Stocks’ Last Cheap Sector

Stocks’ Last Cheap Sector by Adam Hamilton – Zeal, LLC

The lofty stock markets suffered a sharp selloff this week that may prove a major inflection point.  There was one lone sector that bucked the heavy selling to surge in the carnage, the gold miners’ stocks.  They are the last cheap sector in these bubble-valued stock markets, long overlooked and neglected.  Wildly undervalued today, the gold stocks have great potential to soar dramatically even if stock markets keep weakening.

Just several weeks ago, the US stock markets hit new all-time record highs stoking universal euphoria.  The flagship S&P 500 broad-market stock index (SPX) closed at 2930.8 in late September, extending its monstrous bull to 333.2% over 9.5 years.  That made for the 2nd-largest and 1st-longest in US stock-market history!  It also left these markets dangerously overvalued, literally trading at bubble valuations.

Exiting September, the elite stocks of the SPX sported an average trailing-twelve-month price-to-earnings ratio way up at 31.4x.  Weighted by market capitalization, that was even more extreme at 34.9x.  Over the past century and a quarter or so, bubble valuations start at 28x earnings.  So the stock markets were ripe for a fall, and the catalyst would prove surging 10-year Treasury yields along with a hawkish Fed chairman.

While the SPX started weakening last week as 10y yields blasted to a 7.3-year high, the serious selling finally erupted this Wednesday.  The SPX plunged 3.3% to 2785.7, taking its total pullback from the peak to 4.9%.  Leading the way down were the market-darling mega tech stocks, which have valuations much more expensive than the general markets.  Everything was sucked into that frenzied selling, with one exception.

The gold miners’ stocks were an island of green in that roiling blood-red sea, their leading sector benchmark actually rallying 1.3%!  That is the GDX VanEck Vectors Gold Miners ETF.  That seemingly-impossible divergence is exceedingly important for investors to understand.  It is the key to generating great wealth when everything else burns in what will likely snowball into the long-overdue next bear market in stocks.

The gold stocks are a unique sector because stock-market fortunes aren’t their primary driver.  Instead they mirror and amplify the trends in gold, which directly drives their profitability in leveraged fashion.  Gold rallied 0.3% to $1194 Wednesday as investors finally started to return.  The major gold miners of GDX surged 3.9x that much, despite the flaring stock-market fears.  Such contrary action is nothing new.

Weakening stock markets motivate investors to prudently diversify their bleeding stock-heavy portfolios with gold.  Their buying bids gold higher, which eventually fuels monster gold-stock bulls.  Within and after the last secular stock bear, the gold stocks skyrocketed.  GDX was born in the middle of that epic run in May 2006, so we need to use an older benchmark to remember why gold stocks are compelling in stock bears.

Between November 2000 and September 2011, the HUI NYSE Arca Gold BUGS Index soared a truly-astounding 1664.4% higher.  You read that right, the world’s most-hated sector today multiplied wealth by nearly 18x across those 10.8 years!  The SPX actually slumped 14.2% in that span, but was down as much as 56.8% at worst when a mid-secular-bear cyclical bear climaxed.  So investors returned to gold in a big way.

In roughly the same span, it powered 638.2% higher in a massive secular bull.  The HUI leveraged those gains by 2.6x, right in line with the usual 2x to 3x it has seen historically.  If the stock markets are finally on the verge of another bear driven by record Fed tightening, this gold-stocks-to-the-moon cycle is going to repeat.  Gold will be bid for years as investors slowly rebuild normal portfolio allocations, so gold stocks will fly.

This leveraged relationship between gold miners’ stocks and gold prices is deeply fundamental and easy to understand.  While the major gold miners of GDX will report their Q3’18 financial results over the next month or so, their latest-available data is still Q2’s.  That quarter their average gold production cost was $856 per ounce in all-in-sustaining-cost terms, which is way under even Q3’s low average gold price of $1211.

For easier calculations, let’s round these to $850 AISCs at $1200 gold, which yields profits of $350 per ounce.  If gold rallies 10% to $1320, the major gold miners’ profits surge 34% to $470.  A 20% gold upleg to $1440 boosts these earnings to $590, a big 69% gain.  And a little 30% gold bull to $1560 catapults the industry profits 103% higher to $710!  Gold-mining earnings have big leverage to prevailing gold prices.

The costs of gold mining are largely fixed during mine-planning stages, when engineers and geologists decide which ore to mine, how to dig to it, and how to process it.  The actual mining generally requires the same levels of infrastructure, equipment, and employees quarter after quarter with little changing in throughput terms.  Thus average AISCs don’t move around much even when gold prices climb far higher.

Gold-mining profits and thus gold-stock prices would double with a mere 30% gold bull!  And that’s not a stretch at all.  Back in early 2016 gold investment returned to favor in a major way after back-to-back SPX corrections spooked stock investors.  American stock investors in particular buying shares in the leading GLD SPDR Gold Shares gold ETF drove gold 29.9% higher in just 6.7 months in essentially the first half of 2016!

The major gold miners of GDX reacted with a massive 151.2% bull upleg in that ETF’s share price in just 6.4 months in roughly that same span.  That made for outstanding 5.1x upside leverage to gold.  So the idea that gold stocks soar when weakening stock markets spur gold investment demand is based on historical precedent.  This week’s gold-stock rally on an SPX selloff is just a small foretaste of the feast to come.

If gold stocks were already super-expensive like mega tech stocks, the psychology of rising gold prices would still drive them higher.  But this small contrarian sector has been forsaken and left for dead for the last couple years or so.  Investors wanted nothing to do with gold and its miners’ stocks as the general stock markets levitated on Republicans’ massive corporate tax cuts.  So gold stocks are swirling in the gutter.

Their valuations relative to gold are exceedingly low today, an extreme anomaly.  Because they are so deeply out of favor, their stock prices are radically disconnected from their underlying profitability even at $1200 gold.  That means their coming upside as investors return to gold is much greater than it would be normally.  Gold stocks need to mean revert far higher to merely reflect today’s gold prices, let alone future ones.

Gold-stock valuation trends can be understood and gamed through a simple proxy, the ratio between their stock prices and the underlying metal which drives their profits.  Since American stock investors prefer to deploy capital in GDX for gold-stock exposure and GLD for gold, we can construct a GDX/GLD Ratio to analyze this key fundamental relationship.  This GGR reveals gold-stock prices are ridiculously low today.

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