Apathy mounts, leading to gold-stock selling, which is what’s necessary to rebalance sentiment after a major upleg…
The gold miners’ stocks have suffered a lackluster few months. That’s a disheartening contrast to their powerful summer upleg on gold’s bull-market breakout. While this healthy gold-stock correction likely isn’t over yet, the gold miners remain very undervalued relative to the metal they produce. That means they still have massive upside left in this secular gold bull. Sentiment just needs rebalancing before its next upleg.
In recent months I’ve written a lot about gold’s correction, which is naturally driving a parallel one in the gold miners’ stocks. I’ve explained why speculators’ positioning in gold futures, gold’s dominant primary short-term driver, remains bearish with potential selling vastly outweighing likely buying. I’ve shown how shallow and short gold’s recent correction is compared to bull-market precedent, implying it isn’t mature yet.
This hasn’t changed, gold’s correction is alive and well. Based on their gold-bull-to-date trading ranges, the latest weekly read on specs’ gold futures revealed they have room to buy 59.4k contracts. But that is dwarfed by 6.3x with their potential selling at 372.3k! And at worst so far, gold has only retreated 6.4% in 2.8 months. This secular bull’s prior two corrections following uplegs averaged 15.5% selloffs over 6.0 months.
If gold continues grinding lower as specs’ collective bets are normalized, it will drag down the gold stocks with it. The major gold miners tend to leverage gold’s material moves by 2x to 3x. That is evident in their leading benchmark GDX VanEck Vectors Gold Miners ETF. Discussing this gold-stock correction in last week’s essay, I pointed out GDX has only lost 15.4% over 1.3 months at worst. That’s 2.4x downside leverage.
But this gold-stock bull’s prior couple corrections directly driven by gold’s averaged 35.4% GDX losses in 11.8 months. That made for 2.3x downside leverage to gold. If gold’s correction isn’t over yet, neither is the gold stocks’. That being understood, speculators and investors need to look past this valley and start preparing for the next ascent. Uplegs and corrections meander in perpetually-alternating cycles in markets.
The major corrections inevitably following major bull-market uplegs are mostly driven by sentiment. The excessive greed generated late in bull uplegs has to be bled away before the next upleg can follow. The only way to kill major-high exuberance is through subsequent selloffs, which ultimately spawn fear. But the broader bull markets containing those individual uplegs and corrections are fueled by fundamentals.
That’s how much profits gold miners are earning compared to their prevailing stock prices. And they are looking fantastic. In mid-November as the latest earnings season ended, I dug into the GDX gold miners’ Q3’19 results. These fundamentals are the strongest they’ve been in years, thanks to gold’s bull-market breakout rally this past summer. Q3’s average gold price of $1474 soared a colossal 21.7% year-over-year!
That drove explosive profits growth unparalleled in all the stock markets. Based on the average all-in sustaining costs of the GDX miners, their earnings catapulted an astounding 68.9% higher YoY! That was awesome 3.2x upside leverage to gold’s gains. And that stupendous earnings growth is likely to persist. With gold’s correction tarrying, Q4’s average gold price so far at $1481 is even a bit better than Q3’s.
I’ve done deep bottom-up analysis on many individual gold miners every quarter for years, which is very data-intensive both to do and explain. That proves the strong relationship between gold-mining profits and prevailing gold prices. Gold stocks are essentially leveraged plays on gold. Thankfully there’s a simple proxy to visualize gold stocks’ valuations relative to gold, the ratio between stock prices and gold’s own price.
The gold stocks as a sector can be measured by GDX. Its daily closes can then be divided by those of the world’s dominant gold ETF, the GLD SPDR Gold Shares. The result is the GDX/GLD Ratio, or GGR for short. Charting it over time shows whether gold stocks are gaining or losing ground relative to gold, and more importantly whether they are richly-valued or undervalued compared to the metal they bring to market.
The latter is true today, gold stocks remain very cheap relative to gold. Again that doesn’t mean that their healthy and necessary correction is over. But it does greatly boost the odds the coming gold-stock uplegs in this secular gold bull are going to be outsized. The gold stocks have to power far higher to reasonably reflect these higher prevailing gold prices. The biggest gains of their bull market are almost certainly yet to come.
At best in this entire bull so far, GDX had blasted 151.2% higher by early August 2016. That’s actually still tiny by gold-stock-bull standards! This sector’s last secular bull ran for 10.8 years from November 2000 to September 2011, straddling the birth of GDX. The older benchmark HUI NYSE Arca Gold BUGS index skyrocketed 1664.4% higher over that span! Gold stocks were that decade’s top-performing stock sector.
Like most other indicators, the GGR is still bearish over the near-term. It joins the chorus suggesting this gold-stock correction isn’t finished yet. This first chart superimposes the GGR in blue with its technicals over GDX itself in red during this gold-stock bull. The GGR hasn’t yet retreated low enough to signal a likely bottoming in gold stocks. This key gold-stock valuation metric remains high for a gold-stock correction.
The GGR’s primary value over the short-term is highlighting trends in gold-stock performance versus the metal they mine. When this ratio is rising, the gold stocks are outperforming gold. That usually happens during gold uplegs, when the major gold stocks of GDX again amplify gold’s gains by 2x to 3x. All 3 of this gold-stock bull’s major uplegs saw big GGR gains. Gold stocks were advancing much faster than gold.
But gold stocks’ leverage to gold is a double-edged sword, working equally as well on the downside when gold corrects. So the GGR has retreated during this gold bull’s prior couple corrections, showing the gold stocks as measured by GDX were falling faster than gold as measured by GLD. So in other words, gold outperforms its miners’ stocks during corrections by not selling off as much. The GGR nicely quantifies this.
Heading into this gold-stock bull’s initial correction in mostly the second half of 2016, the GGR peaked at 0.244x. A share of GDX was worth almost a quarter of a GLD share. By the time the dust settled, GDX had plummeted 39.4% compared to gold’s milder 17.3% correction! That crushed the GGR back down to 0.176x. This key fundamental indicator plunged by 27.9% or 0.068x absolutely in that utterly brutal selloff.
This gold-stock bull’s second correction began in early 2017, but dragged on way into summer 2018. It hammered GDX 31.1% lower, again much worse than gold’s own 13.6% correction that drove those gold-stock losses. The GGR peaked at 0.216x in the preceding upleg, before plunging to 0.155x by that next correction bottoming. That’s a 28.1% or 0.061x gold-stock-correction GGR retreat, similar to the earlier correction.
So this bull’s previous corrections averaged tight 28.0% or 0.065x GGR slumps. Contrast that to the gold stocks’ current correction. The latest GGR peak hit 0.211x in early September, and at worst so far merely fell back to 0.188x in mid-October. That makes for only an 11.1% or 0.023x GGR retreat at most. Thus odds are the gold miners’ stocks haven’t fallen far enough yet relative to gold to rebalance their sentiment!
Past gold-stock corrections saw the miners’ stocks drop far enough compared to gold to force the GGR under both its 200-day moving average and gold-bull average. Neither has happened yet in this current correction, with these metrics now running 0.191x and 0.186x. The gold stocks aren’t likely to finish their crucial sentiment-rebalancing selloff until this GGR retreat grows larger, more in line with bull-to-date norms.
Given the better prevailing psychology now after gold’s summer bull-market breakout, there’s probably no need for this gold-stock correction to snowball to much-higher bull averages. That’s both in terms of GDX itself and its fundamental relationship to gold as quantified by the GGR. But this gold-stock selling still has to persist long enough and be big enough to largely eradicate greed, which really hasn’t happened yet.
The reason gold-stock prices have stayed relatively high absolutely and compared to gold since their latest upleg toppings in early September is residual greed. Major uplegs generate great greed, complacency, and euphoria as they go terminal. These can only be eradicated and turned to fear, worry, and despair through sizable correction selloffs. That has yet to happen after this latest topping, the downside has been mild.
Regardless of this near-term bearish outlook on gold-stock prices, their longer-term prospects driven by fundamentals instead of sentiment look awesome. An analogy is a spring snow storm. As spring progresses, temperatures are generally warming and daylight lengthens. That’s similar to a secular-bull uptrend in the markets. Spring and summer are coming in gold stocks, after their long winter bear ending in early 2016.
Yet even in the warmest of springs, strong snow storms are always possible. Temps plunge in those, and they make it look like winter is returning. Yet no matter how severe they get, they can only last for short spells. The spring warming trend driven by far-larger factors persists, despite any temporary reversals. There’s no contradiction inherent in expecting near-term gold-stock weakness before a resuming secular bull.
This next chart uses this same GGR data but zooms out to a longer time horizon, since 2007. As GDX was birthed in May 2006, that encompasses nearly its entire lifespan. Despite their near-term correction risks, the gold miners’ stocks remain deeply undervalued relative to the metal they mine. Thus they have massive upside as this gold bull’s future uplegs unfold. Gold stocks still need to mean revert radically higher!
This current young gold-stock bull that has enjoyed some powerful uplegs in recent years still looks tiny in big-picture context. Incredibly its average GGR of 0.186x is so darned low that it is still below the wildly-extreme stock-panic levels from late 2008! That first true stock panic in a century was the biggest market fear event of our lifetimes. It’s crazy that nearly this entire gold-stock bull has drifted below that miserable metric.
Gold stocks traded far higher relative to prevailing gold prices before that panic, with the GGR averaging 0.591x in the preceding 2 years. While that drooped to 0.422x in the 2 years after that panic, that was still far higher than today’s gold bull. For GDX merely to regain those levels relative to GLD, it would have to soar another 114% higher from this week’s levels! Gold stocks remain radically undervalued compared to gold!
A more-conservative post-stock-panic GGR average is the 4-year one from 2009 to 2012. That was after that stock panic, but before 2013 where the Fed epically distorted markets. That year was when its third quantitative-easing bond-monetization campaign peaked. The Fed’s balance sheet skyrocketed 38.7% or $1125.3b higher that year alone, far beyond any precedent! The US stock markets soared 29.6% on that.
Such astounding stock-market gains killed demand for alternative investments led by gold. So the yellow metal plummeted by 27.9% in that peak-QE year, crushing GDX a gut-wrenching 54.5% lower in 2013! Thus the 4 years between those wild events were arguably the last quasi-normal years in the markets. During that span, the GGR averaged 0.381x. GDX would have to soar 93% higher to regain those levels today.
Gold stocks are still super-cheap relative to the metal they mine which drives their profits. That anomaly has to be rectified before this gold bull runs its course. GGR extremes never last, but see sharp mean reversions and subsequent overshoots eventually. That will happen as today’s secular gold bull matures in future years. The gold stocks will far outperform gold’s coming uplegs, regaining much lost ground.
No one knows how big gold’s bull market will ultimately prove, but it’s likely to be very large given the vast monetary inflation the world’s major central banks are spewing into the markets. But even considering the next upleg alone shows how compelling the gold-stock opportunities are. This gold bull has enjoyed 3 major uplegs so far, up 29.9%, 20.4%, and 32.4%. Gold’s next major upleg should prove relatively in-line.
While these bull-to-date upleg gains averaged 27.6%, let’s conservatively assume 20% for the next one. If gold’s correction extends to 10%, much smaller than that 15.5% bull-to-date average, gold will bottom near $1400. A 20% upleg from there would carry gold near $1680. At the current gold-stock bull’s super-low GGR of 0.186x, that implies GDX would rally near $29.50. The gold-price-to-GLD conversion loses 5.8%.
GLD’s managers have big costs storing gold bullion, so they charge investors 0.4% of its net assets each year. Cumulatively since GLD’s late-2004 launch, that adds up to about 5.8%. GDX $29.50 isn’t very exciting though, just 7.5% above this week’s levels. That’s because GDX would leverage a 10% gold correction by 2x to 3x, extending its own correction to 20% to 30%. So GDX’s next upleg would start off lower.
But on balance during secular gold bulls, gold stocks regain ground relative to gold. The longer they’ve generally powered higher in a bull uptrend, the more capital speculators and investors deploy in them to chase this sector’s gains. That leads to much-higher prevailing gold-stock prices. The gold miners’ upside over the coming year if the GGR mean reverts back up to that post-panic 0.381x average is impressive.
At $1680 gold and a 0.381x GGR, GDX would soar near $60.25! That’s about 120% higher from this week’s levels, and a whopping 160% higher than where GDX would bottom if its total correction extends to 25% before gold’s next upleg starts marching. With gold stocks remaining so cheap relative to gold today, their upside potential remains massive. And even these targets are conservative on multiple fronts.
Gold’s secular bull is likely to see at least several more major uplegs in coming years, not just one. And gold stocks not only mean revert in GGR terms, but overshoot proportionally to the high side as euphoria builds late in secular gold bulls. So if you plug in higher gold prices, and higher GGRs, the potential gold-stock upside targets get astoundingly high. Remember gold stocks’ last secular bull saw epic 1664% gains!
So it’s exceedingly important not to make the big mistake most traders do during major corrections. As gold and gold prices grind lower over a few months or more, traders gradually lose interest. Apathy mounts leading to gold-stock selling, which is what’s necessary to rebalance sentiment after a major upleg. By the time gold and gold stocks have bottomed, traders have either moved on or given up on those bulls.
That means they won’t buy low as corrections end, greatly limiting their potential gains in the following uplegs. The only way to overcome these natural human tendencies is to always follow the markets, to keep the big picture in mind no matter what short-term trends are. And while today’s remain bearish for gold stocks over the near-term, their deep undervaluation relative to gold implies their bull is still young.
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The bottom line is gold stocks remain very undervalued relative to gold. They’ve spent most of this bull languishing under stock-panic extremes, which means they still have vast room to mean revert higher. Such low gold-stock prices compared to prevailing gold levels virtually guarantee the miners will enjoy seriously-outsized gains during future gold uplegs. They can way-outperform gold for years before normalizing.
But that longer-term super-bullish fundamental outlook doesn’t negate the need for periodic corrections to rebalance sentiment. The recent one is likely still underway today, as key gold and gold-stock indicators have shown no signs of bottoming yet. That’s wonderful news if you’re looking to deploy capital in this highest-potential sector, as the next big mid-bull buying opportunity before gold’s next upleg is likely still coming.
Adam Hamilton, CPA