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Gold Stocks, The Ultimate Contrarian Buy

Gold Stocks, The Ultimate Contrarian Buy

By Adam Hamilton & Scott Wright 17.06.2013


Successful investing requires buying low before later selling high.  And stock prices are the lowest when they are the most deeply out of favor.  That perfectly describes gold miners’ stocks these days, this sector is loathed and despised after a horrendous year so far.  But these battered stocks are now offering epic buying opportunities for contrarians who have steeled themselves to be brave when others are afraid.

Between November 2000 and September 2011, the flagship HUI gold-stock index rocketed up an astounding 1664%!  This dwarfed gold’s 603% gain over that same span, and the general stock markets as represented by the mighty S&P 500 actually lost 14%!  Gold stocks were almost certainly the past decade’s best-performing sector.

Though their secular bull has truly been glorious, it’s been far from an easy ride.  The gold miners have always been a very volatile sector, with massive swings that can persist longer than anyone expects.  I’ve seen them loved near major highs and loathed near major lows.  But the visceral antipathy towards them these days is something special.  It’s the worst I’ve ever seen, even exceeding that in 2008’s stock panic.

It’s not hard to understand why.  Gold stocks as a sector have not made new highs since September 2011, a couple weeks after gold’s last new highs.  They corrected with gold and were stuck in a high consolidation until the end of 2012.  And then the bottom fell out this year.  At worst in May, the HUI had plummeted a gut-wrenching 44.6% year-to-date!  This was driven by gold’s parallel and unprecedented 18.8% selloff.

Gold stocks were long overdue to surge as 2013 dawned, and are radically more bullish now after 2013’s gold debacle.  A perfect storm of low-probability events hammered gold and destroyed investor interest in the gold miners.  Melting-up general stock markets seduced stock traders into dumping GLD gold-ETF shares en masse, flooding the global markets with far more gold supply than could quickly be absorbed.

This wildly unprecedented extreme GLD liquidation is either ending or over, as I explained in depth in our new monthly newsletter.  So the fierce gold headwinds sparked by levitating stock markets are already abating.  And as gold rebounds dramatically in its new upleg, gold stocks are going to catch a monster bid.  They are so universally despised that not much buying at all will catapult them dramatically higher.

Unfortunately a lot of investors, including me, have been burned trying to game the long-overdue gold-stock bottom earlier this year.  But getting stung by ultra-low-probability events shouldn’t discourage contrarians.  If I’m playing poker, and I draw four of a kind, I’m going to bet huge.  It’s a fantastic hand with 4,200-to-1 odds.  In nearly every situation, that high-probability-for-success hand will easily win big.

But if my opponent happens to draw a straight flush, an ultra-low-probability hand with 72,000-to-1 odds, I will lose despite my strong position.  That sucks, but such is life.  I wouldn’t quit playing poker because an exceedingly rare event trumped my strong hand.  And I certainly won’t quit investing because gold stocks I bought really cheap were pummeled even cheaper by an ultra-low-probability perfect storm in gold.

If you liked gold stocks last autumn with the HUI near 500, you ought to love them this spring near 250!  It is never easy fighting the crowd, being brave when others are afraid, but that’s when a sector has the greatest odds of soon soaring.  Gold stocks are epically oversold after such extreme selling in 2013, and I’ve never seen any sector so viscerally abhorred.  Their recovery upleg ought to be massive beyond belief.

The extreme contrarian appeal of gold stocks today is readily evident both technically and fundamentally.  This first chart examines the former front.  It looks at the benchmark HUI gold-stock index superimposed over a technical indicator I created called the Relative HUI (rHUI).  Gold stocks as a sector have only been this oversold one other time in their decade-plus secular bull, and that was during 2008’s crazy stock panic.

Just look at the HUI’s (blue) path over the past decade or so, it’s been one wild ride.  Gold stocks are a really volatile alternative sector not for the faint of heart.  While casual investors can thrive during the HUI’s massive uplegs, it takes tough-as-nails battle-hardened contrarians to not be scared away during the subsequent brutal corrections.  I can’t even count the number of sharp selloffs we’ve had to weather.

In pure technical terms, the absolute level of any market price at any given time doesn’t matter all that much.  The important question is how fast the price got to prevailing levels.  The slower the move the more durable the price, the faster the move the more precarious.  When prices move too far too fast in either direction, sentiment gets unsustainably excessive.  And then a mean reversion soon reverses the trend.

In order to measure how fast a price has moved, you need some kind of objective yet slowly-evolving baseline.  My favorite is the 200-day moving average.  Looking at prices relative to their own 200dmas is the basis for my highly profitable Relativity Trading system.  A price is divided by its 200dma, and the resulting multiple is charted over time.  These tend to form quite distinctive horizontal trading ranges.

For most of gold stocks’ enormous secular bull, the rHUI multiple (red) revealed this sector was too oversold when it slid below 0.95x.  Once the HUI was sold off quickly enough to slump 5%+ under its own 200dma, a reversal from correction to new upleg was imminent.  There were periodic exceptions when fear flared particularly potent, but they didn’t last long.  Oversoldness, prices falling too far too fast, was short-lived.

So it was generally exceedingly profitable to buy gold stocks whenever the HUI slid under 95% of its 200dma.  The great exception was 2008’s once-in-a-lifetime stock panic, an ultra-rare event like drawing a straight flush in poker.  Much like in 2013, a rare confluence of stock-market events led futures traders to dump gold while the SPX was plummeting.  So as gold plunged, gold stocks plummeted even faster.

With the VIX fear gauge skyrocketing to 80, we’d never seen and never will see such extreme fear again in our lifetimes.  With it feeling like the global markets and economy were imploding, this unprecedented selling was understandable.  The HUI ultimately plummeted 70.6% in less than 8 months!  At its October 2008 nadir, it was trading at an rHUI low of just 0.382x.  The HUI was pummeled 60%+ below its 200dma!

As you may remember, the gold-stock despair then was overpowering and universal.  It reminded me a lot of today, although today feels more extreme in some ways because during the stock panic the wounds were still fresh enough that some gold-stock investors still held out hope this sector would rally again.  These days all hope is abandoned, the true contrarians still bullish have dwindled to inconsequential levels.

Gold stocks were hyper-oversold during that stock panic.  Virtually everyone thought the fact that gold was sucked into the stock panic instead of surging was the final nail in its secular bull’s coffin.  Endless commentaries came out making bearish cases for gold and gold stocks to keep falling indefinitely on rotten fundamentals.  But as always at technical extremes, the consensus was dead wrong.  The HUI would soar.

Starting from those very black depths of despair, the HUI gold-stock index would more than quadruple over the subsequent several years!  It easily powered to new all-time highs, earning fortunes for brave contrarian investors like us and our subscribers.  Hyper-oversoldness is always short-lived.  The faster a price falls, the more extreme the technical anomaly becomes, the more bullish that market actually is.

The HUI didn’t get hyper-oversold again until May 2012, after a healthy correction following its massive multi-year upleg.  If you dig up any historic gold-stock commentary (except mine) from the middle of that month, it was overwhelmingly bearish and pessimistic.  The rHUI read 0.714x, a massive divergence from this index’s 200dma baseline.  Traders had abandoned and forsaken the gold-stock sector yet again.

But as usual they did it at the worst possible time!  Extremely oversold technical conditions are never sustainable.  Over the next 4 months, including in the summer which is traditionally weak seasonally for gold, the HUI surged 39.9% higher.  The carefully-researched high-potential smaller gold miners we prefer far exceeded these sector gains.  Peak gold-stock despair was the most bullish time to buy.

And that brings us to 2013, which vies with 2008’s stock panic as the single most difficult psychological trial gold-stock investors have faced in this secular bull.  As capital fled GLD shares to chase the levitating SPX, gold and especially gold stocks plummeted in a seemingly endless death spiral.  By mid-May this year, the HUI had been hammered so low that the rHUI fell to a shocking stock-panic-like 0.598x!

Think about that a second.  This year’s gold-stock selling was so extreme that the main gold-stock index was crushed 40% below its own 200dma.  Other than during that once-in-a-century stock panic, this had never happened before in gold stocks’ entire decade-plus secular bull.  The sheer magnitude of selling necessary to force a price that far under its 200dma is staggering, betraying epically extreme levels of fear.

I’ve been a hardcore student of the markets for decades, living and breathing them every day of my life.  I’ve forgotten more about markets than most will ever know.  So I can pretty much guarantee you that in any market in the world at any time, any price being driven 40% below its 200dma marks extreme unsustainable oversoldness.  The huge bearishness, fear, and despair necessary to spawn this is inherently self-limiting.

There are only so many investors susceptible to being scared into selling into any extreme selling event.  And once they have all sold, only buyers are left.  So prices soon start rallying, forcing the legions of shorts that glommed on during the selloff to aggressively buy to cover.  Thus the more oversold any price gets, the bigger and more powerful the subsequent rebound upleg.  The HUI is now due for a massive one.

With panic-level oversoldness in both gold stocks and gold in recent months, the mean reversion out of this technical and sentimental extreme is going to be big.  After the stock panic, gold stocks as measured by the HUI more than quadrupled in the subsequent years, with high-potential smaller ones dwarfing those gains.  We are due for a similar gigantic upleg in the coming years out of recent months’ crazy extremes.

While huge rebound uplegs out of extreme oversoldness are utterly inevitable solely for technical and sentimental mean-reversion reasons, if there is fundamental support it’s all the better.  And gold stocks also happen to be dirt-cheap fundamentally, screaming buys.  A great proxy for their valuations is the classic HUI/Gold Ratio, since gold prices drive gold miners’ profits.  And earnings ultimately drive all stock prices.

I’ve written about this relationship extensively in the past, but I still believe this chart is one of the most compelling in all the markets.  For 5 full years before 2008’s stock panic, a secular time frame, the HGR averaged 0.511x.  The HUI tended to trade at about half the prevailing gold price.  As gold climbed, the profits for mining it leveraged its rise.  So gold stocks were bid up accordingly and generally thrived.

But the extreme selling from that ultra-rare stock panic shattered that long-standing fundamental relationship between gold stocks and gold.  Despite me raving at the time about how wildly bullish gold stocks were during that panic, a dead-right contrarian play, countless former gold-stock investors gave up and walked away.  The markets’ straight flush beat their four of a kind, so they sold low and never came back.

Nevertheless, smart new investors arrived to fuel the HUI’s inevitable mean reversion out of such extreme panic oversoldness.  And gold stocks climbed much faster than gold for the first year or so, nearly pushing the HGR back into its pre-panic fundamental range.  Over the next year and a half gold started climbing so fast that the HUI merely paced its gains, so the HGR stabilized not far under 0.40x.

As gold stocks started falling out of favor again in mid-2011, the HGR began losing ground.  This is natural during a gold correction.  Gold miners have profits leverage to the gold price, a given percentage move in gold itself translates into much larger changes in profitability for mining it.  So they always fall faster than gold when this metal is correcting.  The upside of this is their stock prices usually leverage gold’s rallies too.

The HGR had finally stabilized in late 2012 and was starting to climb again, a very bullish sign.  That was the gold-stock equivalent to that four-of-a-kind poker hand, a high-probability-for-success bet in early 2013.  But then the Fed-driven SPX melt-up started sucking copious amounts of capital out of GLD, flooding the world with too much marginal gold supply to quickly absorb.  So gold and therefore gold stocks crumbled.

This GLD mass liquidation was so far beyond precedent it should have been impossible.  It was the straight flush, an exceedingly unlucky hand for the contrarians on the other side of the trade.  So as the HUI fell even faster than gold this year, the HGR plummeted lower.  It hit an astounding 0.181x in mid-May, well below the stock-panic extreme of 0.207x in October 2008.  This was the lowest in gold stocks’ entire secular bull!

But is such an absurdly-bad HUI/Gold Ratio sustainable?  History argues no way.  After that stock-panic extreme, the HGR more than doubled over the subsequent year as gold stocks soared in their mean-reversion recovery upleg.  And even if the pre-panic average HGR isn’t attained again, the 2009-to-2012 post-panic average HGR will certainly be hit in gold stocks’ necessary and inevitable mean reversion.

That number is 0.346x, and is 91% higher than mid-May’s extreme HGR low.  What this means is if the HUI merely returns to its post-panic average relative to gold, and gold does nothing but languish at its current oversold levels, gold stocks would rally 90% from their mid-May lows!  Even if the 2013 extreme selling anomaly is included, the full post-panic average HGR is still 0.333x.  That is 76% higher than today’s 0.189x.

Gold stocks were also just pounded to the cheapest levels of their entire secular bull by traditional valuation metrics including price-to-earnings ratios.  The HUI has been trading around just one-third of its 2007-to-2012 average P/E ratio.  So fundamentally gold stocks are a screaming buy too, making their mean-reversion massive-upleg case based purely on technicals and sentiment all the stronger today.

Gold stocks are the ultimate contrarian buy.  No sector in the entire stock markets is cheaper fundamentally, no sector is more oversold, and no sector is more despised.  It is never easy fighting the crowd and being brave when others are afraid, but that’s when fortunes have been made in this secular gold-stock bull.  The best time to buy is when you least want to, when it literally feels nauseating.

All these factors make gold stocks look like a royal flush today, the rarest of poker hands (650,000-to-1 odds) that beats everything else.  No matter what any other markets do, gold stocks are way overdue for an enormous new upleg to accelerate higher.  Most investors will miss this mean reversion, and fail to get interested in gold stocks until the HUI is several times higher a couple years from now.  You don’t have to.

The bottom line is gold stocks are the ultimate contrarian bet today.  An unprecedented confluence of events that is already abating drove 2013’s incredibly anomalous selloff.  This left gold stocks extremely oversold, extremely undervalued, and extremely unloved.  But the deeper out of favor any sector falls, the higher the odds for a massive mean-reversion rebound.  And they’re approaching certainty for gold stocks.

With gold emerging from a similar hyper-oversold extreme, it won’t take much buying at all to push the yellow metal higher.  And any meaningful gold rally at all will be taken as the all-clear signal by the contrarians awaiting gold stocks’ long-overdue recovery.  Soon buying will beget more buying, and within a few years the HUI should again more than quadruple.  Great small gold miners will fare much better.

© Copyright 2000-2013, Zeal Research (www.zealllc.com). Zeal Research is a US-based investment research company - you can visit their website at http://www.zealllc.com/. Zeal's principals are lifelong contrarian students of the markets who live for studying and trading them. They employ innovative cutting-edge technical analysis as well as deep fundamental analysis to inform and educate people on how to grow and protect their capital through all market conditions. All views expressed in this article are those of the author, not those of TheBull.com.au. Please seek advice relating to your personal circumstances before making any investment decisions.  

 



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WHAT’S ON THIS WEEK

week 8 August 2014
    • 04
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