Gold stocks pummeled by precious metals fundamentals

Stress spawned by weakness "intense"

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Gold stocks have been pummeled mercilessly this month, their price action looking almost apocalyptic. The psychological stress spawned by such extreme weakness is intense, breaking the wills of this sector’s few remaining bulls. This week their selling cascaded into a full-blown capitulation, a mass surrender by weary investors. While exceedingly miserable, these events flag major long-term bottoms.

Over the course of gold’s powerful secular bull, the gold stocks have been a sentiment roller coaster. Early on their gains were enormous, gold stocks even rocketed higher while the general stock markets plunged in a brutal cyclical bear. Though they were nearly obliterated in 2008’s once-in-a-lifetime stock panic, as expected they soon soared in a massive recovery. Last autumn they hit new all-time highs.

But since the flagship gold-stock index (HUI) peaked in September, this sector has really fallen out of favor. Selling begets more selling, technical levels are broken, sentiment waxes increasingly bearish, so gold stocks are driven ever lower. In the first couple weeks of May alone, the HUI plunged 15.2%! Relentless selling leading to abysmal new lows eventually shakes out all but a bull’s true believers.

Even though the HUI was already hyper-oversold by its own bull-to-date standards, it plunged another 8.6% over 3 trading days ending this past Tuesday. Such massive selloffs from already-deep lows are a hallmark of capitulation. The frenzied exit of traders throwing in the towel in great frustration leads to selling exhaustion. Everyone susceptible to being scared into selling anytime soon is squeezed out.

But this leaves only buyers, so the nearly total absence of sellers after a capitulation ignites a big surge. This major reversal usually matures into a strong upleg. Thus capitulations, the wholesale abandonment of a sector by traders pushed to their emotional limits, are one of the greatest buy signals. And this week’s intense technical weakness and extreme sentimental distress in gold stocks sure looked like one.

While capitulations are psychological events, collective emotions can’t be measured. But the miserable impact of excessive fear and disgust is readily apparent in price action. So the mass surrender of capitulation is easily identifiable on charts. And the recent cascading selloff from already-low gold-stock levels is perhaps most vividly illustrated across multiple gold-stock measures in indexed terms.

The first is the HUI, long the leading gold-stock index closely followed by investors and speculators. Officially known as the NYSE Arca Gold BUGS (Basket of Unhedged Gold Stocks) Index, it currently includes 16 elite major gold miners. But in this increasingly ETF-dominated world, the GDX gold-stock ETF is vying for the HUI’s throne. This Market Vectors Gold Miners ETF was launched in May 2006.

Today GDX has 31 component stocks, but despite its broader reach it still trades very similarly to the HUI due to the way each metric’s major components are similarly weighted. For a variety of reasons beyond the scope of this essay, I suspect GDX will eventually replace the HUI as this sector’s measuring rod of choice. Its little brother, the GDXJ junior-gold-stock ETF, offers the best view of the latest capitulation.

This Market Vectors Junior Gold Miners ETF was launched by Van Eck Global just like GDX, but quite a bit later in November 2009. While GDX focuses on major gold miners, GDXJ offers a valuable window into the volatile world of much-smaller producers and explorers. It currently has a whopping 86 components, dominated by small market-cap companies. Juniors were ground zero for this capitulation.

And of course no look at gold stocks would be properly framed without considering gold. This metal’s price naturally drives the long-term profitability and hence ultimately the stock prices of the companies that produce it. The fact that gold stocks plunged so dramatically relative to gold remaining high and strong greatly enhances the odds for success in this post-capitulation gold-stock buying opportunity.

With 4 data series on 4 different scales, the only way to parse them all at once is by indexing them. This makes them perfectly comparable in percentage terms. I set each individual index to 100 as of the HUI’s recent all-time high in early September 2011. From there a 10% move higher or lower takes any index to 110 or 90 respectively. This first chart establishes some strategic context for identifying capitulations.

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Because gold’s fortunes are gold stocks’ only real long-term fundamental driver, I zeroed the vertical axis so this latest capitulation can be understood relative to gold. Gold has had a rough time lately, no doubt. A relentless parade of economic fears out of Europe, Asia, and the US, as well as traders realizing the Fed isn’t going to launch a third round of inflationary quantitative easing anytime soon, really hit gold.

Since its latest interim high in late February, gold was down 13.9% as of this week. While that isn’t a trivial selloff, gold was still only dragged back to a 10-month low. Even though gold fell under $1550 and spooked excitable traders, you have to remember that before a year ago such levels had never even been seen before! Technically gold has merely been consolidating high after getting very overbought last August.

Next page: Overreaction?

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