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Gold Stocks - On Fire Sale?

By David Skarica      Printer Friendly Version
Oct 27 2008 4:53PM

Right now it is no use to look at P/E ratios and the like when evaluating most resource stocks. Why? Cause the E is about to decline big time. However, the P's have already declined discounting this. When a stock like Freeport Copper and Gold declines from 120 to 23 it has discounted a major slowdown in earnings and decreases in Gold and Copper prices (for the most part Copper). Many gold stocks are trading below book value some half at book value. Some juniors are trading below cash value.

One way I like to evaluate gold and resource stocks is to simply divide the prices of the stocks and especially, resource indices, by the prices of the underlying resource. You see resource stocks are usually more leveraged than the prices of the underlying commodities. We saw this in gold when gold quadrupled from 2000 to 2008 whereas the HUI index went up 13 to 1 from its low in 2000 to its high in 2008.

Why? Well let's look at it this way: say gold is 300 and your cost of production is 300; say gold rockets to 600 in a year but your cost of production has only gone up 10% or 30 dollars (due to inflation and other factors). Well at 300 gold you were making 0 dollars an ounce; at 600 gold you are making 270 dollars an ounce. Gold has doubled but you have gone from making nothing to 270 dollars an ounce. Therein lies the leverage.

Also as the gold price increases, gold, which is deeper in the ground and which may cost more to dig out becomes economic to mine. Again let's say a company has hard- to-get gold that is going to cost 500 dollars an ounce to mine. Well at 300 it makes no sense to mine that gold; whereas at 700 dollars you can. Therefore, your cash flow goes up and the size of your resource and value of your company goes up. This is why gold stocks are more leveraged as the total value of what they have in the ground can go up as the price of the underlying commodity goes up.

However, there is also a psychology to it. Stocks tend to go up faster than the commodity, as stated above, but they can get ahead of the commodity. We find that when stocks go up too fast in comparison to the commodity, it is a sign of a top; when they go down too fast, a sign of a bottom.

We find that there is an excellent case to be made for buying Gold stocks right NOW. The indicators we watch are the HUI to Gold index and the XAU to gold index.

Again all you do is divide the price of these indices by the price of gold.

HUI Gold Index to Gold

The HUI gold index is an index of unhedged gold stocks.

The HUI gold index has traded about between .40 and .60 since 2003. Near the bottom of the market in 2000, it got below .20., actually to .14. From 2003 to 2007, when it got above .60, it meant that gold stocks were expensive, the rally was over done and a correction would occur. This happened at the 2006, 2003 tops in gold and gold stocks. At the bottoms in 2004, 2005, 2007 whenever the HUI to gold ratio got below .45, gold and gold stocks almost always rallied.

However, this mass liquidation has changed everything. The HUI to Gold ratio is currently trading at .22 or where it was in early 2002 when gold was trading at just over 300 dollars an ounce and the HUI around 80!! Therefore, HUI is trading at extremely cheap levels. When the HUI first broke 200 in 2003, gold was not even 500 dollars an ounce. It is 170 today with gold at over 700 dollars an ounce.

The XAU Gold Index

The XAU to gold index has traded at a strict range in the past 10 years of .28 to the upside and .16 to the downside. Whenever the XAU to gold ratio got above .26 gold stocks were expensive and they corrected; whenever it got below .19 and especially .18, gold stocks were cheap. This again occurred at the 2006 and 2007 summer bottoms for gold stocks. The lowest reading was .16, which was the 2000 low for gold stocks.

What has currently happened to the XAU is shocking. Hedge funds have had to dump large cap gold stocks to meet redemptions. Gold stocks held up until early July, then everything tanked. The XAU has fallen an amazing 55% since early July. It is down 40% in October alone!

The XAU to gold ratio currently is .09; that is the lowest level ever!!!!! It is 40% lower than at the 2000 bottom. This means that in comparison to gold, gold stocks are 40% cheaper now than in 2000 when gold was 250 dollars an ounce!!

This is why we think we are getting a huge buying opportunity.

Is the US Dollar Rally Almost Finished?

We think the rally in the dollar is near done; yes the dollar could go a few points higher and we could definitely see the Euro falling to 1.25 or even 1.20. Once the reality of 10% inflation and 1 trillion dollar deficits sets in, we see the dollar headed a lot lower, especially when the next bubble (the US long bond) begins to deflate. Consider as well the lack of foreign investment (as previously discussed) that will occur in the coming years.

Remember in the seventies the CRB commodities Index went up 120%, then pulled back about 40% before continuing on another 100% run in the late seventies.

Gold pulled back from 200 to 110 from 1974 to 1976 before rocketing to 800 in 1980. Big pullbacks can happen within the long-term cycle; we just think this is a big pullback.

Now, we have seen massive liquidations from hedge funds in commodity stocks. This is why we think this is a great buying opportunity in commodity stocks; you are getting companies, still in the midst of a great bull market, on fire sale.


David Skarica



David Skarica is the editor of a newsletter that specializes in technical, fundament and psychology analysis of the market. He has had two books on the markets published, Stock Market Panic! And How the Contrarian Saved the World. Please log onto too to sign up for his free e-letter.