Gold stocks have to be the most despised sector in all the markets. Mainstreamers barely even know they exist, while even the vast majority of so-called contrarians scorn them. The sheer contempt for this sector is amazing considering gold stocks were almost certainly the best-performing sector of the past decade. This universal antipathy has driven them to panic levels, by far the markets’ best fundamental bargains.
Gold stocks weren’t always held in derision. From November 2000 to September 2011, the flagship gold-stock index known by its symbol HUI catapulted an astounding 1664.4% higher! This was over a very long 10.8-year secular-bear span where the broad stock markets as measured by the mighty S&P 500 fell 14.2%. After multiplying their investors’ wealth by 18x, they should have been the most-popular sector.
But Wall Street has always hated gold, so there has never been adequate or fair coverage of the secular gold bull or the resulting secular gold-stock bull. When gold stocks are strong, they are ignored. CNBC might spend a few minutes a day on them even if their gains trounce every other sector’s. And when they are weak, they are mocked. What kind of fools would want to grow their capital 18x in a secular stock bear?
That ride was far from easy, let me tell you. We’ve been trading great gold stocks and silver stocks, and recommending them to our subscribers, for this entire secular gold-stock bull. It’s always taken hardened contrarians to weather this sector’s intense volatility. Like everything else, gold stocks don’t move in a straight line. There were plenty of incredibly painful sharp plunges and big corrections along the way.
The worst by far occurred during 2008’s once-in-a-lifetime stock panic. From March 2008 to October 2008, a very short 7-month span, the HUI plummeted a catastrophic 70.6%! Holy cow, you should have seen gold-stock investors then! They were totally convinced the sky was falling, that the secular gold bull was over, and that gold stocks were going to zero. The wailing and gnashing of teeth was deafening.
Sounds like today, eh? The recent totally irrational gold panic fueled by anomalous futures forced selling pummeled the gold stocks down to prices totally disconnected from fundamental reality. The current crop of pantywaist gold-stock investors literally panicked, succumbed to their overwhelming fear rather than transcending emotion to think rationally. Fear is transient, how did the gold stocks look fundamentally?
Over the long term, all stocks are ultimately valued based on their underlying earnings streams. Legendary value investor Benjamin Graham, Warren Buffett’s mentor, described this valuation function of the markets as a weighing machine. All stocks slowly gravitate to a righteous fundamental price based on their underlying companies’ profits. This includes gold stocks, which aren’t exempt from market laws.
But over the short term, the powerful and dangerous emotions of greed and fear batter stocks all over the place. After long uplegs greed propels stocks to wildly-overbought levels totally disconnected from their earnings. And after long corrections fear hammers stocks to radically-oversold levels equally as absurd. Graham said that the markets act like a voting machine in the short term, opinion trumps fundamentals.
But emotional extremes never last, they are fickle. Excessive greed or excessive fear quickly burn themselves out, and stock prices resume their slow fundamental march to reasonably reflect their underlying profits. Gold stocks are now trapped in a voting-machine moment where everyone hates them for irrational emotional reasons, resulting in them weighing far less than their fundamentals demand.
At the S&P 500’s last nominal record high on April 11th, the collective price-to-earnings ratio of all its component stocks was about 21.2x. General stocks were priced at levels 21 times their underlying annual profits. This is actually overvalued, pricey. Over centuries all throughout the world, the long-term fair value of stock markets is 14x earnings. Markets trading above this are expensive, and below it cheap.
Meanwhile on April 17th with gold-stock investors foolishly choosing to panic, the collective P/E of the HUI gold-stock index was around 9.3x! Not only is this the lowest of gold stocks’ entire secular bull by far, it is very cheap in absolute terms. A dollar of earnings in gold stocks could be purchased for just $9 in stock price, compared to $21 for general stocks. Gold stocks were 56% cheaper than the rest of the markets!
Now in most sectors (not necessarily individual stocks), value investors would flood in to buy companies at 9x earnings. It is a guaranteed win over the longer term as the weighing function of the stock markets overcomes the temporary swings in sentiment. And 9x for gold stocks is far cheaper for this sector than it would be for general stocks. Gold stocks usually trade at a premium due to their very outsized returns.
Between 2007 and 2012, the HUI’s P/E ratio averaged 27.9x earnings. This long 6-year span included both major uplegs and major corrections, even 2008’s insane stock panic. So by their own recent standards, the loathed gold stocks are now trading at steep discounts of 2/3rds to their normal valuations! The magnitude of this total fundamental disconnect is mind-boggling, it makes no sense whatsoever.
Was Graham wrong? Do earnings no longer matter? Are gold stocks going to be perpetually hated and therefore never reflect their underlying profitability? Of course not. The extreme fear holding down gold stocks can’t and won’t last. The markets have always abhorred sentiment extremes, they are very temporary. And once they inevitably pass, misvalued sectors spring back to normal relatively rapidly.
This certainly happened in gold stocks after that once-in-a-lifetime 2008 stock panic. After plummeting 70.6% and stoking epic levels of gold-stock fear that dwarfed today’s, in just 13 months the HUI had fully bounced back. The weak-willed investors who succumbed to their own fears sold near the bottom to set their terrible losses in stone. But the strong contrarians held on to enjoy the massive 236.9% recovery.
By September 2011, the gold stocks as measured by the HUI had more than quadrupled since the panic lows with a staggering 319.0% gain over 2.9 years. Why? This sector had been wildly mispriced when the vast majority of investors chose to vote against it when they were blinded by their own fear. But that fear quickly dissipated and the weighing-machine function of stock markets gradually normalized prices.
This background is very important now because gold stocks are actually at more-extreme lows today than they were during 2008’s stock panic! And if they quadrupled after that panic anomaly, they are highly likely to at least quadruple from their recent panic lows in the coming years. This is measured by the all-important HUI/Gold Ratio. The HGR is a simple construct that divides the HUI’s close by gold’s own.
Obviously gold miners mine gold. Their profits as a sector balloon when gold rises and contract when gold falls. So the price of gold is the overwhelming primary driver of gold miners’ long-term profitability, which ultimately determines their stock prices. Thus the HUI/Gold Ratio has been one of the best tools to measure how gold stocks are faring fundamentally throughout their entire decade-long secular bull.
This chart, long one of my favorites, superimposes the HGR in blue over the HUI itself in red. By this key valuation metric, gold stocks were just driven to levels relative to gold well under even the crazy 2008 stock-panic levels! This is the biggest valuation anomaly ever seen in this gold-stock bull by far, showing how excessive fear has been. The market voting machine temporarily forced gold stocks to ludicrous lows.
In October 2008 in the dark heart of the stock panic when it really looked like the world was ending, the HGR slumped to 0.207x on mind-boggling fear. That turned out to be a 7.5-year low for the HGR, since April 2001 which happened to be the very month the past decade’s powerful secular gold bull was born. Without context that HGR extreme is meaningless, so this chart really puts it in proper perspective.
For 5 full years before that ultra-rare fear superspike, the HGR traded in a tight secular range between 0.46x and 0.56x. Gold stocks became more valuable relative to gold when investors got greedy and loved them, and less valuable when they got scared. But the HGR didn’t spend too much time far away from its secular average of 0.511x. The HUI gold-stock index generally traded at half the prevailing gold-price levels.
But the first true stock panic in 101 years shattered this longstanding fundamental relationship between the gold miners’ stocks and the driver of their profits. As gold-stock investors fled in terror, gold stocks were driven down far faster than the also-weak gold price. So the HGR plummeted, shattering support and falling to levels previously unthinkable. It was very obvious at the time that this anomaly wasn’t sustainable.
And indeed the crazy-oversold gold stocks bounced back sharply, rallying far faster than gold. At 0.437x in late 2009, the HGR had made up so much lost ground that it was on the verge of breaking back into its pre-panic trading range. But even though gold stocks kept powering higher dramatically after that, gold climbed so fast in the Fed’s inflationary quantitative-easing era that it kept pace with the HUI’s big gains.
So the HGR stalled, starting to drift sideways between 0.35x and 0.40x or so. But this new post-panic norm started to break down in the summer of 2011. That was when the anxiety about Washington technically defaulting on Treasuries surrounding the last debt-ceiling debate ignited a rare sharp summer rally in gold. Gold stocks weren’t as attractive as gold in such a scary scenario, so the HUI lagged the metal.
And gold-stock psychology, which had never quite fully recovered from the deep scarring of 2008’s stock panic, started deteriorating rapidly as both gold and gold stocks corrected after gold reached very overbought extremes in August 2011. Since gold stocks nearly always fall faster than gold in a correction due to their profits leverage to the metal, the HGR kept sliding lower and losing even more ground.
This long downtrend finally started reversing late last summer when gold and its miners’ stocks surged after gold sentiment hit unsustainably-bearish extremes. I explained the gold action since in much depth in a February essay on gold’s capitulation and last week’s essay on gold’s wild panic selling. As gold continued to be sold off, the already-oversold gold stocks started collapsing. This dragged the HGR lower still.
Just last week, this key gold-stock valuation metric was pummeled to 0.187x. This was a 12.0-year low well below even the level seen in 2008’s stock panic! So relative to gold, gold stocks were just driven to sub-panic levels. That extreme anomaly couldn’t persist in the stock panic and it can’t persist today. Gold stocks have never been so hated in their entire secular bull, meaning fear has to have finally peaked.
Seeing a sector that usually trades at 27.9x earnings languish at just 9.3x, a 2/3rds discount, certainly illustrates the fundamental absurdity of today’s gold-stock prices to those familiar with valuations. But I wonder if that can resonate well enough with less-studied investors. So let’s look at the HUI’s ludicrous disconnect from fundamental reality another way, from previous HUI milestones at the same level.
At April 17th’s closing low of 257, the HUI was at its worst levels seen in 4.3 years. That very day, gold and silver were trading at $1374 and $23.25. But the last time the HUI was under 257 in January 2009, gold and silver were 41% and 55% lower at $810 and $10.50! And lest you think gold miners were more profitable back then, they weren’t. The HUI’s P/E then was 23.6x, far higher than last week’s 9.3x.
The very first time the HUI challenged 257 in this secular bull was way back in December 2003. Back then gold and silver were 70% and 76% lower at $405 and $5.50! Seeing gold stocks trading at the very same levels today with gold and silver 240% and 327% higher defies all logic. This disconnect between gold stocks and their underlying fundamentals couldn’t be more extreme, it is ludicrously absurd.
Per the HUI/Gold Ratio, gold stocks have been falling out of favor since either early 2006 or early 2011 depending on how far back you want to take the trend. Does any market run in one direction forever? Will gold stocks be hammered down to 7x or 5x or 3x earnings? The chance of that within a fundamentally-driven secular gold bull is likely zero. The extreme antipathy to this sector will have to abate.
This one-way trade of irrationally hating gold stocks and ignoring their fundamentals has created a thriving cottage industry of analysts and traders trying to rationalize all this as normal. There are several major theses and countless sub-theories trying to justify gold stocks trading as if their earnings will never matter again. Traders as a group wax the most bearish at the worst-possible times, right at major bottomings.
Earnings are the only thing that matter for long-term stock prices, period. No sector is exempt from ultimately being weighed and fairly valued. And as long as the secular gold bull isn’t over, which it can’t be without a proper popular-mania climax, gold miners will remain very profitable. Sooner or later their incredibly low valuations will matter, value investors will move capital into the cheapest sector in the stock markets.
I am probably the last one on the planet, but as a rational contrarian I still expect gold stocks to regain their pre-panic average HGR of 0.511x. Before you laugh, realize not too long ago silver was in a similar situation where everyone thought it was hopeless for it to regain its pre-panic average relative to gold. But silver not only surged to hit those levels once again as it returned to favor, it far exceeded them to the upside.
The markets are tyrannically cyclical, every sector out of favor eventually returns to favor again and vice versa. That law of sentiment is as immutable as stock prices ultimately reflecting underlying corporate earnings. Based on today’s still-battered gold prices, a 0.511x HGR would put the HUI at 731. This is 157% higher than it was in the middle of this week even after recovering 3/7ths of its gold-panic losses!
And even if you believe the bears’ endless rationalizations about why gold stocks are doomed, consider the post-panic average HGR which includes the extremely low levels of 2013. That is 0.338x. Even if gold stocks will somehow never again be as popular as they were pre-panic, when everyone but hardcore contrarians ignored them just like today, that HGR with today’s gold levels puts the HUI at 484.
Which is still 70% higher than this week’s horrendous gold-stock levels! With the general stock markets very overbought, hyper-complacent, and at nominal record highs in a secular bear, can you think of any other sector with a high probability of climbing 70% just to return to merely average? I sure can’t. Gold stocks can’t keep falling deeper out of favor forever, there is no one left who doesn’t already hate them!
So if you’re a contrarian, if you really walk the walk and buy low, gold stocks are by far the most attractive sector in the stock markets today. Yes it’s been a tough 2013, but so what? The lower this sector is pummeled the cheaper it gets, and the bigger and faster the subsequent mighty upleg will be as sentiment inevitably turns. Buying low and holding as prices are driven lower is irrelevant if they are due to at least quadruple.
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The bottom line is gold stocks have been driven down to panic levels by the recent gold-futures forced selling. They have never been cheaper relative to gold in their entire secular bull. They have never traded at lower traditional valuations based on their underlying earnings. And they have never been cheaper compared to their average valuations of recent years or the general stock markets’ prevailing valuations.
So naturally everyone loathes gold stocks. I’ve never seen them so universally hated and deeply out of favor. But this is a sentiment anomaly that won’t last. Eventually all stocks are weighed by the stock markets and priced to fairly reflect their underlying earnings streams. Gold stocks are no exception. Their pricing anomaly is so extreme today that it will take a gigantic upleg to mean revert to normal levels.
Adam Hamilton, CPA
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