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Contrarian Gold Stocks Investing

Commodities / Gold and Silver Stocks 2013 Dec 13, 2013 - 06:11 PM GMT

By: Zeal_LLC

Commodities

The gold-mining stocks have suffered a disastrous year, plummeting while the rest of the stock markets soared.  This vast performance gap has catapulted bearishness on this sector to epic extremes.  Few own gold stocks anymore, and everyone aware of them loathes them.  This has crushed their stock prices to unsustainable fundamentally-absurd levels.  They now offer the ultimate contrarian buying opportunity.


Legendary investor Benjamin Graham, Warren Buffett’s mentor, wrote that stock markets act like a voting machine over the short term.  Stock prices are largely a function of popularity.  The more investors like a sector, the higher they bid its stock prices.  The opposite is true as well of course, an unloved sector sinks as investors abandon it.  That is what happened to gold stocks this year, investment demand evaporated.

This has left gold-stock prices radically undervalued, with the flagship HUI gold-stock index trading under 200 this month.  This is an extraordinary anomaly.  After first hitting 200 over a decade ago in September 2003, the HUI finally left it behind a couple years later in August 2005.  Over the 8+ years since, the HUI has spent only one month under those levels.  That was during 2008’s brutal stock panic and this month.

When a price level is seen only 1% of the time over an 8-year span, there is no chance it is normal or rational.  Such hyper-bearish anomalies always lead to massive mean-reversion bulls.  In less than 3 years after that last gold-stock pricing anomaly in 2008’s stock panic, the HUI more than quadrupled with a monster 319% gain!  Today’s pricing anomaly is far more extreme, making an even bigger recovery likely.

Occasionally investors succumb to groupthink and get way too greedy or fearful as a herd.  Thus their “voting” on stock prices per Graham’s model is wildly skewed.  Very popular sectors see their prices driven far too high, while very unpopular sectors’ stock prices plunge far too low.  This disconnects stock prices from their underlying companies’ true fundamental values derived from their businesses’ earnings power.

Thankfully these popularity and resulting pricing anomalies are soon corrected.  Graham went on to say that over the long term the stock markets act like a weighing machine.  Stock prices ultimately reflect their underlying fundamentals.  So in order to buy low before later selling high, investors should look for sectors that are exceptionally unpopular and thus greatly mispriced.  That describes gold stocks to a tee today.

Gold mining is a rather unique business with one massively dominant fundamental driver of earnings power, the price of gold.  When gold rises, so do the profits for mining it.  And this relationship is certainly not linear.  Due to the largely-fixed costs of mining any particular gold deposit, profits leverage the gains in gold.  Earnings rise much faster than gold, and higher profits make gold miners fundamentally cheaper.

If you want to dig deeper into gold-mining profits, I’ve written about them extensively this year in the midst of this brutal gold-stock pricing anomaly.  Gold-stock valuations have plunged this year to their lowest levels of their entire decade-plus secular bull, way below the general stock markets’.  And many gold miners are now trading at single-digit P/Es despite low prevailing gold prices, very cheap by anyone’s standards.

Since gold-stock fundamentals are so inexorably linked to gold prices, the relative valuations of gold stocks can be easily followed with a simple ratio.  The HUI/Gold ratio divides gold-stock prices as measured by the flagship HUI gold-stock index by the gold price.  HGR analysis shows when gold stocks are cheap or expensive relative to the metal that drives their profits.  And they’ve almost never been cheaper!

This week the HGR fell to 0.157x, literally the lowest level seen since January 2001.  Back then gold was languishing in the $260s late in a multi-decade secular bear.  Its massive secular bull hadn’t even been born yet!  To realize gold stocks today are as undervalued and unpopular as they were nearly 13 years ago before gold’s bull is a stunning revelation.  Is it even possible for this sector to fall more out of favor?

Contrarians should be pilling into these epically-cheap gold stocks today because market sentiment is forever cyclical.  Extreme fear and unpopularity is always followed by gigantic mean-reversion rallies.  In the decade or so after those last similar hyper-low HUI/Gold Ratio levels, the HUI skyrocketed 1664% higher in a span where the benchmark S&P 500 general-stock index fell 14%!  It pays big to buy out of favor.

Incredibly despite that gigantic gold-stock secular bull in the midst of a brutal general-stock secular bear, gold stocks lost much ground relative to gold.  The HGR peaked way up near 0.64x in late 2003 and then again near 0.61x in early 2006.  The latter episode, when the HUI rocketed 38% higher in just 2 months, was the last time gold stocks were truly popular.  Spring 2006 is fondly remembered by gold-stock veterans.

Nevertheless, prior to 2008’s market-wrenching stock panic gold stocks traded in a tight range relative to the gold price which drives their profits.  In a secular 5-year span ending in mid-2008, the HGR spent most of its time between support at 0.46x and resistance at 0.56x.  Its normal pre-panic average was 0.511x, which means gold stocks as measured by the HUI generally traded at a little over half prevailing gold prices.

Unfortunately 2008’s once-in-a-century stock panic shattered that core fundamental relationship.  While gold got sucked into the frenzied panic selling too, the gold stocks fell far faster than gold.  Thus the HGR plunged since gold’s relative performance was better.  In the dark heart of that stock panic, the HGR fell to a secular-bull low of 0.207x.  Gold stocks were despised then too, with extreme bearishness running rampant.

Other than a handful of hardcore contrarians including me, everyone believed this sector was doomed in late 2008.  But I saw those extreme lows as an amazing buying opportunity.  Why?  In late October 2008 near its lows, the HUI was trading at levels it first hit nearly 6 years earlier in January 2003.  At that time, gold was merely trading in the $360s.  But at worst during 2008’s stock panic, it was nearly twice as high.

With gold in the $730s, it made no sense at all for the gold stocks to trade at the same price levels they had been at when this metal was half as high.  So we aggressively bought gold stocks and recommended our subscribers do the same.  Of course we were mocked and ridiculed back then for buying such a wildly unpopular sector.  But when the HUI subsequently more than quadrupled, we multiplied our fortunes.

As gold stocks’ popularity recovered out of those extreme stock-panic lows, the HGR surged to 0.437x by September 2009.  This was more than double its panic lows!  And after that, over the next couple years or so gold stocks stabilized relative to the price of gold.  They advanced with gold, but merely paced it rather than leveraging its gains.  Still, gold stocks were one of the post-panic markets’ best-performing sectors.

But near the height of their post-panic popularity, which was much less than their pre-panic peaks of being in favor, gold started surging in the summer of 2011.  Fears about Washington’s debt-ceiling fight leading to the first-ever US technical default drove huge investment demand for gold.  This is very unusual in gold’s summer doldrums, so gold-stock investors didn’t believe gold’s exceptional gains were sustainable.

We were right.  After becoming extremely overbought in August 2011, gold started correcting sharply.  As usual when gold falls, the gold stocks got hit harder than gold.  Thus the HGR started contracting on gold’s relative outperformance.  This trend persisted until mid-2012, when the HGR bottomed at 0.244x.  The gold stocks were again very unpopular and therefore on the verge of a big mean-reversion rally.

They indeed started surging in 2012’s late summer, but stalled out with gold heading into last year’s fourth quarter.  The HGR was stable heading into that year-end, but started plunging in 2013 on this year’s extreme gold-selling anomalies.  I’ve discussed these in great depth in past essays, and they are critically important for investors to understand.  Gold’s brutal 2013 came from gold selling that is exhausting itself.

As the Federal Reserve convinced stock investors it wouldn’t let stock markets correct, they shunned all alternative investments including gold to flood into general stocks.  This dynamic led to extraordinary record selling of the mighty GLD gold ETF, which was forced to dump massive amounts of gold into the markets to absorb its epic differential selling pressure.  As GLD’s holdings dwindle, this selling is waning.

Fundamentally the flood of gold from gold-ETF liquidations was responsible for all of 2013’s decrease in global demand.  But American futures speculators were quick to jump on the resulting declining gold prices, pummeling gold even lower.  But like extreme gold-ETF selling, extreme futures selling is self-limiting.  So the two factors responsible for 2013’s epic gold anomaly will be dramatically smaller in 2014.

This flood of gold selling pressure in an environment where gold investment was very unpopular due to levitating stock markets destroyed gold stocks.  The HUI plunged to 207 in late June, more than cut in half year-to-date at that point!  And then as this month dawned, more gold selling pressure forced this premier gold-stock index under 200.  And that is where it has languished for the past couple weeks, dismal levels.

At 0.157x this week, the HUI/Gold Ratio has never been lower in this entire secular bull!  This is well below even the gold-stock extreme seen during 2008’s stock panic, which was the greatest fear event anyone old enough to be investing then will witness in our lifetimes.  Gold stocks are so unpopular, so voted out of favor, that they are now trading at end-of-secular-bear levels relative to gold.  This is crazy.

And totally fundamentally absurd!  The HUI hit 193 last week, a level last seen in November 2008 in the dark heart of the stock panic.  Yet back then, gold was merely trading near $745.  Last week it was 65% higher near $1226!  Is it rational for gold stocks to trade as if gold was nearly $500 lower?  Of course not, it is just ridiculous.  Investors are absolutely wrong in abandoning gold stocks to such silly valuations.

That’s not the half of it either.  The first time the HUI hit its past week’s lows was over a decade ago in August 2003.  Back then gold was merely $373.  With gold over three times as high today, it makes zero sense at all for gold stocks to be trading at those same levels.  They are a total anomaly driven by extreme sentiment, irrational fear beyond stock-panic-grade.  That isn’t sustainable and will soon pass, just like in late 2008.

With gold stocks so low relative to gold, it almost doesn’t even matter what gold does.  After falling almost continuously for 3 entire years, the HGR is wildly overdue to mean revert higher.  No trend in the markets lasts forever, and extremes are always followed by mean reversions.  And that portends a massive upleg in the gold stocks.  Before this year’s wild gold-selling anomaly, the HGR averaged 0.346x between 2009 and 2012.

Let’s zoom into these post-panic years in this next chart.  It is similar to the first one with the exception of the yellow line.  That shows where the HUI would be trading at if it returned to its pre-panic average HGR of 0.511x.  Looking at the actual HUI levels (red) compared to that hypothetical line (yellow) offers another way to quantify just how epically unpopular gold stocks have become.  This can’t and won’t last forever.

The HUI/Gold Ratio’s downtrend as gold stocks have fallen more and more out of favor relative to gold in recent years is really pronounced at this scale.  Though the HUI traded between about 60% to 80% of its pre-panic average levels relative to gold in the initial couple post-panic years, this year it is challenging 30%!  It is hard to imagine how gold stocks could get any more unpopular, there has to be a limit at some point.

Gold stocks are so absurdly cheap that some of the smaller miners in our portfolio are trading under 7x earnings even at today’s gold prices!  Contrast this with S&P 500 valuations around 23x.  No matter what gold does, sooner or later value investors are going to take stakes in the dirt-cheap gold stocks.  And since this sector is so out of favor, it won’t take much buying to catapult these stocks higher.  It is inevitable.

If gold stays at $1250, and the HGR merely mean reverts to its pre-2013 post-panic average of 0.346x, the HUI would have to soar 119% higher from today’s dismal levels!  No matter what, the gold stocks are due to more than double in the coming year.  With the general stock markets near nominal record highs, can you think of any other sector that should still double at an absolute minimum?  No, there aren’t any others.

But one of the reasons contrarian investors love mean reversions out of extreme lows is they rarely stop at the mean.  The more extreme prices were pulled in one direction, the more extreme their rebound overshoot tends to be in the opposite direction.  So instead of merely hitting 0.346x, there is an excellent chance that gold stocks will actually get somewhat popular again and see an inversely-proportional upside HGR target.

If you take the pre-2013 post-panic average HGR, subtract this week’s extreme low, and then add the difference back on to the average for an opposite-side mean-reversion overshoot, it yields an HGR target of 0.535x.  We certainly have a far lower chance of seeing this than just the mean, but it isn’t a great stretch.  Even at such a high HGR, gold stocks would remain less popular than they were in much of the pre-panic period.

Even at $1250 gold, that implies a HUI of 669 which is 239% higher from this week’s levels!  For the entire post-panic period, I’ve been predicting the HGR would return to its pre-panic secular average of 0.511x which is very similar.  That would yield a 224% HUI upleg.  But regardless of how high the HGR goes, it can’t remain near today’s extreme 13-year lows.  Sentiment in gold stocks simply has to improve.

At this point it is so bombed out that I suspect the only way it will happen is when gold itself finally starts decisively rallying.  We got a little taste of that this past August, when the HUI rocketed 27.2% in just over a week on a mere 6.1% gold rally!  It’s hard to believe, but there is still a sizable contingent of contrarian investors out there who want to own gold stocks again but are waiting for a green light from gold prices.

And gold really is due to rally big, to experience a huge mean-reversion upleg out of this year’s extreme anomalous selloff.  As I explained last week, the waning of gold-ETF differential selling pressure alone will allow global demand growth to well outpace supply growth and trigger a major upleg.  And the higher gold prices mean revert, the more investors will bid on gold and gold stocks to vote up their popularity.

Consider the impact of the HUI merely mean-reverting to its 2009-to-2012 average HGR in a higher-gold-price environment.  At $1500 gold a 0.346x HGR implies the HUI at 519, 163% above this week’s levels.  Kick the gold price back up to $1750, where it traded just over a year ago, and the conservative HUI target rises to 606 (a triple).  No matter how you want to crunch these numbers, the gold stocks are in for massive gains.

And given the state of gold and the general stock markets today, I fully expect much of this mean reversion to happen soon in 2014.  Gold is loathed and wildly unpopular, hence its price is exceptionally low.  Meanwhile the general stock markets are loved and super-popular, leaving general-stock prices exceptionally high.  Seasoned investors are well aware of this, and will increasingly reposition their capital accordingly.

When the expensive stock markets inevitably start rolling over into a major correction or even a new cyclical bear, institutional investors are going to look for undervalued places to move capital.  And there is no asset class more undervalued now than gold.  Since gold remains such a tiny part of overall portfolios, it won’t take much of a shift (a couple percent) to fuel a mighty upleg in the beleaguered yellow metal.

At Zeal we’re ready.  We’ve fought the good contrarian fight all year long, buying gold stocks as they were pounded lower and lower.  Being brave when others are afraid is the best way to buy low before later selling high.  We expect most of our smaller high-potential gold and silver stocks to far exceed the HUI’s gains in its coming mean-reversion upleg, at least quadrupling.  It is going to be a heck of a ride for contrarians.

You ought to join us.  We publish acclaimed weekly and monthly newsletters for contrarians that offer a priceless perspective you’ll never hear in the mainstream financial media.  In them I draw on our hard-won experience, knowledge, wisdom, and ongoing research to explain what is going on in the markets and why.  Since 2001, all 655 stock trades recommended to our subscribers have averaged annualized realized gains of +28.6%!  Subscribe today, grow as a contrarian investor, and multiply your wealth.

The bottom line is gold stocks are as unpopular today as they’ve been since the end of the last secular gold bear.  They are now priced as if gold was just 30% to 60% of its prevailing price levels, which is truly fundamentally absurd.  Gold stocks weren’t even this low relative to gold in 2008’s stock panic, after which they more than quadrupled.  An even bigger mean-reversion upleg is due out of today’s greater anomaly.

But only contrarians will reap these massive coming gains.  It is exceedingly hard psychologically to fight the crowd, to invest in sectors cheap and loathed rather than expensive and loved.  But investors will gradually return, they always do after extreme fear drives prices way too low fundamentally.  Gold stocks trading at secular-bear price levels relative to gold is just too enticing to keep smart capital away for long.

Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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