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Adam Hamilton

Adam Hamilton

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…

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Gold-Stock Upside Huge

The gold miners’ stocks have huge upside potential in 2018, likely the best among stock-market sectors.  They really lagged gold last year, so a major mean-reversion catch-up rally is coming.  The gold miners are universally ignored and deeply undervalued relative to the metal which drives their profits.  And gold itself is likely to power dramatically higher this year as euphoric record-high stock markets inevitably start to falter.

Gold has always been the leading contrarian investment, tending to move counter to stock markets.  So not surprisingly investment demand stalled last year as the extreme taxphoria-fueled stock surge blasted relentlessly higher.  When stock markets apparently do nothing but rally indefinitely, investors feel no need to prudently diversify their portfolios with the anti-stock trade gold.  So they ignored the yellow metal in 2017.

That was certainly evident in the leading proxy for gold investment demand, the flagship American GLD SPDR Gold Shares gold ETF.  Its physical gold bullion held in trust for shareholders merely grew 1.9% or 15.3 metric tons in 2017.  That was a colossal slowdown from 2016’s massive 28.0% or 179.8t growth!  Given the weak gold investment demand last year, it’s rather impressive how well gold managed to perform.

Big up-years in the stock markets sometimes drive big down-years in gold, and 2013 was a key case in point.  That year extreme Fed easing catapulted the benchmark S&P 500 broad-market stock index (SPX) an amazing 29.6% higher.  Exuberant investors wanted nothing to do with gold, and dumped it in droves.  So the gold price plummeted 27.9% in 2013, leaving deep psychological damage that persists to this day.

In 2017 the SPX soared 19.4% on hopes for big tax cuts soon from the newly-Republican-controlled US government.  Extreme complacency, greed, euphoria, and even hubris ran rampant among investors.  It was a perfect scenario to see gold crushed again on a mass exodus of investor capital.  Yet despite the stock markets enjoying their best year since 2013, gold was still able to achieve a strong 13.2% gain in 2017!

Nevertheless, the wildly-optimistic stock-market sentiment drowned out everything else so psychology in precious metals remained exceptionally weak.  The leading indicators for gold sentiment are this metal’s peripheral leveraged plays of silver and gold miners’ stocks.  Both typically amplify gold’s upside by 2x to 3x.  But oddly in 2017 despite gold’s big rally, silver and the main gold-stock index only climbed 6.4% and 5.5%.

That index is of course the NYSE Arca Gold BUGS Index, better known by its symbol HUI.  It is closely mirrored by the dominant gold-stock ETF, the GDX VanEck Vectors Gold Miners ETF.  The composition of these gold-stock trackers is very similar by necessity, as the universe of major gold miners to pick from when building indexes is small.  Without scales, it’s impossible to tell the difference between HUI and GDX charts.

In a 13.2% gold up-year like 2017, the HUI really should’ve leveraged that by 2x to 3x to enjoy solid annual gains of 26.4% to 39.7%.  Yet because investors weren’t interested in either gold or its miners’ stocks, the HUI languished with that miserable 5.5% gain last year.  That made for terrible 0.4x leverage to gold, which is wildly unacceptable.  Gold miners must generate greater returns than gold to be viable investments.

Owning gold miners is much riskier than simply owning gold itself.  On top of all the price risks that gold faces, the miners heap many additional operational, geological, and geopolitical challenges.  They must compensate investors for these considerable added risks relative to owning gold outright, or there is truly no point in owning them at all.  2017 was a rare anomaly where they dramatically lagged gold’s solid rally.

That’s very unlikely to persist into 2018, as we’re already seeing.  Since the Fed’s 5th rate hike of this cycle in mid-December, gold and the HUI have rallied 5.5% and 12.8% as of the middle of this week.  That makes for solid 2.3x upside leverage, already a vast improvement over last year’s 0.4x.  Thus investors are already returning to gold stocks in a meaningful way, and this young trend should accelerate.

The gold miners’ stocks are radically undervalued fundamentally after so horribly underperforming gold last year.  Gold mining is a simple business from a profits standpoint.  Miners painstakingly wrest gold from the bowels of the Earth, then sell it at prevailing market prices.  So their earnings are the differences between current gold prices and mining costs.  Gold-mining profitability was actually fairly strong in 2017.

Right after quarterly earnings seasons, I dig into the newest reports from the world’s top gold miners included in that leading GDX gold-stock ETF.  In their latest-reported quarter of Q3’17, the top 34 GDX component gold miners averaged all-in sustaining costs of $868 per ounce.  AISCs are this industry’s main profitability measure, accounting for not only mining but maintaining production by replenishing reserves.

One of the primary attributes that makes gold stocks so attractive to investors is the fact these costs don’t change much regardless of prevailing gold prices.  Over the past 7 quarters ending in Q3’17, GDX’s top-34 gold miners reported average AISC of $833, $886, $855, $875, $878, $867, and $868.  That makes for a tight variance, despite gold trading as low as $1074 and as high as $1365 during this same span.

These quarterly major-gold-miner average AISCs within this gold bull have their own mean of $866, so let’s assume this industry can operate at $865 all-in sustaining costs.  In 2017 gold averaged $1258 per ounce, so the major gold miners were collectively earning profits of $393 per ounce.  That equates to hefty 31% profit margins, levels most industries would die for.  Yet gold-mining stocks certainly didn’t reflect this!

The HUI averaged just 196.0 in 2017, incredibly-low levels.  This leading gold-stock index first hit 196 in September 2003 when gold was only trading near $375.  Back then the major gold miners were far less profitable in both absolute and percentage terms.  In 2004 the HUI averaged 212.2, considerably better than 2017 levels despite gold’s super-low average price of $409 that year.  Today’s gold-stock prices are absurd!

In 2010 the gold price averaged $1228, a bit below 2017’s $1258.  Yet the HUI averaged 471.5, or a whopping 141% higher than last year’s ridiculous levels.  The gold miners’ stocks are now priced as if this industry was operating at massive cashflow losses with its very future viability called into question.  Yet obviously that isn’t the case, as the gold miners are generating big positive cashflows and profits today

The only explanation for this epic fundamental anomaly is extreme sentiment, which never lasts for long.  Because the stock markets soared in taxphoria last year, investors shunned gold and everything related to it.  Thus the gold stocks fell deeply out of favor, universally ignored if not scorned.  When that weird psychology inevitably shifts, the beaten-down gold stocks are going to stage a massive catch-up upleg.

There’s plenty of precedent for that.  Back in early 2016 when the general stock markets suffered their last correction, gold investment demand exploded for prudently diversifying stock-heavy portfolios.  The SPX only fell 13.3% over 3.3 months, but even that minor correction was enough to rekindle big gold buying.  That catapulted gold 29.9% higher in 6.7 months, birthing its first new bull market since 2011!

Like today, gold stocks were neglected and anomalously-cheap before that last stock-selloff-driven gold upleg.  Then in roughly that same first-half-of-2016 span, the HUI skyrocketed 182.2% higher in just 6.5 months!  That made for amazing 6.1x upside leverage to gold.  When gold stocks have underperformed their metal, their catch-up rallies are huge and greatly amplify gold’s gains.  2018’s action should echo 2016’s.

Gold stocks certainly have the potential today to see similar fast gains this year to their near-triple in a half-year on gold powering less than a third higher a couple years ago!  The lead-in to 2018 was very similar to that lead-in to 2016, with gold stocks deeply out of favor and thus languishing at fundamentally-absurd price levels relative to their profits.  But the vast majority of traders haven’t figured this out yet.

Investment is all about buying low then selling high, and that requires buying when assets are unpopular and thus underpriced.  Unfortunately most investors ultimately perform poorly because they reverse this.  They instead wait to buy until assets are adored, which forces them to buy really high.  Then once those assets inevitably mean revert to much-lower levels, investors succumb to popular fear and sell low for big losses.

In late 2015 just like in late 2017, the contrarian gold-stock sector was despised.  Few investors were even aware of it, and most of those didn’t want to touch it with a ten-foot pole.  Yet in 2016, the gold stocks were the best-performing stock-market sector.  The HUI rocketed 64.0% higher that year on a mere 8.5% gold rally, trouncing the SPX’s 9.5% gain!  Fighting the crowd to buy low really multiplies wealth.

There’s a high probability the gold miners’ stocks will once again prove the best-performing stock-market sector in 2018.  There’s virtually nothing else deeply out of favor and radically undervalued in these entire taxphoria-inflated stock markets!  Everything else has already been bid dramatically higher, and thus is susceptible to suffering sharp selloffs as the stock markets roll over.  Gold stocks are the only bargains left.

Since prevailing gold prices directly drive gold-mining profitability and hence ultimately stock prices, the HUI/Gold Ratio is a great valuation proxy for this sector.  It simply divides the daily HUI close by the daily gold close.  When charted over time, this core fundamental relationship reveals when gold stocks are overvalued or undervalued relative to gold.  And there’s no doubt the latter is true in spades heading into 2018.

Despite the gold miners’ nice post-FOMC-meeting rally in recent weeks, they left 2017 trading at an HGR of just 0.148x.  In other words, the HUI was trading at just under 15% of the gold price.  This ratio means nothing in isolation, but years of history shows when gold stocks are high or low compared to gold.  And they almost couldn’t be lower today, or more undervalued.  Essentially only 2015 saw worse gold-stock prices.

That happened to be the climaxing stretch of a major gold bear that ran 6.1 years leading into the Fed’s first rate hike of this cycle in December 2015.  The HGR slumped to all-time lows near 0.09x late that year, extreme and unsustainable.  And indeed the gold stocks rallied sharply out of that anomaly, again nearly tripling in a half-year.  Gold-stock prices remain super-low, overdue to mean revert dramatically higher.

This long-term HGR chart encompasses a 15-year secular span that included every conceivable market condition for gold and its miners’ stocks.  The HGR averaged 0.341x through all of it, or fully 2.3x higher than today’s extreme lows.  That means the gold stocks as measured by the HUI ought to be trading at least 127% higher than today’s levels!  And that’s assuming gold just stalls out instead of rallying further.

Instead 2018 is almost certain to see gold surge dramatically higher in its next major bull-market upleg.  That leaves the gold stocks with early-2016-like potential to skyrocket again, greatly outperforming gold until their stock prices catch up or more likely overshoot to the upside.  The driver will once again be these euphoric stock markets rolling over into their next correction or more likely the long-overdue bear market.

Despite the extreme stock euphoria as 2018 dawns, today’s stock markets are hyper-risky.  They have powered higher for years now on extreme central-bank easing before the recent taxphoria.  But that has forced them to exceedingly-dangerous bubble valuations.  The SPX left 2017 with its elite component stocks sporting an average trailing-twelve-month price-to-earnings ratio of 30.7x, above the 28x bubble threshold!

The SPX has now gone 1.9 years without a 10%+ correction, and such selloffs tend to happen at least once a year in healthy bull markets.  Now that the highly-anticipated Republican corporate tax cuts have indeed come to pass, 2017’s taxphoria will naturally fade.  The more-optimistic Wall Street estimates are for those tax cuts to boost corporate earnings by 10% in 2018, which still won’t justify today’s lofty stock prices.

If this year sees SPX earnings indeed grow 10%, that still leaves its components’ average P/E ratio way up at a near-bubble 27.6x!  Stock valuations are so extreme after an extraordinary 8.8-year 301.0% SPX bull market that the biggest US corporate tax cuts ever will barely put a dent in bubble valuations.  That leaves stock markets at risk for their first correction-grade selloff since early 2016, which is great news for gold.

But the real coup de grâce to these euphoric record stock markets will be this year’s enormous central-bank tightening radically unprecedented in history.  The Fed’s new quantitative-tightening campaign is ramping up in 2018, starting to unwind years of epic quantitative easing.  And the European Central Bank is sharply tapering its own QE bond buying by slashing it in half.  Together this will strangle this stock bull.

There is nothing more important to the global markets this year than this unparalleled tightening by both the Fed and ECB.  I wrote a whole essay analyzing it in depth back in late October, which every investor needs to understand!  Compared to 2017, 2018 and 2019 will respectively see $950b and $1450b more tightening and less easing from the Fed and ECB!  Nothing remotely like this has ever before been witnessed.

When these central-bank-easing-inflated record stock markets face the biggest central-bank tightening in world history, while trading at bubble valuations no less, the only possible outcome is a serious selloff.  At best it will be a major correction approaching 20% in the SPX, but far more likely a new bear market.  Those tend to run near 50% losses over a couple years, annihilating wealth of investors who get trapped in them.

Just like in early 2016, the long-overdue next major stock-market selloff will quickly rekindle major gold investment demand.  Investors will remember gold when their stock-heavy portfolios start tanking, and rush to diversify into it.  The reason gold rallied 29.9% in roughly the first half of 2016 is investors flooded back into gold following the last SPX correction.  That was led by American investors heavily buying GLD shares.

This dominant global gold ETF saw its holdings skyrocket 55.7% or 351.1t over that same short span!  That was just after a 13.3% SPX correction.  Imagine the gold investment demand if we approach 20% or go beyond into the inevitable next bear.  The differential GLD-share buying forcing stock-market capital into physical gold bullion could very well be unprecedented.  That’s exceedingly bullish for gold stocks!

When this gold-demand-killing stock euphoria inescapably breaks, gold could easily power another 30% higher in 2018.  But let’s be conservative and look for a 20% upleg, which would leave gold near $1563.  That’s still well below gold’s all-time high of $1894 in August 2011, not extreme by any measure.  Gold was above $1550 almost continuously for 1.8 years between July 2011 to April 2013, we’ve seen it before.

At $1565 gold and those top-34 GDX gold miners’ average all-in sustaining costs of $865 during this gold bull, their profits would soar to $700 per ounce!  That’s 78% above 2017 levels.  There’s nowhere else in all the stock markets where such huge earnings growth is even possible, let alone probable.  Such a big surge in profits coupled with excessively-low gold-stock prices would lead to huge fundamentally-driven gains.

At $1565 gold and that 15-year-average 0.341x HGR, that implies the HUI fair value is around 534.  That is 170% above this week’s gold-stock levels.  Thus much like early 2016, the gold stocks truly have the potential to nearly triple again in 2018 on higher gold prices!  Even better, after being excessively low the gold stocks tend to not just mean revert but overshoot to overvaluations.  So their upside potential is huge.

The gold stocks are really a coiled spring today, ready to explode higher in 2018 and trounce everything else.  They are deeply out of favor, incredibly undervalued, and one of the only sectors that can rally sharply when general stock markets sell off.  If you want to multiply your wealth this year by fighting the crowd to buy low then sell high, this small and forgotten contrarian sector is the place to be.  Nothing else rivals it.

While investors and speculators alike can certainly play gold stocks’ coming powerful upleg with the major ETFs like GDX, the best gains by far will be won in individual gold stocks with superior fundamentals.  Their upside will far exceed the ETFs, which are burdened by over-diversification and underperforming gold stocks.  A carefully-handpicked portfolio of elite gold and silver miners will generate much-greater wealth creation.


The key to this success is staying informed and being contrarian.  That means buying low before others figure it out, before undervalued gold stocks soar much higher.  An easy way to keep abreast is through our acclaimed weekly and monthly newsletters.  They draw on my vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks.  For only $12 per issue, you can learn to think, trade, and thrive like contrarians.  Subscribe today, and get deployed in the great gold and silver stocks in our full trading books!

The bottom line is gold-stock upside potential is huge in 2018.  The gold miners really lagged gold last year due to the extreme stock euphoria gutting gold sentiment.  That left gold stocks deeply out of favor and exceedingly cheap relative to the metal which drives their profits.  This extreme anomaly won’t last for long, as investors will flood back into these fundamental bargains as gold starts powering higher again.

Gold investment demand is set to surge again when these euphoric stock markets inevitably roll over into their next major selloff.  The likely trigger will be massive central-bank tightening at wildly-unprecedented levels.  The last time stock markets corrected, gold shot up almost a third while gold stocks nearly tripled in merely a half-year!  2018 is perfectly set up for a similar scenario, portending massive gold-stock gains.

By Adam Hamilton

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