Recently, the Erste Group published a 120 page report covering precious metals. The report contains an absolute treasure of analysis, figures and charts concerning gold and the gold stocks. I have selected a few of the charts which help us explain the current status of the gold stocks. Essentially, there is a huge divergence between financial performance and valuations. Ultimately, the performance of the shares over the coming months will answer the question as to the resolution of that divergence.

We often hear how difficult of a time some mining companies are having. Although that is true, the reality is present conditions for gold miners have never been better. Rising costs are a problem but margins for the large unhedged producers are at bull market highs (and likely all-time highs).

The rising margins explain the consistent increase in cash flow and net income (with a few bumps) as the chart below depicts. Cash flow and net income for 2012 will also reach a bull market high.

Given the high margins, cash flow growth and record earnings why are the stocks struggling and trading well off their highs? A major and often forgotten explanation is the current low valuations. Several months ago, the price to cash flow valuation of senior producers was equivalent to valuation lows seen in 2000 and 2008. No chart better illustrates valuations then this one from BMO Capital Markets.

Now let’s examine the current technicals and draw a comparison between today’s bull market and the bull market from 1960 to 1980. Below we plot the current bull market in the HUI (red) and the Barron’s Gold Mining Index (BGMI). There are some differences but also some similarities. Note that the level 170 was key support and resistance for the BGMI for nearly five years. Once the Bgmi broke 170, it was headed much higher.

One can better view the current key pivot point from the chart below. The 52-55 range has been key support and resistance for GDX since late 2007. If and when GDX makes a weekly close above 55, you can bet that the prognosis will look quite bullish.

The market is at an interesting crossroads. Financial results have been strong but valuations are weak. The market believes earnings and cash flow will decline and has priced in that outcome to some degree. Ultimately, this will resolve itself in one of two ways. Producer margins can decline which would impact cash flows and profitability. That would eventually lead to lower share prices and GDX could threaten a break below 40. On the other hand, should margins increase then share prices will explode higher from a compounding effect. Rising margins will generate stronger cash flow and higher profits and the low valuations will rebound as sentiment would normalize. This is the fundamental case for the next major breakout in the gold shares.

Given the technical damage from the recent selloff (which went a bit further than expected) one should not anticipate this crossroads to be resolved anytime soon. Think months rather than days or weeks. Ultimately, the shares will break 55 to the upside in 2013 thanks to the combination of a breakout in Gold combined with stable costs in 2013. In the meantime the shares will consolidate providing you time to do your research and find the companies that will lead the next leg higher and outperform. If you’d be interested in professional guidance in uncovering the producers and explorers poised for big gains then we invite you to learn more about our service.