Gold Revisited, Part II: Tremendous Potential in Gold Mining Stocks

Submitted by Rich Toscano on May 7, 2012 - 13:13

If you haven't done so already, we recommend you first read Gold Revisited, Part I: The Fundamental Case for Gold.

Gold stocks have undergone a fairly serious downturn over the past 8 months, with the main gold stock index (the HUI) down 35% over that time.  This is actually a very typical correction in this sector: in the past 10 years, there have been 6 other HUI declines of 30% or more, and each time, the index has eventually gone on to make new highs.

Gold Stocks Extremely Undervalued

What's atypical about this particular correction is that it has resulted in the stocks of gold miners becoming unusually undervalued compared to the price of product they produce.

Based on our favorite valuation measure1, gold mining companies are now 30% cheaper than they should based on the value of the gold they own and produce.  This level of valuation is a very rare outlier.  The only time this ratio was lower was at the depths of the 2008 panic, when markets were pricing in a complete economic collapse and multi-year deflationary spiral (and even then, it showed gold stocks as only slightly more undervalued than now, at 34%).

Here's a chart showing the ratio of the HUI gold stock index to the gold price (the lower the line, the more undervalued gold stocks are relative to gold itself).  This valuation measure isn't as sophisticated as the one cited above, but it provides roughly similar results and gives us a visual aid to work with.  The chart validates the idea that gold stocks are cheaper compared to gold than they have been at any time over that past decade, besides the 2008 end-of-the-world panic. 



Source: stockcharts.com

History Says Gold Stock Valuations Will Return to Normal

Over time, gold stock prices move with the gold price.  This simply makes sense, as gold miners do in fact make their money by selling gold2.  And history shows this has been the case.  This is indicated by the following chart, which shows the correlation between weekly gold and gold stock price movements over the past 1, 3, 5, 7 and 10 years.  The chart makes it clear that the recent disconnect has been an anomaly, and that the prices of gold and gold stocks have been highly correlated over longer time periods.


Let's look at that HUI to Gold ratio chart again, and examine what happened when gold stock valuations dropped sharply in the past.  There are four major moves down on the chart below.  The fourth is the one currently underway.  Of the prior three, the HUI went on to make dramatic gains in the year or so after the bottom of the correction:



Source: stockcharts.com

Just because something has happened in the past doesn't necessarily mean it will happen again.  The main point of this chart is to show that, given the decline in valuations that has taken place, it wouldn't be out of the ordinary to experience a monstrous rally in the gold stocks at some point ahead.

It is of course possible this relationship could get back in line via gold prices falling instead of gold stock prices rising.  But that's not how it's happened during the gold bull market to date, and -- as we explained in Part I -- we think the long-term direction for gold prices is up.

Conclusion

Based on the positive long-term prospects for gold, the extreme level of undervaluation in the gold miners, and the historical tendency for the miners to make huge gains following situations like the current one, this is a sector in which we most definitely want to be invested.  This is why we've taken the opportunity during this downturn to build up our gold stock exposure, bringing our allocation to near the top of our historical range of exposure to this asset class.
 
There are reasons to believe the correction in gold stocks is nearing its end: both the duration and the magnitude of the decline are now roughly at the limits reached by all prior corrections over the past decade with the exception of 2008 (which was more pronounced for reasons discussed above).  Of course,  anything is possible in the markets over the short term, so this correction could potentially be an outlier and last longer, especially if gold itself corrects further.   

Fortunately, we aren't dependent on any particular timing.  The fundamentals and valuations for gold stocks give us great confidence that patient investors in the sector will eventually be rewarded -- perhaps dramatically so.

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1 The gold stock valuation measure we prefer, developed by John Doody of the Gold Stock Analyst, provides a historical comparison of the market capitalization of a large basket of gold miners to the equally-weighted value of those miners' gold reserves and annual gold production.

2 It's theoretically possible that this relationship could break down if gold miners' costs rose much faster than their revenues, but that's not what's happening.  Another valuation metric developed by Mr. Doody, which accounts for costs by measuring gold miners' market capitalizations against their operating cash flows, shows that miners are cheaper compared to cash flows than at any time over the past decade, even including 2008.

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