Gold Stocks' Major New Upleg

By: Adam Hamilton | Fri, Aug 15, 2014
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The gold stocks are almost certainly in the early stages of a major new upleg. Given the widespread apathy and antipathy still plaguing this beaten-down sector, that's hard for most traders to swallow. But the gold stocks' performance this year has already been outstanding. And heading into gold's strong season, their gains should only accelerate. Gold stocks' overdue mean reversion higher is well underway.

Gold stocks are the Rodney Dangerfield of the investment world, they get no respect. Wall Street hates alternative investments that can entice capital away from its beloved stock markets. And since gold not only dominates that category but rallies when general stocks are weak, it is all the more loathed. So it and its miners' stocks are usually ignored and sometimes ridiculed. Gold stocks just aren't politically-correct.

But investing is not about popularity, but profits. During gold stocks' incredible secular bull between November 2000 and September 2011, the flagship HUI gold-stock index rocketed 1664% higher! Over that same span, the broad-market S&P 500 stock index lost 14%. Since general stocks' secular bear was born in March 2000, the S&P 500 is up 27% as of this week. But the HUI climbed 279% during that time.

That massive gold-stock outperformance is back this year, though you will rarely hear about it on CNBC. Year-to-date, the HUI is up 25.8% despite gold only being up 8.7%. This compares to a rather pathetic 5.3% for the universally-adored S&P 500. Gold stocks have returned from the dead, fighting howling sentiment headwinds to already be one of 2014's top-performing sectors. And gold's strong season is just starting.

The dominant fundamental driver of gold-miner profitability and hence ultimately gold-stock price levels is of course the price of gold. Gold-mining profits leverage gains in the underlying yellow metal, often greatly. A $100 gold rally off $1300 gold isn't big in percentage terms, just 8%. But if a particular miner was only earning $200 per ounce before that, its profits still soar by 50%. Gold stocks blast higher when gold runs.

The worst time of the year for gold is the summer doldrums, a sentiment wasteland devoid of recurring global gold-demand surges. Yet this year, gold stocks as measured by their HUI index are enjoying their best summer ever! That's despite the Fed's ongoing stock-market levitation continuing to suck capital and interest away from alternative investments. This outsized performance confirms this sector's new upleg.

This first chart looks at all the HUI summers since gold stocks' mighty secular bull's early days in 2001. To keep the wildly-different HUI prices over the years comparable in percentage terms, each summer is individually indexed. The final trading day of May's close, just before the market summer of June, July, and August, is set at 100. This renders every summer's gold-stock percentage moves in common terms.

Gold-Stock Summers

This spilled-spaghetti mess of yellow lines reveals the HUI's summer performances between 2001 and 2013. They have a center-mass trading range between 85 to 110 indexed, from 15% below to 10% above where the HUI starts summer. The red line is the average of all these past HUI summers, which tends to drift lower during the dreaded summer doldrums. And the blue line is 2014's summer gold-stock performance.

Gold stocks have enjoyed a record summer this year, for the majority of it the best of their entire bull! As of the middle of this week, the HUI has surged 20.7% since the end of May! That's outstanding 4.4x leverage to gold's 4.7% gain. No other summer has even come close in performance terms, though the gold stocks took off back in mid-August 2003. Why is capital flowing back in during this sector's worst time of the year?

And this summer has been far more hostile than most for gold. Since early 2013, the stock markets have been levitating on the Federal Reserve's implied backstopping. The Fed has fallen all over itself to telegraph that if stock markets fall it is ready to step up its money printing. As 2013 proved, stock melt-ups suck vast amounts of capital out of gold. American stock traders dumped GLD gold-ETF shares at epic record rates.

But despite the Fed's ongoing artificial general-stock melt-up, the extreme differential selling of GLD has vanished this year. Its holdings have stabilized, and thus so have gold prices. Though gold has been recovering on balance in 2014, it's sure not flying higher. Yet investors and speculators are returning to gold stocks anyway. They are betting on the super-high-potential mean reversion higher in precious metals.

This year's resulting strong gold-stock buying has radically improved gold stocks' technicals. And the better they look, the more traders are attracted to this sector. This next chart examines the performance of the flagship gold-stock ETF, GDX. It is a fantastic gold-stock benchmark that tracks the HUI perfectly and is directly tradable. Today's gold-stock technicals look the most bullish they have been in years now.

Gold-Stock Technicals 2013-2014

Gold stocks remain so unpopular today because they plummeted in early 2013 in a gold-driven free-fall downtrend. First gold's panic-like plunge last April, and then Ben Bernanke starting to talk about slowing the Fed's QE3 bond monetizations in June, hammered gold and therefore gold stocks. This sector challenged 2008's stock-panic lows last summer, which was the greatest market fear event of our lifetimes!

At the time, ominous predictions for gold stocks to continue spiraling lower indefinitely abounded. The bearishness on this sector was universal and extreme. Yet instead of dropping farther, the gold stocks stabilized. They've spent the entire year since then in a consolidation basing zone. After essentially a retest of their summer lows last December, capital finally started flowing back into this left-for-dead sector.

So the gold stocks have actually enjoyed a major new uptrend in 2014. And this was driven by gradual and sustained buying. That is much more sustainable and healthy than the sharp short-covering rallies seen last summer that soon fizzled out. Gold stocks' uptrend is well-defined this year, with higher lows and higher highs. This has attracted the initial vanguard of technical traders to gold stocks, a bullish omen.

Back in March gold stocks flashed a fabled Golden Cross buy signal when GDX's 50-day moving average crossed back above its 200dma. Golden Crosses usually signal major trend changes, the early days of large new uplegs. This is even true when the 50dma drifts around the 200dma afterwards for a spell, triggering an opposing Death Cross. But that is short-lived as another confirming Golden Cross soon arrives.

The flagship GDX gold-stock ETF broke decisively back above its 200dma in June, and hasn't looked back despite gold's inherent summer weakness. And a couple more critical breakouts are rapidly nearing, which will attract in many new investors and speculators. GDX isn't far from breaking out above its uptrend resistance between $28 and $29, and its entire year-long consolidation basing zone at $30.

It's no wonder smart traders really like these super-bullish gold-stock technicals. The gold stocks haven't staged this long of a rally, which is really a new upleg at this point, since before their latest all-time high in September 2011! This sector's 2014 performance is far different from that witnessed in the preceding couple of years. So contrarian investors and speculators willing to buy early and low are taking notice.

While these bullish gold-stock technicals reveal what is happening, they don't explain why. We have to turn to fundamentals for that. A massive mean-reversion trade is just getting underway in the beaten-down gold stocks. Their prices plunged way too far relative to the price of the metal that drives their profits in 2013's extreme gold-selling anomaly. And now they've started their long march back to normalcy.

This next chart looks at the most important gold-stock valuation metric, the ratio of gold-stock prices to the price of gold. Using GDX as a proxy for the former and GLD for the latter, the GDX/GLD Ratio reveals how gold stocks are faring compared to the driver of their profits. And the big GGR changes now underway offer near-ironclad confirmation that capital returning has indeed ignited a major new gold-stock upleg.

GDX/GLD Ratio 2007-2014

When the blue GGR line is rising, gold stocks are outperforming gold. When it is falling, the opposite is occurring. For nearly 7 years now, gold stocks have been losing ground relative to gold. Their stock prices have vastly lagged their existing profits and high potential future earnings. The duration of this trend is staggering, as the financial markets are forever cyclical. Prices never move in one direction forever.

Historically gold stocks have oscillated between periods of outperforming and underperforming gold. The longer that either trend exists, a rising or falling GGR, the higher the odds a major trend change is imminent to mean-revert out of that extreme. And the long-overdue reversal out of this 7-year trend of weak gold-stock performance has finally begun this year. And very few traders are even aware of it yet!

For almost 7 years, the GGR relentlessly falling on balance carved a strong secular resistance line. The gold stocks almost broke above it in late 2010 and early 2011, but failed. Another attempt happened in late 2012, after the gold stocks had bottomed prior to 2013's Fed-driven anomaly leading to extreme once-in-a-lifetime gold selling. But this falling GGR secular resistance had never been seriously challenged.

Until 2014. After bottoming late last year, the GGR has spent this year basing. It is actually rising in a fledgling uptrend much like GDX's. Gold stocks are outperforming gold again, despite the lingering poor sentiment environment. This 2014 outperformance has been so strong that it just triggered the biggest upside breakout from that GGR resistance yet. And that happened despite the fierce bearish gold headwinds!

The prudent contrarian investors and speculators fighting the herd to buy unpopular gold stocks this year are betting on this young mean reversion in gold-stock prices relative to the gold price continuing. If it does, the upside potential in gold stocks is absolutely massive. They have the potential to be the best-performing sector by far over the next year or two, thanks to the extreme magnitude of 2013's gold-selling anomaly.

Before 2008's stock panic, an ultra-rare once-in-a-century fear superstorm, GDX averaged 0.591x the price of GLD over the first 8 calendar quarters of GDX's existence. That remains the baseline level for the fundamental relationship between gold-stock prices and gold in normal market conditions. But the stock panic shattered that, with gold stocks plunging way faster than gold as traders dumped everything.

GDX plummeted 71% in just over a half-year on that, crazy! And that left the GGR way down at 0.227x at gold stocks' brutal October 2008 low. Those dismal prices were purely emotional, fundamentals had nothing to do with them. So before the dust even settled that year, I predicted a massive mean-reversion rally in gold stocks based on them being too cheap relative to gold. And that bet proved absolutely correct.

Over the next several years, GDX would more than quadruple. And the gains in the smaller higher-potential gold and silver miners we prefer to trade dwarfed those of the larger miners dominating GDX and the HUI. During the 10 full calendar quarters of that mighty mean-reversion upleg, the GGR averaged 0.419x. So that can conservatively be considered the middle of the normal post-stock-panic gold-stock trading range.

As of late 2013 thanks to the Fed's extreme market dislocations, precious-metals sentiment was so universally and overwhelmingly bearish that the GGR slumped well below stock-panic levels to ultimately hit just 0.174x. Now if you remember the epic fear of the stock panic, the idea of gold stocks falling below those levels relative to gold was fundamentally absurd. Again they were a screaming contrarian buy.

So they started recovering relative to gold as 2014 dawned despite the ongoing stock-market-levitation headwinds cursing alternative investments. And that necessary and overdue mean reversion back up to fundamentally-reasonable gold-stock price levels compared to the gold price strengthened throughout this year. Not even the summer doldrums slowed it down considerably, which is quite amazing.

If gold-stock prices could quadruple after 2008's stock panic, surely they were (and are) due for a similar gigantic mean reversion higher after late 2013's sub-panic all-time-low gold-stock prices relative to gold. The upside potential from here, even after 2014's rallying to date, is utterly massive. This week the GGR was only back up to 0.217x, still significantly below 2008's extreme stock-panic levels! Think about that.

Even if the gold price does absolutely nothing, GDX would have to soar 93% higher from this week's levels merely to return to its initial post-panic GGR average of 0.419x! The major gold stocks are an easy double from here, something that is exceedingly rare in these chronically-overvalued stock markets. But the potential gains of the gold stocks are much greater than that because gold itself is also powering higher.

Gold's strong season is just getting underway, a series of major income-cycle and cultural drivers of outsized gold demand from around the world. During its entire secular bull since 2001, gold has averaged a strong 15.4% gain over this period. If gold merely enjoys an average seasonal rally this year, it will be challenging $1500 by next spring! That would equate to GLD share prices somewhere around $144.

GDX returning to its initial post-panic-average levels relative to GLD, a GGR of 0.419x, would put GDX over $60 in such a scenario. This week it was trading just above $27, so that lifts GDX's conservative rallying potential by next spring alone to almost 120%! But gold stocks are likely to head far higher than that, as excitement and greed will come into play sooner or later in a major upleg. They are powerful forces.

It's rare for more-mainstream investors and speculators to get excited about gold stocks, but when they do capital floods back into a very tiny sector. As of the end of last month, the HUI component stocks had a collective market capitalization of under $110b. This compares to $18,451b for the S&P 500. If even 1% of that capital starts chasing gold stocks as their mean reversion makes them hot again, they'll skyrocket.

And there's another major fundamental booster coming into play this autumn too. The ratio of gold-stock prices to the gold price is an unconventional valuation measure, likely to never be widely accepted in the mainstream. Instead gold stocks' conventional trailing price-to-earnings ratios will come into focus. But over this past year, they haven't existed due to this industry's extreme writedowns in Q2'13.

The second quarter of 2013 was actually gold's worst in an astounding 93 years! The gold miners were so shell-shocked by this that they scrambled to revalue their gold projects as if those super-anomalous gold prices would last forever. These writedowns were so large they dwarfed ongoing operating profits, which left most of this industry with no accounting earnings. This has masked gold stocks' true profitability.

P/E ratios are calculated on a trailing-twelve-month basis, the last four quarters of results. So starting in last quarter's results, those massive non-cash writedowns of Q2'13 will roll off. So the past four quarters of solid operating profits will finally translate into serious earnings. And with gold-stock prices so anomalously low, these profits will be relatively large leading to very low conventional gold-stock valuations.

So the vast pools of capital controlled by value investors will join the hardcore contrarians and technical traders already buying gold stocks, accelerating their upleg. Nothing begets buying like higher prices, and the array of factors lining up to push gold and the stocks of its miners higher today is actually unprecedented coming out of last year's epic anomaly. What an amazing opportunity to multiply your wealth!

The sad part is most investors and speculators won't get interested until the vast majority of the gains have already been won, when gold stocks are way higher and more exciting. Being in the financial-newsletter business for 15 years now, I've seen this many times and it still confounds me. The time to buy into gold stocks' major new upleg is right now when these stocks are still very cheap, not next spring at far-higher prices.

We've been doing exactly that at Zeal, aggressively deploying into the fundamental best of the smaller gold and silver miners. These companies' gains will even leverage those of the major miners that dominate GDX and the HUI. Our many new trades are still near great entry prices, you still have time to get deployed. And our older trades from closer to GDX's bottom already have unrealized gains up to +119%.

You ought to join us while bargains abound! We publish acclaimed weekly and monthly newsletters covering the markets from an essential contrarian perspective. They draw on our decades of hard-won experience, knowledge, wisdom, and ongoing research to explain what's going on in the markets, why, and how to profit with specific trades. We also publish comprehensive reports on our favorite gold and silver stocks with the best fundamentals. Our track record is stellar. Since 2001, all 686 newsletter stock trades have averaged annualized realized gains of +22.6%! Subscribe today and start partaking.

The bottom line is the beaten-down gold stocks are almost certainly in a major new upleg. This sector has defied the fierce headwinds of the Fed's ongoing stock-market levitation and the summer doldrums to climb considerably this year. This has led to greatly-improved gold-stock technicals as well as a key fundamental breakout relative to gold prices. And all this before gold's strong season just getting underway!

As gold rallies in the coming months on the usual seasonal demand surges, the capital flows back into gold stocks will accelerate. Since this largely-abandoned sector is so tiny relative to the broader stock markets, it doesn't take a great deal of buying to drive outsized gains. Now is the time to deploy in the best of the gold and silver miners ahead of that, when interest and therefore stock prices remain low.

 


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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