Gold-Stock Panic Levels
The beleaguered gold stocks have spiraled lower this month, heaping misery on poor fools like me naive enough to invest in them. Dwindling interest and capital has left this realm a desolate wasteland, I've rarely seen anything so deeply out of favor. In fact, relative to gold the gold stocks are now back down to levels only seen briefly during 2008's epic stock panic! Are they dying, gasping their last breath?
This question has enormous implications for speculators and investors. If gold stocks are doomed to never rally again, we ought to cut our losses and move on. But if this embattled sector is likely to return to favor in the near future, then its current extreme malaise is an incredible contrarian buying opportunity. The more any sector is loathed and forgotten, the more potential its stock prices have for massive rallies.
As I ponder this vexing puzzle, my mind keeps returning to how the stock markets in general work. Any stock is ultimately a fractional share of its underlying company's future profits stream. If those profits are high or rising relative to the stock price, investors bid up the stock to reflect its underlying economic reality. Over the long term, the markets eventually price all stocks to fairly represent their profits.
And despite the many challenges of mining gold, profits are rising dramatically. My business partner Scott Wright recently updated his fascinating research thread proving this. By painstakingly analyzing detailed data from individual major gold miners collectively representing nearly half of global mined production, it is apparent gold-mining profits are amazing. Last year the average gross margin of this elite group ran $915 per ounce, or an astounding 58%! Gold miners are making money hand over fist.
As long as such fat profit streams continue, the immutable law of long-term stock pricing guarantees gold stocks will eventually be bid up to reflect their earnings. The only way today's brutally-cheap prices make sense fundamentally is if gold is on the verge of a serious collapse. The price of gold is everything for the gold-mining business, strictly controlling the profitability limits of mining this scarce metal.
Gold is so dominantly central to this sector that its stock valuations can best be expressed relative to gold. Since gold prices directly control profitability, and profitability drives long-term stock prices, gold naturally drives gold-stock price levels. My favorite way to look at this relationship is via the HUI/Gold Ratio. It simply divides the daily close in the flagship HUI gold-stock index by the daily close in gold itself.
And as you can see in this chart, the HGR looks positively apocalyptic today. This critical ratio is rendered in blue, and slaved to the right axis. Underneath for comparison purposes is the raw HUI in red. With the HUI in its numerator, a rising HGR indicates the gold stocks are outperforming gold. Conversely a falling HGR, the norm for the past year, means gold is outperforming gold stocks.
Let's buck convention and cut to the chase at the lower right. This week the HGR slumped to levels only seen two other times in this secular gold bull. The first was way back in early 2002 when the gold-stock bull was just getting underway so participation was light. And the second was briefly during late 2008's once-in-a-century stock panic. Quite literally, relative to gold the gold stocks are trading at stock-panic price levels today!
Is this rational? Do these dirt-cheap prices fairly reflect the current and future profits streams the gold miners are spinning off? History argues no way. The entire stock-panic event essentially encompassed the second half of 2008, with normal market conditions existing before. Over the 5 years between mid-2003 and mid-2008, the HGR averaged 0.511x! The HUI tended to trade at about half the price of gold.
Now the longer any trend in the stock markets persists, the more likely it is righteous and justified by core underlying fundamentals. A 5-day or 5-week or even 5-month trend is probably dominated by psychology. But a massive 5-year one transcending many greed-fear sentiment cycles certainly isn't. There has to be some underlying fundamental reason, or it never would have lasted so long.
Thus I believe this 5-year pre-panic average HGR of 0.511x established the baseline relationship of gold stocks to gold in normal market conditions. Ever since the depths of panic despair in late 2008, I've believed and written that this HGR ought to eventually mean revert to pre-panic norms. And though it hasn't yet, that certainly doesn't mean it won't. We and our subscribers have still made a lot of money in gold stocks since the panic by betting on this HGR mean-reversion thesis.
And indeed as expected, the HGR initially rocketed up fast out of its crazy-oversold panic lows. But unfortunately it stalled out about a year later heading into autumn 2009. Though it consolidated not far from those recovery highs for well over a year after that, in early 2011 the HGR started to slump. And this troubling trend has continued more or less unabated to this day, thrashing the poor gold stocks.
While everyone is understandably cursing the day they first heard about gold stocks now, there are some critical things on this chart to consider. First, note that the last time the HGR fell to today's levels during the stock panic they weren't sustainable for long. With gold stocks so radically and irrationally beaten down relative to gold, they were due for a massive rally for fundamental reasons. And indeed one soon launched.
If gold stocks couldn't sustain such panic levels relative to gold even right after the most extreme fear event of our lifetimes, why should they today when no one is particularly frightened about anything? When stocks are battered to ludicrous fundamental levels relative to their profits streams, contrarian value investors soon pour in capital which bids up their prices and rectifies the pricing anomaly.
Second, note that throughout this entire secular gold and gold-stock bull, gold stocks' favor in the eyes of investors and speculators naturally flowed and ebbed. A year or so where traders love gold stocks and bid them up dramatically relative to gold is followed by a year or so of capital exiting. These sentiment cycles driven by popular greed and fear happened before the panic and are still happening after it.
So regardless of how high gold stocks ought to be fundamentally relative to gold, after an entire year of underperformance they are now due for a major outperformance cycle. Some catalyst is almost certain to soon emerge that will entice capital back into the forgotten gold stocks. This will drive them to rally much faster than gold, probably for a year or so if the duration of past sentiment cycles continues to hold true.
Finally, how high are gold stocks likely to go relative to gold as the wildly-pessimistic sentiment today gradually yields to optimistic sentiment as they rally? After 3 rough post-panic years, you may think that expecting a return to pre-panic HGR norms around 0.511x is crazy. No problem. Even the post-panic average HGR (from 2009 on) is now running at 0.364x, which we can use as a conservative baseline.
As of the middle of this week, the HGR closed at a hyper-discouraging 0.288x. To merely return to its post-panic average of 0.364x, no big stretch by any means, we would need to see a 27% HUI rally. And after being so radically undervalued at panic levels, the odds are great that this sentiment-driven mean reversion will overshoot. The more extreme the sentiment pendulum is dragged in one direction (fear now), the farther it subsequently swings back in the opposite direction (greed) to fully rebalance sentiment.
So how about 0.41x, which is the HGR's upper resistance in this depressed post-panic era. This ratio has spent plenty of time above 0.41x in 2009, 2010, and 2011, so it isn't some pie-in-the-sky goal. To just regain this weak post-panic standard for greed and enthusiasm, the HUI would have to surge 43% higher from here. And realize that all these targets assume gold merely stays flat, which isn't very likely given the rampant fiat-currency inflation around the globe.
Thus even if you think I'm a total nutcase for still expecting to see gold stocks regain pre-panic norms sooner or later, the incredible opportunity in today's HGR mean-reversion play doesn't require such a belief. Even purely in depressed post-panic terms, gold stocks are due for a major outperformance relative to the metal they mine which will carry their stock prices a lot higher from here.
And zooming in to this very post-panic period offers more detailed insights into what is going on in the HGR. This next chart considers 2009 on, the "New Normal" as elite bond investor Mohamed El-Erian likes to call it. In addition to the first chart's data, this one adds a third series that shows where the HUI would hypothetically be trading if the HGR mean reverted to its pre-panic secular average of 0.511x.
This post-panic perspective really drives home just how incredibly cheap the gold stocks have become relative to gold. The recent apocalyptic HGR levels are even below early 2009's secondary-panic-low ones. The state of gold stocks' prices relative to their fundamental driver today is truly the worst it's been since the stock panic. And that event offered a once-in-a-lifetime ultra-cheap gold-stock buying op!
Prior to spring 2011, the HGR was indeed regaining ground relative to gold. After a fast initial recovery that made fortunes for brave contrarians like us willing to buy during and after the panic when everyone else was terrified, the HGR continued trending higher. Its rising uptrend is rendered above. At a couple HUI major interim highs in this timeframe, the actual HUI peaked at 81% to 82% of where it would have hypothetically been trading at the pre-panic average HGR of 0.511x.
But last April, the strong support of this post-panic uptrend started to crumble. It wasn't that the gold stocks were falling initially, but gold was shooting up and the HUI wasn't following. While the metal rocketed a staggering 8.7% higher that month (closing at new all-time record highs on half its trading days), the HUI merely crept 3.4% higher. Gold-stock traders were understandably skeptical of this metal's exuberant surge.
And indeed the reckoning soon started in May, when gold plunged 5.7% in its initial 4 trading days. Despite not rallying earlier in line with gold, the gold stocks still took a major blow from this worried gold psychology. The HUI plunged 10.0% over this short span! This relative outperformance of gold (falling less in a correction) drove the HGR down to 0.36x or so. This HGR-support breakdown, especially in spring, wreaked tremendous sentiment damage.
One problem was gold and the gold stocks were heading into the dreaded summer doldrums. June, July, and August, when many traders are enjoying long vacations and countless others lose focus on the markets, are usually a wasteland for the precious metals and their producers. So there was little incentive to buy the cheap gold stocks heading into last summer, thus the HGR continued to drift lower.
And then gold did something it has never done before in this entire secular bull, it defied all precedent to rocket higher in July and early August. Obama's record profligacy and resulting mind-bogglingly-huge deficits were on the verge of sparking the first downgrade of US Treasuries in our nation's history. No one knew how the markets would react to such a catastrophe, so capital flooded into gold on gigantic safe-haven demand. But the gold stocks didn't really participate, the uncertainty was too intense.
Thus the HGR's brutal collapse continued into August. Incredibly the day gold peaked at super-overbought levels that month (which I warned about at the time), the HGR was merely running at 0.319x. This was not much higher than what was seen in early 2009 at the secondary stock-panic lows in a time of extreme general-stock-market fear! Weathering this brutal May-to-August period sapped the strength and will of the remaining gold-stock investors.
So as capital fled this sector, instead of peaking at 82% of hypothetical HUI levels at its pre-panic average HGR this flagship gold-stock index was merely hitting 66% to 67%. Gold-stock investors and speculators had lost faith in this sector, too demoralized to risk deploying new capital. All these events together were really like the perfect storm for gold-stock psychology, collectively spawning a slow spiral lower to today's panic levels.
But once again, don't lose the forest for the trees. Yes gold stocks stink these days, yes they have performed poorly for an entire year. This is inarguable. But such episodes are not uncommon in the stock markets, which are moved around by perpetual cycles of greed and fear. As sectors get too popular greed grows extreme, sucking in all near-term buyers which leaves only sellers, so a correction soon erupts.
But eventually the resulting fear gets too extreme, convincing everyone susceptible to selling to exit which leaves only buyers. And then the sector gradually returns to favor as capital migrates back in to chase the resulting bargains. These sentiment cycles, trader psychology, are what account for the lion's share of all short-term stock-market action. And boy, are the gold stocks ever overdue for returning to favor again!
In addition to needing to flow again after such a serious ebbing, gold stocks' prices ultimately need to reflect the profit streams their underlying companies can spin off. Over the long term, the stock markets are a weighing machine. Cheap stocks generating big profits attract contrarian value investors, and their early buying ignites the rising stock prices that attract in other traders. This process feeds on itself.
The only potential monkey wrench in these inexorable market processes is a big plunge in the gold price, which is very unlikely today. This entire secular gold bull has been largely driven by massive paper-money inflation all over the world. The major money supplies are being grown by central banks at 7%-to-8% rates annually. Meanwhile the global mined gold supply only increases by about 1% a year. So with far more paper money available to chase relatively less gold, its secular bull remains far from over.
And if gold doesn't plunge in the coming months, the HUI's mean reversion back up to reasonable levels relative to gold is probably inevitable. If you're skeptical, consider the example of silver. The Silver/Gold Ratio plunged in the panic just like the HGR, and people thought silver would never regain those levels relative to gold. But I took the contrarian side and argued the opposite. And indeed silver eventually regained favor and not only attained its pre-panic SGR average, but greatly exceeded it in early 2011!
Mean reversions are one of the most powerful forces in the financial markets. And gold stocks are in the catbird's seat with two huge ones in their favor. Not only do gold stocks need to be much higher to reflect today's prevailing gold prices fundamentally, but this sector's psychology is due for a radical shift as well. Thus just like back during the stock panic, today's panic-priced gold-stock levels aren't sustainable.
Though our gold-stock positions have taken big hits in the past 5 months as well, we haven't given up on this sector. We continue to actively research it, looking for the most fundamentally-promising companies to buy to ride the mean reversion. And naturally the elite juniors continue to capture our attention. These small companies' gains should really leverage the HUI's as gold stocks inevitably return to favor.
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The bottom line is gold stocks are so deeply oversold and out of favor that they are trading at panic levels relative to gold. Such an anomaly wasn't sustainable even with the panic's extreme fear, and it certainly isn't sustainable today. All stocks are ultimately priced to reflect their underlying profit fundamentals, and gold stocks are no exception to this ironclad rule. And their sentiment can't stay this depressed forever.
So despite all the gold-stock hate out there, this beaten-down sector is overdue for a major rally. And even if you don't believe pre-panic levels relative to gold are attainable again, merely mean reverting by depressed post-panic standards offers an enormous buying opportunity. Valuations and sentiment ebb and flow everywhere in the stock markets, and gold stocks are not immune from these powerful forces.
Mar 23, 2012
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