The
lofty stock markets suffered a sharp selloff this week that may
prove a major inflection point. There was one lone sector that
bucked the heavy selling to surge in the carnage, the gold miners’
stocks. They are the last cheap sector in these bubble-valued stock
markets, long overlooked and neglected. Wildly undervalued today,
the gold stocks have great potential to soar dramatically even if
stock markets keep weakening.
Just
several weeks ago, the US stock markets hit new all-time record
highs stoking universal euphoria. The flagship S&P 500 broad-market
stock index (SPX) closed at 2930.8 in late September, extending its
monstrous bull to 333.2% over 9.5 years. That made for the
2nd-largest and 1st-longest in US stock-market history! It also
left these markets dangerously overvalued, literally trading at
bubble valuations.
Exiting September, the elite stocks of the SPX sported an average
trailing-twelve-month price-to-earnings ratio way up at 31.4x.
Weighted by market capitalization, that was even more extreme at
34.9x. Over the past century and a quarter or so, bubble valuations
start at 28x earnings. So the stock markets were ripe for a fall,
and the catalyst would prove surging 10-year Treasury yields along
with a hawkish Fed chairman.
While the SPX started weakening last week as 10y yields blasted to a
7.3-year high, the serious selling finally erupted this
Wednesday. The SPX plunged 3.3% to 2785.7, taking its total
pullback from the peak to 4.9%. Leading the way down were the
market-darling mega tech stocks, which have valuations
much more
expensive than the general markets. Everything was sucked into
that frenzied selling, with one exception.
The
gold miners’ stocks were an island of green in that roiling
blood-red sea, their leading sector benchmark actually rallying
1.3%! That is the GDX VanEck Vectors Gold Miners ETF. That
seemingly-impossible divergence is exceedingly important for
investors to understand. It is the key to generating great wealth
when everything else burns in what will likely snowball into the
long-overdue next
bear market in stocks.
The
gold stocks are a unique sector because stock-market fortunes aren’t
their primary driver. Instead they mirror and amplify the trends
in gold, which directly drives their profitability in leveraged
fashion. Gold rallied 0.3% to $1194 Wednesday as investors finally
started to return.
The major gold miners of GDX surged 3.9x that much, despite the
flaring stock-market fears. Such contrary action is nothing new.
Weakening stock markets motivate investors to prudently diversify
their bleeding stock-heavy portfolios with gold. Their buying bids
gold higher, which eventually fuels monster gold-stock bulls.
Within and after the last secular stock bear, the gold stocks
skyrocketed. GDX was born in the middle of that epic run in May
2006, so we need to use an older benchmark to remember why gold
stocks are compelling in stock bears.
Between November 2000 and September 2011, the HUI NYSE Arca Gold
BUGS Index soared a truly-astounding 1664.4% higher. You read that
right, the world’s most-hated sector today multiplied wealth by
nearly 18x across those 10.8 years! The SPX actually slumped
14.2% in that span, but was down as much as 56.8% at worst when a
mid-secular-bear cyclical bear climaxed. So investors returned to
gold in a big way.
In
roughly the same span, it powered 638.2% higher in a massive secular
bull. The HUI leveraged those gains by 2.6x, right in line with the
usual 2x to 3x it has seen historically. If the stock markets are
finally on the verge of another bear driven by
record Fed
tightening, this gold-stocks-to-the-moon cycle is going to
repeat. Gold will be bid for years as investors slowly
rebuild normal portfolio allocations, so gold stocks will fly.
This
leveraged relationship between gold miners’ stocks and gold prices
is deeply fundamental and easy to understand. While the major gold
miners of GDX will report their Q3’18 financial results over the
next month or so, their latest-available data is still Q2’s. That
quarter their average gold production cost was
$856 per ounce
in all-in-sustaining-cost terms, which is way under even Q3’s
low average gold price of $1211.
For
easier calculations, let’s round these to $850 AISCs at $1200 gold,
which yields profits of $350 per ounce. If gold rallies 10% to
$1320, the major gold miners’ profits surge 34% to $470. A 20% gold
upleg to $1440 boosts these earnings to $590, a big 69% gain. And a
little 30% gold bull to $1560 catapults the industry profits 103%
higher to $710! Gold-mining earnings have big leverage to
prevailing gold prices.
The
costs of gold mining are largely fixed during mine-planning stages,
when engineers and geologists decide which ore to mine, how to dig
to it, and how to process it. The actual mining generally requires
the same levels of infrastructure, equipment, and employees quarter
after quarter with little changing in throughput terms. Thus
average AISCs don’t move around much even when gold prices climb far
higher.
Gold-mining profits and thus gold-stock prices would double
with a mere 30% gold bull! And that’s not a stretch at all. Back
in early 2016 gold investment
returned to favor
in a major way after back-to-back SPX corrections spooked stock
investors. American stock investors in particular buying shares in
the leading GLD SPDR Gold Shares gold ETF drove gold 29.9% higher in
just 6.7 months in essentially the first half of 2016!
The
major gold miners of GDX reacted with a massive 151.2% bull upleg in
that ETF’s share price in just 6.4 months in roughly that same
span. That made for outstanding 5.1x upside leverage to gold. So
the idea that gold stocks soar when weakening stock markets
spur gold investment demand is based on historical precedent. This
week’s gold-stock rally on an SPX selloff is just a small foretaste
of the feast to come.
If
gold stocks were already super-expensive like mega tech stocks, the
psychology of rising gold prices would still drive them higher. But
this small contrarian sector has been forsaken and left for dead for
the last couple years or so. Investors wanted nothing to do with
gold and its miners’ stocks as the general stock markets levitated
on Republicans’ massive corporate tax cuts. So gold stocks are
swirling in the gutter.
Their valuations relative to gold are exceedingly low today, an
extreme anomaly. Because they are so deeply out of favor, their
stock prices are radically disconnected from their underlying
profitability even at $1200 gold. That means their coming upside as
investors return to gold is much greater than it would be normally.
Gold stocks need to mean revert far higher to merely reflect today’s
gold prices, let alone future ones.
Gold-stock valuation trends can be understood and gamed through a
simple proxy, the ratio between their stock prices and the
underlying metal which drives their profits. Since American stock
investors prefer to deploy capital in GDX for gold-stock exposure
and GLD for gold, we can construct a GDX/GLD Ratio to analyze this
key fundamental relationship. This GGR reveals gold-stock prices
are ridiculously low today.

This
GDX/GLD Ratio rendered in blue simply divides the daily closes in
GDX and GLD. Charted over time, this reveals whether gold stocks
are relatively cheap or relatively expensive compared to the metal
they mine. This Wednesday even after gold stocks’ counter-market
surge, the GGR was still only running 0.165x. That’s very low in
secular terms, highlighting how undervalued gold stocks are relative
to gold.
Gold
itself remains in that bull market ignited in mid-December 2015
immediately after the Fed’s first rate hike
of this cycle.
Gold soared in the first half of 2016 after American stock investors
returned to GLD with a vengeance following the
first
stock-market corrections in years. Once these guys remember
stock markets can’t rally indefinitely because they are forever
cyclical, they shift some capital back into gold to diversify.
Gold
started falling out of favor again after the SPX started climbing to
new record highs in mid-2016. And all that accelerated dramatically
after Trump’s surprise election victory late that year. Republicans
controlled both sides of Congress, so stock markets soared on hopes
for big tax cuts soon. While gold fell in a huge correction,
it didn’t exceed the -20% new-bear threshold. Gold’s bull has
consolidated since.
Because gold-stock fortunes are overwhelmingly dominated by gold’s
own, this sector is still considered to be in a bull market because
gold is. During the past 2.8 years of gold’s bull, the GGR averaged
just 0.187x. GDX’s share price tended to close at just under a
fifth of GLD’s share price since gold’s current bull was born. That
is exceedingly low historically, not normal at all. The GGR
needs to mean revert far higher.
Again GDX was launched back in May 2006, when gold stocks were
really in favor after rocketing higher in their young secular bull.
Over the next 2 years, the GDX/GLD Ratio averaged 0.591x. If the
gold stocks fully mean reverted back up to those levels relative to
today’s gold prices, GDX would have to soar 258% higher from
here! But late 2008’s first stock panic in a century torpedoed this
core fundamental relationship.
Gold
stocks plummeted in that stock panic, with GDX collapsing 71.0% in
just 7.5 months! That’s a major exception to the rule that gold
stocks tend to thrive during stock weakness. While episodes of epic
extreme fear are mercifully brief, free-falling general stock
markets can suck in gold stocks and even gold for a spell. The baby
gets thrown out with the bathwater when investors’ fear reaches
blinding peak levels.
At
worst in October 2008 after the SPX had plummeted 30.0% in a single
month, the GGR bottomed at 0.227x. That highlights the sheer
absurdity of recent years’ gold-stock prices. Even in the
most-extreme stock-market fear event we’ll likely witness in our
entire lifetimes, the gold stocks were trading over a fifth
higher relative to gold than their average over the past few
years! They rebounded powerfully from that anomaly.
Over
the next 2.9 years after that epic stock panic, GDX more than
quadrupled with a 307.0% gain! In the first couple years of
that post-stock-panic mean reversion, the GGR averaged 0.422x.
Restoring that fundamental relationship between gold miners’ stocks
and gold prices would require a 156% GDX rally from here. In the 4
years after that panic, the GGR averaged 0.381x which is 131% higher
than this week’s levels!
But
effectively starting in 2013, the Fed began radically distorting the
markets with its third quantitative-easing campaign. That led to
soaring stock markets
which mirrored
the Fed’s ballooning balance sheet as it bought massive amounts of
bonds with money newly conjured out of thin air. So gold fell
deeply out of favor as stock markets rocketed higher on epic Fed QE,
suffering a multi-year bear which crushed gold stocks.
That
ultimately culminated in mid-December 2015 on the Fed’s first rate
hike of this cycle ending 7 years of its stock-panic-spawned
zero-interest-rate policy. The GGR hit an all-time low of 0.120x
about a month later as gold stocks bottomed before soaring in their
new bull. Just like after the stock panic, gold-stock upside was
explosive after being pummeled to unsustainable lows relative to the
metal which drives their profits.
GDX
again skyrocketed 151.2% higher over the next half-year or so in
early 2016, but its young bull was still tiny. Ever since gold
stocks have languished, grinding sideways to lower as investors
forgot about them. There was little demand for contrarian
investments while the SPX surged dramatically on taxphoria since
late 2016. But this week’s action warns those stocks-higher
gold-lower trends may be starting to reverse.
There are several key takeaways from this long-term fundamental
relationship between gold-stock prices and gold levels. First, in
the past the gold stocks have surged sharply in strong bulls after
their prices fell too low compared to gold. Gold-stock prices as
measured by GDX have doubled to quadrupled in recent years’
mean reversions out of anomalous extremes. Similar gains at least
should be expected in the next one.
Second, gold-stock prices can’t fall relative to gold forever.
While this small contrarian sector can lapse out of favor at times,
investors flood back in once the stock markets weaken and investors
return to gold. Between 2008 to 2015, the GGR’s trend was sharply
lower. It stabilized and consolidated low from 2016 to 2018. Now
gold stocks are due for a secular reversal where their gains outpace
gold’s on balance for years.
No
markets or relationships between markets move in one direction
forever! American stock investors are being shocked into
remembering this core reality this week. Everything is forever
cyclical. The longer any market is stuck in any particular trend,
the bigger and longer its proportional mean reversion will last.
Gold and especially gold stocks are likely to experience years of
plenty after suffering years of lean demand.
Third, all this GGR analysis so far makes the unlikely assumption
that gold prices don’t rally too. But gold is likely to enjoy a
powerful bull in the coming years as stock investors re-diversify
small fractions of their stock-dominated portfolios into
counter-moving gold. As gold prices are bid higher, the upside in
gold stocks will leverage and amplify gold’s gains. The higher GLD
is bid, the higher GDX’s mean reversion will go.
As
an example, assume the most-conservative mean reversion of the GGR
back to that 4-year post-panic average of 0.381x. At today’s gold
levels, that implies GDX has to more than double from here with a
131% gain. But if GLD is bid 10%, 20%, or 30% higher, the necessary
GDX upside to regain that normal gold-stock pricing relative to gold
climbs to 154%, 177%, or 200%. And that’s actually quite
conservative too.
After anomalous price extremes, mean reversions don’t simply stop at
the averages but tend to overshoot proportionally in the
opposite direction. So gold stocks are due for a period where they
outperform gold so greatly that the GGR soars to the high side
instead of mere normal levels! That portends far-larger gold-stock
gains than anything discussed. Run the numbers with a GGR
mean-reversion overshoot and be amazed!
This
last chart zooms in to the past few years or so, essentially the
current gold and gold-stock bulls. The GGR was recently driven to a
2.6-year low by the
forced
capitulation in gold stocks in August and the echo capitulation
in early September. So even in the context of recent years alone,
the gold stocks are way too low relative to prevailing gold
prices. The GGR is due for a sharp surge back above that meager
mean.

At
worst in mid-September, the GGR plunged to 0.155x. That was a
breakdown from its downtrend of recent years, and 0.032x under its
past-few-years average of 0.187x. A full proportional
mean-reversion overshoot out of this latest anomaly would drive the
GGR back to 0.219x. Just to normalize relative to gold in even that
little way would require another 33% rally from this Wednesday’s
close to $24.73 in GDX!
With
gold stocks so wildly undervalued relative to the metal which drives
their profits, their upside is huge no matter how you slice it. The
gold miners are truly the last cheap sector in these entire
lofty, euphoric stock markets! And since their earnings are totally
dependent on gold prices which tend to rally on big investment
buying when stock markets weaken, gold stocks have the unique
ability to climb during stock bears.
We
got a small preview of that this week, when GDX rallied 1.3% on
Wednesday despite that sharp 3.3% SPX plunge. Given the bubble
general-stock-market valuations and the Fed’s unprecedented
now-full-steam
quantitative-tightening campaign to destroy QE money, every
investor needs to make portfolio allocations to gold and the
stocks of its miners. They tend to power enormously higher when
little else will.
And
even if the stock markets again evade the hangman’s noose and
somehow continue grinding higher still, gold investment demand could
still climb. Once stock investors are spooked, they usually add
gold for a long time after to get some semblance of portfolio
diversification. So gold and gold stocks still soared from 2009 to
2011 and in the first half of 2016 even as the SPX recovered from a
panic and corrections.
Wall
Street has long hated gold because it thrives when stock markets
weaken. So it’s essential for all speculators and investors to
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The
bottom line is the gold miners’ stocks are the last cheap sector in
these entire lofty stock markets. They’ve languished deeply out of
favor for years as investors forgot the wisdom of prudently
diversifying their stock-heavy portfolios with gold. But once stock
markets weaken enough to spook them, traders start returning to gold
and gold stocks. This classical behavior started to play out again
with this week’s selloff.
As
capital flows back into this forsaken sector, the gold-stock upside
is truly extreme. These gold miners’ stock prices are wildly
undervalued relative to the metal which drives their profits. So
they are overdue for a massive mean reversion and eventually
overshoot. When this dynamic of gold stocks returning to favor
after a long exile has played out in the past, contrarians who
bought in early and low really multiplied their wealth. |