As Gold Breaks Out, Miners Remain Historically Undervalued

Friday, September 1, 2017

fine gold

In the last update , we noted the important technical breakout that gold had shown above its key long-term 2011 – 2017 downtrend. The successful breakout came after multiple failed attempts over the past 12 months. We note the change in behavior that gold has seen as it has now held above the long-term downtrend for three straight weeks. Further confirmation has been seen just this week in the break of horizontal resistance at $1,300. As August is now officially in the record books, we can say that $1,300 has held on a daily, weekly, and monthly closing basis. The final print on the front-month futures contract was $1,322 today, August 31.

The updated gold chart appears below. Note the clear breakout above key declining long-term resistance that is now being solidified on higher volume:

As indicated in the last article, we have higher targets ahead for gold prices through the end of 2018. A key confluence of metrics point to a target range of $1,485 - $1,535 as the next region where gold is likely to find an intermediate top. From today’s close of $1,322, the target range would yield gains of 12.3% - 16.1% for the age-old store of wealth over this timeframe.

Gold Miners to Outperform

While gains in the double digits will certainly be celebrated by precious metals investors, there is another opportunity that those with a higher reward and risk tolerance should consider – and that opportunity exists in the gold mining sector.

We know that over time, the precious metals miners should be leveraged to the prices of the metals themselves. A simple mathematical example will illustrate the point:

Say ABC Gold Corp. owns a deposit of one million ounces of gold in the ground, and is able to mine every ounce for total costs of $900 per ounce. When they later sell that gold for $1,300 per ounce (at current prices), they will profit $400. Now suppose the price of gold increases to $1,500. Assuming the costs to mine stay relatively stable, ABC now sells each ounce for a $600 profit.

So, we can see here that as the price of gold increased by 15% ($1,300 to $1,500) the profits and therefore share price of the company would have increased by 50% ($400 to $600). Thus, an investor can achieve profits well in excess of the actual rise in the price of gold.

Miners Are Historically Undervalued

This would be the expected trajectory for the prices of gold and the miners that dig the metals out of the ground – were it not for the anomalous situation which currently exists: miners are historically undervalued relative to the metals themselves. What this means is that in a rising gold-price environment over the intermediate term, the miners should be set to vastly outperform the historical leverage factors discussed above.

The best way to illustrate just how undervalued gold miners are presently is to examine the long-term ratio between these producers and gold itself. Below we are examining the XAU to gold ratio, which measures an average value of the approximately 20 companies that make up the XAU miners index compared to the very product that these companies primarily produce – gold.

The XAU Miners Index contains data dating back to 1984, although we can calculate the index back through the mid-1970’s by examining the charts of constituent companies. What we see from the chart above is that from the year of inception through 2008, the XAU to gold ratio oscillated between 0.16 and 0.38 (shares of the index required to purchase one ounce of gold). The mean value was 0.27.

In this chart, the lower the ratio, the more poorly valued the miners are relative to their own product.

We can see that during the crash of 2008, as risk capital froze for mining projects, the miners became undervalued by an order of magnitude more than they ever had in the previous 24 years. And then to make matters worse, three years later the prices of gold and silver themselves topped out at $1,923 and $50, respectively. The net result is that by 2016 the miners fell to their lowest valuations in almost 40 years of record keeping.

Ratios between real asset classes cannot go to zero. Such would imply that the miners have zero value relative to their own product – gold. Such is an impossibility – yet in early 2016 the miners were valued the closest to zero that has ever been recorded.

It was a misevaluation of epic proportions.

2016 Surge Just The First Act

From these depressed valuations, as gold rose 31% in early 2016 some miners surged 100% - 500% or more over the first half of the year.

Many investors assumed that these moves were over after 2016.

Refer Back To The XAU/Gold Ratio Chart Again.

Our analysis shows that from the current value of 0.068 on the ratio, the average miner would still need to appreciate nearly 300% to reach just the historic average valuation – with no increase in the price of gold. If gold were to rise 12% - 16% as our targets suggest over the next 18 months, these gains would be multiplied into the reversion to the mean for the miners.

Again, these calculations do not require gold to rise to $5,000 per ounce due to some Armageddon scenario. They do not require a stock market crash. All that is required is for the miners to return to an average 40-year valuation versus their own products.

How would this reversion to the mean occur? It will not happen overnight. It took eight years for the mining sector to become historically undervalued, and we envision an equal-length return to normal valuation, as shown below. The sector is 18 months into this process:

Takeaway On Gold And The Mining Sector

Gold looks strong technically. We do not envision skyrocketing prices, but our targets remain $1,485 - $1,535 by late 2018. This may coincide with a further weakening in the US dollar and/or the broad stock market.

While ownership of physical gold should be the cornerstone of a precious metals portfolio, we are overweight the miners at this juncture. Despite gains of 100% - 500% in 2016, the gold mining sector is still historically undervalued relative to gold.

Throughout history, ratios between real asset classes revert to the mean when they become radically undervalued, and this time will prove no different. For those contrarian-minded investors who have a higher tolerance for reward and risk than the above targets for gold bullion alone would provide, the opportunities in the gold producing equities are quite significant.


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Christopher Aaron

Christopher Aaron began his career as an intelligence analyst for the CIA and Department of Defense. He served two tours to Afghanistan and Iraq between 2006 - 2009, conducting pattern-of-life mapping for military leaders.

Mapping shares similarities with technical analysis of the financial markets because both involve the interpretation of repeating patterns found in human nature. He is the founder of iGold Advisor, providing research on the precious metals, and iGlobal Analytics, featuring technical analysis of the global capital markets.

Christopher speaks regularly on the cyclical patterns found within the financial markets and on international policy. He has been featured in the New York Times and NPR news amongst other publications.