By Adam Hamilton
Last week when gold started flirting with $1000, the gold stocks caught a serious bid. On an impressive 3.8% two-day gold rally, the flagship HUI unhedged gold-stock index rocketed 15.7% higher! And the volume in this index’s elite gold stocks was staggering those 2 days, 2.8x the 3-month average.

This blisteringly-fast surge easily drove the HUI up to new 2009 highs, eclipsing the 398 witnessed in early June. To see any stock index blast nearly 16% higher in a couple days is exceedingly rare, so naturally all this excitement captivated traders. But it also led to growing fears that this sector is overbought and richly valued, ripe for an imminent correction.

Ever the contrarian, I disagree with this increasingly popular assessment. Despite their big run, gold stocks are still cheap. The primary reason is the massive anomaly in gold-stock pricing driven by last year’s brutal stock panic. Now approaching the first anniversary of that terrible event, gold stocks still continue to gradually normalize relative to gold. Until this necessary process is complete, they remain great buys.

The foundation for this bullish case is the indisputable fact that gold ultimately drives gold-stock prices. In general, a higher gold price translates into higher profits for companies mining this metal. And in the stock markets higher profits always eventually lead to higher stock prices. Any company’s profits are the most important driver by far of its long-term stock price. And for gold companies, the gold price controls profits.

This strategic fundamental truth is certainly proven out technically. In the 5 years prior to the panic, the HUI’s r-square with gold ran 94.9%. Thus 95% of the daily HUI price action over this secular span was statistically explainable by gold’s own. There is no doubt that owning gold stocks is ultimately a leveraged bet on gold itself.

The HUI’s ongoing relationship with gold is easiest to understand when seen visually. My favorite tool for this is the HUI/Gold Ratio, the daily HUI close divided by the daily gold close, charted over time. The following HGR analysis is why I was buying and recommending gold stocks and silver stocks deep in the bowels of last year’s stock panic and why I continue to think they have excellent near-term potential today.

In these charts, the HGR line is rendered in blue and superimposed over the HUI itself in red. When the HGR is rising, it means the HUI is outperforming gold. Gold-stock prices are climbing at a faster rate than gold itself. And when the HGR is falling, it means gold is outperforming the HUI. Most of the time this happens when both gold and the HUI are correcting but the metal isn’t falling as fast as its miners’ stocks.

Until last year’s panics (yes there were two, a bond panic followed by a stock panic), the HUI’s relationship with gold was very well-established as the HGR reveals. For 5 years, the HGR generally traded in a tight range between 0.46x to 0.56x. In other words, the HUI usually meandered between 46% to 56% of the price of gold at any given time. And the actual 5-year pre-panic HGR average ran 0.511x.

In the financial markets, the longer any relationship between two prices persists the more important it is. While a trend that lasts 5 minutes is probably meaningless and driven by random noise, one that lasts 5 years is likely exceedingly important. Any relationship that is established over such a long secular timeframe has to be derived from a strong fundamental connection, like gold driving gold-stock profits.

And interestingly technically, this 5-year HGR trading range was very tight. Most of the time between mid-2003 and mid-2008, the HGR remained between 0.46x and 0.56x. While there was an occasional surge above resistance or slump below support, the HGR quickly returned to trend. So the HGR’s secular average of 0.511x was not the product of a few extreme outlying reads, but a statistically-tight benchmark.

This statistical tightness makes the secular HGR average even more important for investors and speculators to consider when trading. Averaging 45 and 55, or 10 and 90, both yield 50. But as a trader I’m much more likely to heed the tight former than the loose latter. The tighter the original data, the less the average is skewed by extreme outliers, the more relevant it probably is to future market behavior.

So based on this long and technically-persuasive pre-panic secular history, the “normal” level for the HUI is somewhere around half the prevailing gold price. So if gold is near $400 like it was in late 2003, the HUI will probably run around 200. And if gold is near $900 like in early 2008, the HUI will probably be trading around 450. Incidentally, this HGR indicator was quite tradable. I used to buy precious-metals stocks when the HGR neared support and sell PM stocks when the HGR approached resistance.

But 2008’s panics shattered this idyllic world. First the bond panic, then the stock panic, led to a mass exodus of flight capital into the US dollar to buy short-term US Treasuries. This sparked the dollar’s biggest and fastest rally ever over such a short span, which drove futures traders to dump gold aggressively. If you want more background on this, last month I explored the panics’ impact on gold.

As gold fell, and as the general stock markets burned all around, gold-stock investors and speculators panicked. To this day I can’t understand why long-time secular-gold-bull players acted like frightened schoolgirls. There is nothing to fear in the financial markets. While the exceedingly rare stock panics are very unpleasant, they present the greatest buying opportunities ever witnessed. To sell into a panic is utter foolishness, and the weak-willed traders who succumb to this temptation always get wiped out.

The stock panic’s impact on gold stocks was mind-boggling. In less than 4 weeks in October last year, the S&P 500 plummeted 27.1%. Gold got hit hard in this fear maelstrom too, falling 15.1% over this same span. But the HUI, man it got obliterated. Over those very same first 19 trading days in October, the HUI utterly crashed by 51.8%! It looked and felt like gold-stock Armageddon, it was a selloff of Biblical proportions.

On October 27th when the general stock markets finally carved their primary panic low, the HUI closed at 152. Just 7 months earlier in March, it had achieved an all-time high of 515! I doubt any other sector has ever seen a 70.6% decline in such a short period of time within an ongoing secular bull. Since gold ultimately drives gold stocks, this would only have been logical if gold’s own decline warranted such unbelievable gold-stock losses. But it certainly didn’t.

Over this same March-to-October span, gold only fell 26.8%. On that fateful October 27th bottom, the HUI had actually fallen to 0.207x the gold price! It was the lowest HGR level seen since April 2001, which was incidentally the very month this secular gold bull was born. The panics had totally broken the secular HGR relationship. Check out this ratio’s blistering plunge in the chart above.

Now such abysmally-low HGR levels were just plain silly. This impossibly absurd situation just couldn’t last. And lest you suspect this is an insight I conveniently thought up later with the benefit of hindsight, let me share what I wrote to our Zeal Speculator subscribers on October 28th. That was the very next day after the HUI bottomed (when gold closed at $747 and the HUI at 173)…

“And how about gold? We are witnessing the biggest inflationary event in US history, and that is saying a lot. All of this bailout capital will eventually flood into the real economy and drive incredible inflation. I’ve been long gold since the $250s (early 2001) continuously and I’ve never felt more bullish than I do today after this nasty financial panic and its resulting bailout mess. Gold’s fundamentals are stellar.”

“Yet the HUI closed near 152 yesterday, which is end-of-the-world levels as far as I am concerned. This index hasn’t been this low since mid-2003! Where was gold trading back then? In the $350s! Is this madness or what? We have a gold price over twice as high yet stock prices are apparently discounting mid-2003 gold levels. This is clearly not rational and reflects the sentimental nature of this stock selloff.”

Such an epic anomaly presented the greatest gold-stock buying opportunity of this entire secular gold bull, so we started buying new PM-stock investments and speculations right in the heart of the panic. After our subscribers had a chance to get positions deployed, I publicly shared this same HGR reversion thesis I’m offering today in a mid-December essay. Thanks to the panic, gold stocks were too cheap relative to gold. But this anomaly couldn’t and wouldn’t last, the HGR would revert higher to its pre-panic secular relationship.

And although less extreme now since the HGR has indeed been recovering as expected, this same thesis is the reason why gold stocks are still cheap today. The panic anomaly was so extreme that gold stocks remain nowhere close to reflecting today’s prevailing gold prices. Over the last 3 months, gold averaged $944. At the 0.511x pre-panic average, the HUI should have been running 483. Yet its actual 3-month average was just 352, 27% too low. This already-narrowing disconnect will not persist.

This next chart zooms in to the post-panic HGR recovery period since October. The same data shown above is rendered here, in addition to a new yellow series. This yellow line is where the HUI would have been trading since the panic if its 0.511x 5-year pre-panic average HGR had held. Note that since the panic, the distance between the actual HUI and this hypothetical HUI has narrowed tremendously.  Continued...