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Gold Stocks Still Cheap 2

Earlier this week, the flagship HUI gold-stock index powered up to new all-time record highs. While fantastic for gold-stock investors and speculators, such lofty achievements inevitably cement more big bricks on top of the wall of worries. At their highest levels in history, are gold stocks wildly overbought and doomed to correct hard? Provocatively, a strong case can be made that they actually remain cheap!

Given the HUI’s epic progress in its secular bull, this assertion can sound absurd at first. This index hit its secular-bear low of 35.99 in mid-November 2000. This past Monday, it closed at 590.99. The larger gold and silver stocks included in the HUI have collectively seen mind-blowing 1542% gains in their bull to date! I doubt any sector has done better over this tough past decade, where the general stock markets have been mired in a 17-year secular bear. Over this same span, the S&P 500 actually fell 12%.

After multiplying 16.4x, it’s understandable why some traders fear gold stocks are destined to plunge. But this sector, along with other commodities stocks, is unique in the stock markets. The price of its product, gold, has soared 436% higher during the HUI’s bull run. Outside of the commodities industry, can you think of any other sector that has seen such pricing power? A product’s price surging 5.4x higher?

Most industries struggle with perpetually-eroding prices for their end products, either in nominal or real (inflation-adjusted) terms. This is often the result of intense global competition as manufacturing and even intellectual work naturally migrates to the countries with very low labor costs. The gold miners, in producing a precious commodity in which global demand has outstripped supply for a decade, face no such pressures.

While monetary inflation has certainly raised the costs of producing gold, its miners’ profits are primarily driven by this metal’s market price. The higher gold’s secular bull marches, the greater the gold-mining sector’s collective profits grow for extracting it. And ultimately in the stock markets, in every sector, stock prices follow long-term profits. As long as gold’s bull persists, its miners’ profits will continue to grow.

This alone is bullish for gold stocks, but another related factor comes into play that is far more so. 2008’s crazy once-in-a-century stock panic drove gold stocks to ludicrously-oversold levels compared to gold prices, even in that panic’s dark heart. And amazingly, today 2 years later the gold stocks are still continuing to recover. They remain very undervalued relative to prevailing gold prices!

This fundamental anomaly is not sustainable. The price of gold drives the ultimate profits of the industry that is bringing it to market. And in the stock markets, it is long-term profits that eventually determine stock prices. Gold stocks can’t stay low while gold is high, the increasingly-large profits they are spinning off will gradually attract in far more investment capital until they normalize to prevailing gold prices.

This critical relationship is easiest to grasp when considered in HUI/Gold Ratio terms. The HGR is exactly what it sounds like, the daily close in the HUI gold-stock index divided by gold’s daily close. Charted over time, this ratio reveals how gold stocks are performing relative to the metal they mine. And compared to many years of pre-panic history, to this day gold stocks remain anomalously cheap.

For 5 continuous years prior to late 2008’s stock panic, the gold stocks traded in a fairly-tight range relative to gold. The HGR’s secular trading range generally meandered between 0.46x on the low side (support) to 0.56x on the high side (resistance). In other words, the HUI index tended to close at between 46% to 56% of the prevailing gold price. The HGR’s 5-year pre-panic average ran 0.511x, a key metric to remember.

Then 2008’s epic stock panic came along and ripped gold stocks to shreds. The sheer levels of fear, terror, and panic that extraordinary event generated were so far off the scales that merely calling it “unprecedented” is a radical understatement! If you were trading then, you remember well how crazy that episode was. Including challenging 90 twice, the benchmark VXO fear gauge managed to stay above 50 (the previous extreme peak-fear level) for a staggering 11-week span. No one had ever seen anything like it!

While both gold stocks and gold were sold into that maelstrom of fear, gold stocks fell far faster than gold so the HGR plummeted like it was the Apocalypse. A rising HGR means the HUI is outperforming gold, while a falling one means gold is outperforming the HUI. And in the latter’s case, this often happens when gold isn’t falling as fast as gold stocks during one of this metal’s periodic corrections.

By the time the dust settled, the gold stocks were just crazy-oversold. This was readily apparent even at the time to students of the markets. I wrote the following to our Zeal Speculator subscribers on October 28th, 2008, the day after the HUI bottomed and the day we bought and recommended the GDX gold-stock ETF. “I’ve been long gold since the $ 250s (early 2001) continuously and I’ve never felt more bullish than I do today after this nasty financial panic and its resulting bailout mess. Gold’s fundamentals are stellar.”

“Yet the HUI closed near 152 yesterday, which is end-of-the-world levels as far as I am concerned. This index hasn’t been this low since mid-2003! Where was gold trading back then? In the $ 350s! Is this madness or what? We have a gold price over twice as high yet stock prices are apparently discounting mid-2003 gold levels. This is clearly not rational and reflects the sentimental nature of this stock selloff.”

And as expected, gold stocks recovered rapidly out of those silly panic lows. Gold drives their profits, their profits drive their stock prices, and even in the panic’s heart prevailing gold prices were over double what gold stocks’ price levels were implying. Indeed from its panic lows to its latest highs this week, the HUI has already surged 290%! Our subscribers who mirrored our active trading of this gold-stock recovery have made fortunes in the last couple years. Their gains have been massive beyond belief.

I first publicly pointed out this panic-driven HGR anomaly in a December 2008 essay when the HUI closed at 271. In the 2 years since, I’ve written a series of essays on this gold-stock recovery continuing to illuminate this normalization. Despite their enormous rallies since the panic, despite the HUI’s new all-time highs, gold stocks remain very cheap relative to prevailing gold prices as this long-term HGR chart beautifully illustrates.

At worst in the heart of the stock panic, the HGR plummeted to stupendously-low levels of 0.207x. If you subtract this from the 5-year pre-panic average, it yields a mammoth deviation from norms of 0.304x in HGR terms. As of the HUI’s latest high earlier this week, the HGR had recovered to 0.415x. If you run these numbers, as of Monday the HUI had only regained about 2/3rds of the ground it lost relative to gold during the stock panic. This means there is a whole heck of a lot of gold-stock rallying left to be done!

Though the HUI has rallied 31% so far in 2010 (the red line above), compared to gold the gold stocks haven’t made much progress at all. The HGR has risen less than 4% this year, reflecting the fact that gold stocks’ progress relative to gold has totally stalled out. Many traders have grown resigned about accepting this, assuming this year’s average HUI/Gold Ratio of 0.382x is the new norm instead of the secular pre-panic average of 0.511x. I believe the fundamentals flat-out refute this argument.

Universally in all sectors, profits drive stock-price levels. And in the gold-mining sector, gold prices drive profits. The higher prevailing gold prices, the greater gold-mining profits grow. And this is true despite rising mining costs. My business partner Scott Wright recently did an awesome study pulling together a vast amount of individual-gold-miner data to prove this beyond any doubt. Gold-mining margins are rising, both in absolute and percentage terms, as gold’s secular bull marches higher.

Gold stocks can’t stay cheap relative to gold unless this profit-driven core law of long-term stock prices is somehow broken for this sector. This is absurd. Long-term profit levels drive long-term stock-price levels because investors ultimately gravitate towards the sectors and stocks that give them the best returns (highest profits) on each dollar invested. There is no way gold stocks can stay this cheap when their profits are growing so dramatically.

Even though the HGR stalled this year, reflecting little gold-stock excitement despite the widely-admired gold strength, gold stocks are still gradually gaining ground relative to gold. This next chart zooms in to the HGR over the last couple years for a higher-resolution read on its post-panic trends. A third series is added (the yellow line), which reflects where the HUI would be trading if it regained its 5-year pre-panic average of 0.511x the price of gold.

In 2009, the HGR recovered rapidly in a sharp, volatile uptrend. Since we were closer to the panic, meaning both the HUI and gold were far more oversold and thus more easily able to surge rapidly, there was a lot more gold-stock excitement then. The massive gap closed considerably between where the HUI was trading and where it ought to be trading if it regained its historic average HGR. The actual HUI was only trading at 57% of average-HGR levels at its early-March lows, before climbing to 82% by its early-December highs.

But 2010 has been a much weaker year for gold stocks, a psychological phenomenon

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