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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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Are Gold Stocks Still Undervalued?

Gold Stocks

Gold miners’ stocks rocketed out of mid-March’s stock panic, breaking out to major new bull-market highs in mid-May. Such blisteringly-fast gains, and gold stocks’ upleg stalling out since, have left many traders nervous about this sector. Calls for a serious selloff are mounting. But arguing in favor for more near-term gains to come, gold stocks never grew overvalued in this post-panic upleg and are still undervalued today.

The recent gold-stock action is best understood through this sector’s most-popular benchmark, the GDX VanEck Vectors Gold Miners ETF. Holding the world’s biggest and best gold miners, it dominates gold-stock-ETF capital flows. GDX’s world-leading $15.1b in net assets this week are triple the size of its little-brother GDXJ mid-tier gold miners ETF! No other gold-stock ETFs come remotely close to GDX’s scale.

And the major gold stocks of GDX have been on a wild ride in recent months. As gold itself got sucked into mid-March’s stock panic, which was fueled by fears of the economic impact of COVID-19 lockdowns, the gold stocks plummeted. GDX collapsed 38.8% in 0.6 months into mid-March. And the final couple days of that were technically a full-on crash, a 20%+ cratering in 2 days. GDX crashed 24.5% in that span!

That left gold stocks radically oversold and absurdly undervalued, so they immediately staged a violent V-bounce. The mean reversion out of the panic’s exceedingly-anomalous lows was wildly profitable for traders who added gold-stock positions in that brutal carnage. That included our newsletter subscribers, as we started aggressively buying and recommending fundamentally-superior gold stocks right after those lows.

From there GDX skyrocketed 95.8% higher in just 2.2 months into mid-May! That rare opportunity to ride a quick doubling was awesome. Hardened contrarians tough enough mentally to buy in crazy-low when everyone else was fleeing in terror multiplied our wealth fast. But since then gold stocks have weakened on balance. By last week GDX had slumped into correction territory, with a 12.8% loss in the post-peak month.

This gold-stock-bull-technicals chart illustrates this sector’s neck-snapping crashing and savage V-bounce higher. GDX not only soared, but broke out to major new bull-market and secular highs in this massive post-stock-panic rebound. With gold-stock price levels undeniably high in the context of this bull, traders are worried a serious selloff is brewing. Many have been exiting gold-stock positions since mid-May’s peak.

There’s no doubt a near-doubling in a couple months or so really stretched gold stocks technically. When GDX hit a 7.1-year secular high of $37.21 in mid-May, it was far above its 200-day moving average. The relationship between prices and their 200dma baselines illuminates overboughtness and oversoldness. At gold stocks’ latest interim high, GDX was trading way up at 1.311x its 200dma. That was very overbought.

That’s one big reason the major gold stocks have consolidated high since, drifting sideways on balance to bleed off the excessively-greedy sentiment of mid-May. GDX didn’t plunge out of those lofty levels, but gradually drifted lower until it hit its 50dma. That has acted as support since. This technical behavior is much more typical of mid-upleg pauses than far-more-serious selloffs after major uplegs give up their ghosts.

This gold-stock bull’s only other comparable upleg to this current post-panic one was its maiden soaring back in the first half of 2016. Then GDX skyrocketed 151.2% higher over 6.4 months, far-more-extreme gains than the recent 95.8% in 2.2 months. That left GDX wildly more overbought, as it soared as far as 1.646x its 200dma in July 2016! That dwarfed that recent peak-overboughtness which was again only 1.311x.

After a tight double-top peaking in early-August 2016, GDX plunged 16.7% in the first month or so after that greed-drenched topping. That was considerably worse than the major gold stocks’ recent 12.8% retreat into mid-June 2020. In August 2016 GDX’s 50dma decisively failed just a couple weeks into that selloff. This time around GDX’s same 50dma line has again held strong as mid-upleg support for 5 weeks now. Related: Saudi Arabia Is Fighting A War On Two Fronts

The gold-stock price action since GDX’s mid-May peak has been way more consistent with a short mid-upleg pause than a long and deep post-upleg correction. Stallings and subsequent high consolidations are very healthy, rebalancing sentiment by bleeding off the excessive greed always seen after fast gains to major highs. One key reason this already-big gold-stock upleg is likely still alive and well is valuations.

Valuations measure where stock prices are trading relative to underlying corporate earnings, which are the ultimate driver of long-term price levels. The more expensive stocks are relative to their profits, the greater the odds a technical selloff will snowball into a much-larger major correction or even bear market. If the gold stocks had been really overvalued in mid-May or since, it would really up near-term downside risks.

Conventional stock-market valuation metrics like trailing-twelve-month price-to-earnings ratios certainly apply to the gold miners. But that voluminous data is challenging and tedious to amass. Because of the unique nature of the gold-mining industry, there’s a simple valuation proxy that reveals whether gold-stock price levels are relatively undervalued or overvalued. That’s the relationship of gold-stock prices to gold.

Gold-mining earnings are directly driven by prevailing gold prices. Since gold-mining costs are largely fixed quarter after quarter, profits rise and fall amplifying changing gold prices. This is easy to understand with a quick illustration. In Q1’20, the elite GDX gold miners averaged all-in sustaining costs of $932 per ounce. Let’s round that up to $950 to make the math easier. At $1750 gold, that implies profits of $800 per ounce.

If gold falls $200 or 11.4% to $1550 in a correction, gold-mining profits also fall $200 but that’s a larger 25.0% contraction. If gold rallies $200 or 11.4% to $1950, gold-mining earnings also surge $200 making for 25.0% growth. As goes gold, so go the gold miners’ profits in leveraged fashion because of their fixed mining costs. Gold prices are the most-important driver by far of gold-mining profitability, utterly dominating it.

So looking at gold-stock price levels compared to gold prices over time offers a great proxy for valuations in this sector. If gold stocks are high relative to gold, they may be overvalued. If they are low relative to gold, they are likely undervalued. There are various ways to express this ratio, but the easiest one for most people to chart today is the GDX/GLD Ratio. GLD of course is the leading SPDR Gold Shares gold ETF.

Dividing GDX’s daily closes by GLD’s daily closes and charting the resulting GGR reveals trends in gold-stock valuations. And considering recent gold-stock price action relative to gold casts it in a different light. This chart superimposes this GDX/GLD Ratio over the raw GDX index during this secular gold-stock bull. And it reveals gold stocks have yet to get particularly overvalued despite their massive mean reversion higher.

Way back in mid-January 2016, this gold-stock bull was born out of a super-low 0.120x GGR. My essay that week was literally called “Absurd Gold-Stock Levels”, in which I explained that gold stocks were so ridiculously cheap compared to gold that they were due for a massive mean reversion higher. And that’s exactly what happened over the next half-year or so, when GDX blasted 151.2% higher in this bull’s first upleg.

That peaked near a GGR of 0.244x, GDX’s share price was trading at 24.4% of GLD’s share price. Fast-forward to mid-March 2020’s stock panic, and the GGR cratered to 0.133x. That deep 4.1-year low sure wasn’t very far above gold-stock-bull-birthing levels! It’s very rare for the major gold stocks of GDX to fall that low relative to the dominant gold ETF. And those anomalous lows soon yield to massive V-bounces higher.

GDX nearly doubling between mid-March to mid-May, this blistering 95.8% upleg in just 2.2 months, was mostly the mean reversion out of absurd stock-panic lows. Today’s secular gold bull began marching a month before gold stocks’ bull in mid-December 2015. During the 4.5 years since, the GDX/GLD Ratio has averaged 0.187x. That’s something of a fair-value proxy for this gold-stock bull, like a GGR baseline.

During the brutal recent COVID-19-lockdown stock panic, the GGR crashed 0.054x under its bull mean. After gold-stock prices are hammered to extreme lows compared to gold, they don’t just mean revert but overshoot proportionally in the opposite direction. That would imply the GGR surging as high as 0.241x, which is nearing its 0.244x bull peak of August 2016. But the highest the GGR stretched in mid-May was just 0.227x.

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The lack of a proportional overshoot from the stock-panic lows so far argues this big mean-reversion gold-stock upleg isn’t over yet. Our human minds don’t parse decimals easily, so the difference between mid-May’s 0.227x GGR and a full 0.241x overshoot might not sound like much. Yet it is considerable. GDX’s 7.1-year secular high of $37.21 in mid-May was 0.227x. 0.241x would’ve yielded $39.59 at that point in time.

That would’ve extended GDX’s upleg to 108.4% back then. And odds are that proportional post-panic GGR overshoot is still yet to come since it hasn’t been achieved yet. Gold has powered higher since the gold stocks originally peaked in mid-May. A 0.241x GGR applied to this week’s GLD-share price would make for GDX $40.12. The higher gold climbs in its own upleg, the higher gold-stock prices should run.

Despite blasting higher out of those extreme stock-panic lows, the gold stocks have yet to look particularly overvalued relative to prevailing gold prices. That both lessens the risks of a serious selloff and argues this upleg has farther to run yet before kicking the bucket. And there’s no reason gold stocks should just stop at that 0.241x GGR mean-reversion overshoot. They have great potential to soar to much-higher GGRs.

Since late 2018, gold stocks have been gradually regaining ground relative to gold as is apparent in the GGR’s current uptrend. It was only briefly interrupted by that wild stock panic, then the GGR quickly surged back up into trend. GDX shifting back to consistently outperforming gold again makes higher GGRs quite likely. Historically the GGR has meandered at far-higher levels than this young gold bull has yet witnessed.

I wrote my last gold-stock valuation essay back in late December, which included a longer-term GGR chart starting in 2007. From 2009 to 2012 after the previous stock panic, the GGR was meandering way higher averaging 0.381x! And even that was lower than the 0.591x in the 2 years before October 2008’s stock panic, and 0.422x in the 2 calendar years after. The GGR ground lower on balance for about 8 years!

That long trying period of gold outperforming gold stocks finally ended in early 2016 when today’s gold-stock bull was born. After an initial sharp mean reversion in the first half of 2016, GDX’s outperformance compared to gold has stalled. But odds are this key fundamental ratio still needs to mean revert much higher in a secular sense. As gold and gold stocks regain favor, more capital shifting in will push prices higher.

A couple weeks ago I wrote about what’s driving gold’s strong investment demand, and why that is likely to persist for years. Stock panics motivate investors to diversify their stock-heavy portfolios with gold long after those scary selloffs pass. The Fed’s mind-boggling epic record monetary inflation since to attempt to stave off a COVID-19-lockdown-spawned depression has made gold an essential investment for everyone.

The more popular gold grows and the higher its prices get, the more interest will mount and capital flow into the gold miners’ stocks. GDX generally leverages material gold-price moves by 2x to 3x, making gold stocks attractive for multiplying wealth during secular gold bulls. Just like gold, gold stocks will grow more popular with investors the higher their prices go. So much-higher GDX/GLD Ratios aren’t just possible, but likely.

While predicting exactly where the GGR will meander is impossible, it seems reasonable for it to return to its 2009-to-2012 average after the last stock panic of 0.381x. Applied to this week’s GLD prices, that implies an awesome $63.43 GDX! That’s not even back to its $66.63 peak in September 2011 near the end of the last secular gold bull. Gold stocks look really undervalued relative to gold today compared to history!

And this sector’s undervaluation isn’t just apparent in that GGR proxy, but in current implied earnings. In their recently-reported Q1’20 results, the elite GDX gold miners again averaged $932 AISCs. And gold averaged $1582 last quarter. Those implied profits of $650 per ounce had skyrocketed 58.5% YoY from Q1’19’s $410! With higher gold prices driving such massive earnings growth, gold stocks need to soar.

That profits trend is persisting with gold consolidating high after its own post-stock-panic mean-reversion upleg. In the almost-over Q2’20, gold has averaged a much-better $1710. Over the last 4 quarters, the GDX major gold miners have averaged $920 AISCs. Assuming this quarter’s are somewhere around there, the gold miners could be earning $790 per ounce this quarter! That’s up 90.8% YoY from Q2’19’s $414!

Now actual Q2’20 results won’t reach that potential because countries’ national COVID-19 lockdowns temporarily disrupted plenty of mining operations. That means lower Q2 production, which proportionally boosts AISCs. But as outputs have quickly scaled back up after governments let miners resume work, higher prevailing gold prices mean much-bigger earnings going forward. That’s super-bullish for this sector.

Current gold-stock valuations remain relatively low, arguing this post-stock-panic gold-stock upleg still has lots of room to run higher. Add in recent high-consolidation technicals that much more closely resemble mid-upleg pauses rather than post-upleg serious selloffs, and sentiment shifting more bearish since this gold-stock upleg stalled in mid-May, and this powerful gold-stock run sure doesn’t look like it is over yet.

Far from being threats, mid-upleg selloffs are great gifts to traders. They offer the best mid-upleg entry opportunities to add new gold-stock trades at relatively-low prices! So if your gold-stock allocations aren’t yet sufficiently large, mid-upleg selloffs are when to buy more. While gold-stock gains are already huge since the stock-panic lows, they will grow much bigger still as this gold-stock upleg keeps powering higher.

The bottom line is major gold stocks still look undervalued relative to gold today despite their massive post-stock-panic upleg. Ratios of gold-stock prices to prevailing gold levels remain fairly low compared to this gold bull’s own precedent. And they are really low based on historical levels in the years after the last stock panic! This latest post-panic gold-stock upleg has lots of room fundamentally to keep powering higher.

Recent gold-stock technicals support this bullish outlook, with gold stocks consolidating high since their mean-reversion surge stalled out. That price action looks like a healthy mid-upleg pause that’s necessary to rebalance sentiment. The gold miners’ earnings growth is going to be strong in coming quarters after the COVID-19 disruptions to mining operations pass. That should continue to fuel strong gold-stock buying.

By Adam Hamilton

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