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Gold-Stock Upside Targets

Adam Hamilton
Feb 12, 2016

The gold miners' stocks are rocketing higher again, multiplying wealth for smart contrarian traders who bought them low in recent months. But after such a blistering surge, traders are naturally wondering how much farther gold stocks can run. Is it time to realize gains, or buy aggressively for greater gains to come? This critical question can be answered by looking at fundamentally-derived gold-stock price targets.

Many analysts shy away from offering price targets, with good reason. Divining precise future outcomes in volatile markets is all but impossible. Prevailing stock prices result from the chaotic interplay between sentimental, technical, and fundamental drivers. And an effectively-infinite array of variables can affect each one, making forecasting stock prices a fool's errand. Nevertheless, this exercise is absolutely necessary.

Like many things in life, the markets are an inherently-unpredictable probabilities game. Even if fantastic research suggests some outcome has 80% odds of coming to pass, there's still a 20% chance it won't. But a lot of traders read forecasts as if they were advertised as a 100% chance, ridiculing the analyst if events don't play out that exact way. Weather forecasters struggle with this psychological bias all the time.

Most market price targets emerge from technical analysis, looking at chart patterns to extrapolate trends into the future. Price action considered over time indeed reveals a great deal about traders' sentiment and likelihood to keep on buying or selling the way they have been. But as any honest technician will quickly admit, technical analysis is often highly subjective. Price charts are interpreted like Rorschach tests.

So for gaming gold-stock price targets, I prefer a fundamentally-based approach. Fundamentals in the stock markets revolve around underlying corporate profits. And all stocks ultimately gravitate towards some reasonable multiple of their companies' earnings. This is true in every sector including the gold stocks. And from a profits-fundamentals perspective, the gold-mining industry is exceedingly simple.

Gold miners painstakingly wrest gold from the bowels of the Earth, and then sell it for prevailing gold prices. Thus their profits are merely the difference between the gold price and their production costs per ounce. So once you know this industry's cost structure, it's easy to calculate how much gold stocks are likely to rally with any given gold-price increase. Gold's price is their overwhelmingly-dominant earnings driver.

The world's major elite gold miners are all included in the flagship GDX Market Vectors Gold Miners ETF. Like all public companies, these GDX component stocks report their financial results to investors once per quarter. These comprehensive reports are a treasure trove of fundamental data that includes production-cost information. Crunching this for all the GDX components yields representative industry-wide metrics.

For reasons I've never been able to fathom, the gold miners tend to report 4 to 7 weeks after quarter-end. So the Q4 data isn't all in yet, but I hope to publish a comprehensive analysis on it in the coming weeks. The latest full quarterly data from the gold miners is still the third quarter of 2015's. And during that quarter the elite major companies included in GDX reported average all-in sustaining costs of $866 per ounce.

All-in sustaining costs are a relatively-new construct the World Gold Council introduced in June 2013. Unlike traditional cash costs, AISC include all the costs necessary to maintain and replenish existing production levels. This includes mining costs, corporate-level administration, exploration, mine development and construction, remediation, and reclamation. AISC include everything necessary to sustain gold output.

Gold has been deeply out of favor for years thanks to the Fed's surreal stock-market levitation sucking capital away from alternative investments. And that gold antipathy climaxed in mid-December the day after the Fed's first rate hike in 9.5 years when gold plunged to $1051. That was a dark day for the gold stocks, which languished just above mid-November's 13.3-year secular low per the HUI gold-stock index.

This entire sector was trading at stock prices last seen in July 2002 when gold was trading near $305 and had yet to exceed $329 in its young secular bull. Yet even at $1051 gold, this industry was earning $185 per ounce with its average all-in sustaining costs of $866! So those dire left-for-dead gold-stock price levels were truly fundamentally-absurd, as I argued aggressively in July, November, and January.

There was no doubt that gold stocks eventually had to return to some reasonable multiple of underlying corporate profits. And as gold inevitably rallied in a major new upleg as I predicted in late 2015, profits for mining this metal would explode higher. Again the fundamental math is very simple, and critical for all investors and speculators to understand. As of this essay's Wednesday data cutoff, gold had surged to $1197.

Gold-mining costs are essentially fixed when mines are designed and built, so gold-price increases flow directly to the bottom line. At those same industry-wide all-in sustaining costs of $866 per ounce, $1197 gold yielded profits of $331 per ounce. Gold's impressive 13.9% rally in 7 weeks since mid-December translated into a radically-larger 78.9% increase in gold-mining profitability! Gold is always gold stocks' key.

The easiest way to abstract this dominant core fundamental relationship between gold prices and gold is through the HUI/Gold Ratio. The HGR divides the daily HUI close by the daily gold close and charts the results over time. When the HGR is rising, gold stocks are outperforming gold. This generally happens during gold rallies. And when the HGR is falling, gold is outperforming the gold stocks. That happened for years.

Ever since 2008's once-in-a-century stock panic, gold-stock prices have been falling relative to gold on balance. Gold stocks have lost ground relative to the price of the metal which drives their profits for 7.5 years. Provocatively in the initial years after that stock panic, that was despite the HUI soaring 319.0% higher out of those deep late-2008 lows over the next 2.9 years. Gold stocks were falling out of favor.

But all markets are forever cyclical, no trend lasts forever. So as long as the gold-mining industry could remain profitable at prevailing gold prices, a major mean reversion higher in gold stocks was inevitable. Gold stocks had to return to their historical pattern of flowing-and-ebbing performance relative to gold instead of recent years' one-way anomaly. And that reversal I'd forecast erupted with a vengeance in 2016.

Gold stocks are finally returning to favor again, and radically outperforming gold coming off such crazy-extreme lows. In just 4 trading days ending Monday, the HUI skyrocketed 24.7% higher on a 5.5% gold rally! This incredible 4.5x gold-stock leverage is well above the norm of 2x to 3x. It's the result of gold stocks being unjustly and irrationally hammered down to such fundamentally-absurd price levels in late 2015.

After such an anomalous secular period of gold stocks underperforming gold, they are long overdue to outperform gold for years to unwind this gross Fed-conjured distortion. And since the HUI/Gold Ratio approximates that critical core fundamental relationship between gold prices and gold-mining profits, it can provide solid gold-stock price targets. The key is to define some normal level for the HGR to mean revert to.

For 5 full years prior to 2008's epic stock panic, the HGR averaged 0.511x. The HUI generally traded at about half the prevailing gold price. This relationship persisted through all kinds of gold environments, both major uplegs and corrections. While I strongly suspect the HGR will eventually mean revert back up to this pre-panic secular average, almost no one else does. So a more-conservative HGR target is in order.

That stock panic pummeled the HGR to an incredible 7.5-year low, which was utterly unsustainable as I argued at the time. And indeed gold-stock prices would more than quadruple over the subsequent several years, earning fortunes for brave contrarians who bought them low. During the 4 years after that stock panic, from 2009 to 2012, the HGR settled in at a new 0.346x average. Those were the last “normal” years.

Early 2013 saw the Fed ramp its wildly-unprecedented open-ended third quantitative-easing campaign to full steam. Unlike QE1 and QE2, QE3 had no predetermined size or end date. Fed officials brazenly used this ambiguity to their advantage, quickly responding to every stock-market selloff by proclaiming the Fed was ready to expand QE3 if necessary. Traders interpreted this as a Fed Put, it levitated stock markets.

With stocks seemingly doing nothing but rally indefinitely courtesy of the Fed, investors quickly lost all interest in alternative investments led by gold in early 2013. It was dumped with reckless abandon, and the years since were totally fake and artificial in both stock markets and gold. So the only normal span in recent years ran between 2009 and 2012, sandwiched between that stock panic and QE3's epic distortions.

With QE3's new buying long done, and the Fed's parallel zero-interest-rate policy finally slain in December, there's no reason not to expect markets to return to pre-QE3 normal levels before 2013. So seeing the HGR mean revert back up to its initial 4-year post-panic average is an ultra-conservative and near-certain bet to make. That's such a low HGR level relative to history it is actually pretty bearish to expect!

Yet at $1200 gold and that 0.346x post-panic-average HGR, we are looking at a fundamentally-derived HUI price target of 415. That's another 179% above this Wednesday's close, and would see the HUI more than quadruple again off its recent fundamentally-absurd lows as I predicted late last year when everyone still hated gold stocks. Gold mining's huge 39% profit margins at $1200 certainly support such prices.

The incredible fundamental upside potential the gold-mining sector still offers is even more apparent if we zoom in to the bottom-right corner of the long-term HGR chart. This next chart looks at the HGR and HUI over just the past couple years or so. It also includes a hypothetical HUI in yellow, illustrating where the HUI would be trading at that post-panic-average 0.346x HGR that looks exceedingly easy to return to.

It's impossible to overstate just how much things have changed in gold stocks in the past couple months, where they've gone from the most-despised sector on the planet to the best performers by far in 2016. Out of their final fundamentally-absurd capitulation low in mid-January, as of Monday the HUI rocketed 51.2% higher in less than 3 weeks on a 9.5% gold rally! This extreme buying surge proves trends have changed.

Both the HUI and HGR are now carving higher highs in recent months, and gold stocks are radically outperforming gold again as investment capital returns. It's not a stretch at all to see these HGR gains extending back into this critical fundamental ratio's early-2015 uptrend and then the 2014 one above that. The great majority of 2015's HGR damage has already been erased in a matter of weeks, it's incredible.

As this battered HGR inevitably continues mean reverting higher on balance, the HUI will narrow the gap between where it's trading today and where it would be trading at that post-panic-average 0.346x HUI/Gold Ratio. The red actual-HUI line will converge with the yellow hypo-HUI line. That means a heck of a lot of gold-stock buying is left to come, that gold stocks' new upleg is merely getting underway.

And for a variety of important reasons, that 415 HUI target based on this HGR analysis is exceedingly conservative. It makes two assumptions that are extremely unlikely to prove true, that gold won't rally beyond $1200 and that the HGR's mean reversion will magically stop at that post-panic average. The fundamentally-based gold-stock upside targets shoot far higher when more realistic outcomes are considered.

As I pen this essay Thursday, gold is trading at $1255. After years of gold languishing in hyper-bearish sentiment wastelands while the Fed levitated stock markets, today's levels certainly feel high. But they really aren't at all. In 2012 which was the last year before QE3's extreme distortions, gold's average price was way up at $1669. And 2012 wasn't even a topping year, but a grinding consolidation one for gold.

If gold merely mean reverts back up to $1669, which is way under its $1894 August 2011 peak carved before the subsequent years of trillions of dollars of pure Fed inflation, the gold stocks are destined to soar far higher. At $1669 gold, the miners would earn $803 per ounce in profits at the current average AISC of $866! That's 143% higher than today's profitability, which would fuel massive stock-price gains.

At that post-panic-average HGR of 0.346x and 2012's average $1669 gold, we'd be looking at a HUI upside target of 577. That's another 288% higher from this Wednesday's levels! But after any extreme central-bank-conjured market anomaly, mean reversions are vastly more likely to overshoot than just magically stop at the averages. And these overshoots tend to be proportional to the preceding extreme.

The HUI/Gold Ratio hit its all-time low of 0.093x in late September, and revisited that same extreme level in mid-January. That is 0.253x away from that post-panic-average HGR of 0.346x. A completely-normal proportional HGR overshoot would briefly drive the HGR that much above its mean, to 0.599x. That isn't unprecedented, as the pre-panic years saw such HGR levels hit multiple times when gold stocks were in favor.

At that 2012 average $1669 gold and a proportional-mean-reversion-overshoot 0.599x HGR, we'd be looking at a HUI right at 1000! While such levels wouldn't last for long since they'd require extreme popular greed proportional to the extreme herd fear of late 2015, they illustrate the gold stocks' truly-epic upside potential after being artificially battered down for so many years during the Fed's stock levitation.

Now right now today, believing that HUI 1000 is even possible isn't relevant at all. Since the HUI's all-time high was just 635 in September 2011, you may think 1000 is crazy talk. That's fine. All that matters now is whether or not you believe gold stocks can mean revert to those post-panic-average levels relative to the price of the metal that drives their profits. Remember at just $1200 gold, that implies 415 on the HUI!

And with the HUI trading around 150 this week, if you believe there's any chance we'll see 400 again you ought to be aggressively buying gold stocks hand over fist. After spending the past 16+ years as a hardcore full-time contrarian student of the markets and speculator researching and trading gold stocks, few people in the world know more about this forgotten sector than me. I'm convinced HUI 400 is trivial to attain.

A conservative timeframe for the HUI regaining 400, nearly tripling gold-stock traders' wealth from even today's post-surge gold-stock levels, is during the next year or two. And with the general stock markets nosing over into their long-Fed-delayed cyclical stock bear, is there any other sector in all the markets with upside potential to rival the gold stocks? Literally everything else stands to get pummeled in this bear.

So if you're watching gold stocks soar from the sidelines and wondering if it's too late to get deployed, the fundamental answer is heck no! Gold stocks were beaten down to such fundamentally-absurd price levels late last year that they have a vast amount of rallying left to do merely to return to some semblance of normalcy. As always, this mean-reverting sector can be gamed with that GDX gold-stock ETF and its call options.

But also as always the best gains won't come from this sector as a whole, but from the elite gold (and silver) miners and explorers within it with the best fundamentals. An expert-picked portfolio of these winners will trounce the broader sector gains mirrored by GDX. While it's too late to spend tens of thousands of hours researching gold and silver stocks, it's not too late to lean on that hard work already done by others.

As zealous contrarians, we've long specialized in gold-stock research and trading at Zeal. And unlike the great majority of analysts, we kept on studying and learning in the recent dark years instead of giving up and walking away. That makes our hard-won knowledge unparalleled and exceedingly valuable, as we won't have to spend years getting back up to speed. You need priceless expertise like this in your corner.

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The bottom line is gold stocks' upside remains vast even from here. Ultra-conservative fundamentally-derived gold-stock upside targets show this sector is still due to nearly triple from here even after this month's extreme gold-stock rally. After being battered down to such fundamentally-absurd price levels late last year, gold stocks have a long ways yet to rally merely to return to some semblance of normalcy.

And using far-more-realistic assumptions including gold continuing its own mean reversion higher and the gold-stock mean reversion overshooting, the gold-stock upside targets rocket far higher. The gold stocks are offering a rare opportunity to greatly multiply wealth even during a major cyclical stock bear. As always the earliest buyers will reap the greatest gains, with smart and brave contrarians massively rewarded.


Feb 12, 2016
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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