold a relatively-modest 10% lower from its latest early-January peak, gold and GLD would fall back to $1415 and $133.17. At that GGR-uptrend-support level of 0.183x, that implies GDX dropping to $24.37. That's plenty serious, another 15.5% lower from this week's levels making for a total gold-stock correction of 21.3%. Gold-stock downside risk remains.

Gold stocks never got overvalued relative to gold in their last upleg, and are still cheap relative to gold on a long-term basis. From 2009 to 2012 in those last quasi-normal years after 2008's stock panic but before the Fed's extreme stock-market levitationsgutted gold investment demand, the GGR averaged 0.381x! But over the coming weeks and months, gold stocks still have room to correct even from low valuations.

Ultimately the gold stocks will gravitate to reasonable multiples of their underlying earnings, which means far-higher stock prices given their hefty profits today. Valuations drive long-term stock prices. But over the short-term, sentiment always trumps valuations. So if gold corrects more deeply on that enormous gold-futures-selling overhang, the gold stocks will fall with it. Thus it's prudent to remain cautious given this setup.

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The bottom line is gold-miner valuations remain quite low. Last summer's gold-stock upleg was truncated prematurely before gold stocks' strong leverage to gold hit full stride. So the gold miners' stocks failed to reach overvalued levels relative to gold, helping them consolidate high since. And on a long-term basis, the gold stocks are still cheap compared to the metal they mine which overwhelmingly drives their profits.

The hefty gold-mining earnings are likely to grow even larger in Q4 results. But near-term downside risks still abound given speculators' excessively-bullish positioning in gold futures. Gold stocks will follow and amplify gold's price trends, regardless of their fundamentals. But once gold-futures selling normalizes the specs' bets, the gold stocks ought to be screaming buys ahead of gold's next upleg. Be ready to deploy for that.


Jan 24, 2020
Adam Hamilton, CPA

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