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Gold stocks have become the ultimate contrarian play

Commentaries & Views

The week began with most everything being sold, with the U.S. dollar and gold receiving safe-haven bids heading into another highly anticipated FOMC meeting on Wednesday. The selling started in China on concerns over its property market and spread to Europe, then the U.S.

However, when Federal Reserve Chairman Jerome Powell stated the benchmark interest rate will remain near zero, but could rise sooner than originally anticipated during his concluding remarks at mid-week, gold quickly reversed its earlier gains.

Furthermore, once Powell said he personally does not feel the need for a "super strong" jobs report in order to begin tapering economic stimulus during a virtual press conference with the media, the gold price began heading back down to recent support at $1750 into the following session on Thursday.

In response to the potential impact from Fed changes to its stimulus and rate hike on Wednesday, the move lower yesterday was the second time in a week that gold had lost about 2% or more. Gold particularly came under pressure on Thursday after yields on the benchmark U.S. 10-year Treasury note hit above 1.4% for the first time since July.

The yield is an indicator of market expectations about real inflation and how quickly the Fed will have to react to curb inflationary pressures. On the downside, if we see a weekly close in Gold Futures below $1750 later today, investors must be mindful of a possible test of critical support at $1,675 heading into quarter-end next week.

Also, the $22 level in silver is a major support level that precious metals investors should pay close attention to, as this region has been critical support that has been tested three times over the past 14 months. If the bears are able to run the stops below $22, then we could see $19 silver quickly.

Meanwhile, the miners remain mired in a now 14-month correction of out-sized gains in 2020. With risk-on sentiment returning to the marketplace, the GDX lost critical long-term support at the $30 level on Thursday. If we see a weekly close below this level of support later today, I expect a move down to the rising 200-week moving average at $28 may come into play into quarter-end next Thursday.

Despite robust gold prices, gold mining stocks remain deeply discounted when compared to U.S. stocks as investors continue to bid up over-priced equities during the on-going "Fed Put". Even though low-cost gold miners are still making huge profits with all-in sustaining costs rising to $1067 in Q2, and paying healthy dividends, gold stocks have recently become the ultimate contrarian play in the marketplace.

In fact, these call options on an inevitably higher gold price have gone from being generally hated by investors after the Fed began its taper-talk in June, to them becoming downright apathetic recently. Earlier than usual tax-loss selling in the sector has taken the current ratio between the metal and gold stocks, as represented by the NYSE Arca Gold Mining Index (HUI), not far off historic lows struck in 2015.

A new chartbook released by Merk Investments, an investment advisor, and ASA Gold and Precious Metals (NYSE:ASA), shows that if the price of gold remains stable at today’s levels, gold stock valuations would have to more than double to bring it in line with the historical average since the early 1990’s. In other words, while the valuations of general equities remain historically overvalued, the price of gold stock "insurance" is becoming historically cheaper.

Moreover, the GDXJ is now priced at much lower gold prices after losing long-term support at $41 in early August, a level that was strong resistance when gold was attempting to break above $1550 in 2019. But if the $1675 level is seen on this move, we could see this correction continue down to the $35 level in GDXJ, which would most likely clean out the last of the stale longs.

In the case of junior valuations, the 14-month consolidation of the 180% move higher in the GDXJ, which took just 4.8 months to complete, has been frustrating as the potential for multi-bagger gains in select juniors lies in waiting when this brutal correction finally ends. This is why junior resource stock speculators should remain patient while the correction plays out by holding core positions in quality juniors, along with a large cash position in a non-margin account to add more once the sector turns.

The main difference between the aforementioned historic low made in late 2015 and the bottom forming now is that many quality juniors are cashed up well into 2023. When the gold complex was in the process of forming a significant bottom into early 2016, most were in need of cash and barely keeping afloat financially.

Furthermore, the long-term macro fundamentals for the PM sector have never been better, while the stock market is in the process of setting up the next catalyst for the PM sector to move higher by showing some fear as valuations are starting to come off from historic levels.

After rising 180% is such a short period of time, the junior miner ETF has thus far corrected 40% from its August 2020 high and more importantly, is priced at $1550 gold. But even though the precious metals mining space has become deeply oversold, the trend remains down and may not change until technical support at $35 in GDXJ has been reached.

The bad news is we may see more pain even after a short-term bounce takes place in the sector soon. But the good news is that many of the previously high-flying quality juniors have come off by 50% or more during this correction. Patient, cashed-up contrarians are being given an opportunity to buy at lower-risk entry points, as tax-loss selling is in the process of creating ultra-deep value in quality juniors de-risking high-margin projects, located in top-tier jurisdictions.

If the Fed gives us the "soft taper" after the next FOMC meeting concludes on November 3rd, I expect a "buy the news" reaction from the gold complex based on the over-reactive pullback due to "taper-talk" that has taken place since June. But until then, caution is advised while patiently waiting for this correction to play out.

The recent move lower in the precious metals sector since a June peak has gold equities presenting one of the best value propositions seen in quite some time, at a time of both historic global debt-to-GDP imbalances and record central bank money printing. By late November/early December, there is a good chance of a major bottom in the mining sector being in place.

With the mining complex at historic lows in relation to over-priced equities, this is a great time to create a carefully vetted watch list of quality juniors to buy and hold before the next up-leg in this secular gold bull market. If you require assistance in doing so, and would like to receive my research, weekly newsletter, portfolio, watch list, and trade alerts, please click here for instant access.

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.