Wednesday September 05, 2012 13:21
Back in 2008, things were pretty bleak and dreary for gold stocks. From their top in the spring of 2008 to their bottom in the fall of that same year, the Amex Gold bugs Index (or HUI) fell from 510 to 153 or nearly 70 percent in price. Gold only fell about 30 percent in the same time period to about $700 an ounce.
One way to evaluate gold stocks and their valuations is by just simply dividing the price of gold by the price of the HUI gold index.
From 2002 to 2008, the gold to HUI ratio averaged roughly 2. This means that it took roughly 2 shares of the HUI to buy 1 ounce of gold. During the financial crisis, this got up to 4.7 to 1. In a nutshell, it meant during the crisis, gold stocks got extremely cheap when compared to gold. Gold stocks were reduced to less than half of their normal valuation. You could argue that, at that point, many gold stocks were priced for $300-$400 gold, not for the $700 it was trading at.
What happened? After gold stocks fell to this oversold level, they soared, thereby making up for over shooting to the downside, with the HUI index doubling in the months that followed.
This time around, we have seen a decline in slow motion. While the 2008 collapse was fast and swift, the 2011 to 2012 decline has been a sort of Chinese water torture. After peaking at 638 back in the fall of 2011, the Amex Gold Bugs Index has fallen towards the 400 area. It got as low as 372 on this decline. However, instead of collapsing in a few months (like in 2008), this decline is about 10 months in the making.
It has all happened with a relatively tame 20 percent correction in the price of bullion. It has caused the said gold to HUI ratio to spike to over 4.1 to 1. It again means that gold stocks are extremely cheap and trading at roughly half of their 2002 to 2011 average levels. You could argue that many gold stocks are priced for $800 gold, not the $1600 that gold trades at.
In addition, gold stocks are also cheap by more traditional measures. Over the past 10 years, gold stocks have traded at nearly 60 times earnings on average. However, currently, they trade at under 15 times earnings! Even with some stocks reporting disappointing results, they are still very cheap and do not represent the current gold price.
We do not know what the catalyst, for gold stocks, will be. It may be in the form of some sort of bailout in Europe that adds liquidity to markets. It could be another round of QE from the Federal Reserve.
We do not know that they will rally as hard and fast as they did from their 2008 lows. However, what history tells us is, when an asset class is cheap and overshoots to the downside and it still is in the confines of a major bull market, it will usually reflex to the upside. This is why you are best to purchase gold stocks here or at the very least hold your current positions. Once the catalyst is in place, gold stocks should see impressive gains from current levels.
By David Skarica