Despite the pullback this fall, gold has been performing well this year. The price of the yellow metal is up 28% YTD, driven in large measure by strong demand in Asia and the dim economic outlook in the west. Gold miners are reporting good third-quarter bottom lines. In this ointment, however, there is a fly: gold stock performance, which has massively lagged the underlying commodity price surge over the year. This has been ongoing for months, now bringing us to the point where gold mining stocks look notably undervalued.
Technically, we might say, they look dirt cheap. Even Doug Casey, who's a serious bottom feeder, is admitting that compared to the metal itself, gold stocks are looking cheap again.
Consider these charts:
The average price/earnings ratio in the industry – a valuation ratio of a company's current share price compared to its per-share earnings (quarterly figures are used here) – is going down while the price of gold is increasing. This situation has persisted for several quarters; and now gold stocks look cheap on a P/E basis.
This big divergence between companies' earnings and the underlying commodity price won't last: Either gold will retreat or P/Es will catch up, or both. Since the fundamental trends driving gold upward are still very strong, the second scenario looks more probable, raising the prospect of a huge rally of mining stocks somewhere in the short- to mid-term. Comparing changes in the AMEX Gold Bugs Index against gold leads to a similar conclusion: in the second half of 2011, gold stocks have been lagging. See the chart below.
If they are on sale, why aren't we seeing a rush into these equities?
One opinion on why gold stocks are not recognized by the general investing public as being cheap is concealed in the way stocks are estimated. Most analysts prefer to use an unrealistically conservative gold price, which is far below what we have been observing for quite a while now. From Pierre Lassonde, in a Mineweb article:
"Most analysts are using their economist's projections for gold and for the last 10 years it's always been way under the reality. For example today the average is probably looking out five to 10 years as they're using $1,100 gold vis-à-vis a real gold price of $1,600 so what do you expect... they put out recommendations using $1,100 gold, so therefore the price that most of the stocks are trading at on a net asset value is around $1,100 to $1,200 gold and that is not going to change until, either the Street uses todays' [sic] gold price, or even the contango."
This is a fancy way of saying that a price-moving plurality of gold analysts and investors don't expect gold prices to stay this high, let alone go higher. In our view, these people are driving forward looking in the rear-view mirror, rather than understanding what's going on in the global economy and therefore what's likely to happen in the future.
We see global economic uncertainty and currency crises sweeping the whole planet, providing investors – and even some central banks – with incentives to build positions in bullion. In their turn, gold stocks have a leverage effect on the underlying asset prices, courtesy of our friend volatility.
This confluence of trends, to use a tired but apt phrase, is shaping up into a perfect storm. Mining stocks look undervalued, and gold is headed higher. Something's got to give, and we think it could produce a spectacular move in gold stocks before too long – one that could spark the real Mania Phase Doug's been predicting to cap this bull cycle. It's time to take a contrarian stance and buy gold miners while others are selling.