Gold stocks’ reign as the most despised sector in all the stock markets remains unchallenged. They’ve even been abandoned by contrarians. But such universal antipathy and apathy is the breeding ground for major bottoms. And despite gold’s lackluster performance, gold stocks have actually been rallying on balance for 6 months now. Given their extreme undervaluations relative to gold, this strength is likely to persist.

The gold miners’ stocks are essentially leveraged plays on the price of gold. The fortunes of this prized precious metal determine their profitability, and those earnings fundamentals drive their ultimate stock-price levels. And gold’s been deeply out of favor, languishing at relatively-low price levels. This has put great pressure on gold-mining operations, slashing ongoing profits and seriously clouding their future outlook.

This undeniably dark time has swung sentiment on this sector to extreme bearishness. Out of the small fraction of investors and speculators who’ve even considered gold stocks, the great majority are totally convinced this sector is doomed to fade into oblivion. Popular consensus believes gold mining simply can’t be profitable at prevailing or lower gold prices, and doesn’t see gold recovering anytime soon if ever.

Both these notions are pretty silly though.  For nearly the entire history of the modern era of gold mining, this industry thrived with gold well under $1000 let alone $1200.  There aren’t as many deposits that are economically viable at lower gold prices, and the miners have to target higher-grade ores, but they can adapt.  A great example recently came from Newmont Mining, one of the world’s largest gold miners.

Newmont reported its Q1 operating results late on April 23rd, and they were excellent.  Adjusted earnings per share of $0.46 doubled both the consensus expectations of $0.23 and the prior year’s $0.24.  And sales surged 12% year-over-year.  Most of corporate America would die to report earnings and revenues like that!  Newmont’s profitability was mostly the result of it driving down all-in sustaining costs to $849 per ounce.

Annualize that Q1 profitability, and Newmont stock is trading at a 2015 P/E ratio of 13.8x even if gold continues to languish around $1200.  That’s quite cheap compared to the simple average trailing P/E ratio of all the elite S&P 500 component companies, which was way up at 26.0x as April ended!  And it’s surprising how many smaller gold miners are trading at similar or lower P/E ratios today, truly dirt-cheap.

But when gold inevitably mean reverts higher, gold-mining profits are going to leverage those gains to soar dramatically.  That will make gold stocks even cheaper fundamentally.  Today’s weak gold levels are the result of the extreme stock-market levitation fueled by the Fed’s QE3 campaign and all its associated jawboning, and the universal but-totally-false belief today that the coming rate hikes will slaughter gold.

Rate hikes are actually bullish for gold investment demand because they hammer general stock markets, leading investors to seek alternatives.  During the 1970s gold super-bull which saw it skyrocket over 24x higher, the Fed hiked its benchmark Federal Funds Rate from 3.5% to an astounding 14.0%!  Yet gold still soared in its biggest bull of modern times.  It had another major bull in the 2000s, again during higher rates.

In particular during the Fed’s last rate-hike cycle between June 2004 and June 2006 where it more than quintupled the Federal Funds Rate from 1.0% to 5.25%, gold surged 50% higher!  Gold’s lack of yield has nothing to do with it being in or out of favor.  Rising and high-rate environments are great for gold because they seriously damage conventional stocks and bonds forcing investors to diversify into gold.

So beaten-down gold prices are almost certain to power higher in a major new bull as the coming Fed rate hikes deflate the lofty, overvalued, and overextended general stock markets.  This is likely one of the main reasons gold stocks have been recovering over the past half-year.  This first chart looks at this sector as seen through the lens of the GDX Gold Miners ETF, the leading gold-stock benchmark today.

With all the gold-stock hate out there, you’d think these miners’ stock prices were still plummeting into the abyss.  But nothing could be farther from the truth.  Since bottoming at an extreme 6.0-year low back in early November, the gold stocks have been climbing on balance.  This was despite gold being weak for most of the period since, largely languishing around or under that bearish-psychology-feeding $1200 level.

This entire sector has actually enjoyed a strengthening uptrend in the past 6 months, carving higher lows and higher highs.  And while gold did surge in early January which sparked a really impressive 38.3% GDX rally in 2.5 months, that was certainly the exception.  Most of the time since GDX started recovering in this young uptrend, gold was drifting sideways to lower near $1200.  Yet investors bought gold stocks anyway.

April’s action was a great example of this disconnect.  After gold enjoyed an initial surge, it drifted lower to finish that month dead flat in the low $1180s.  There was not only nothing going on to encourage investors to return to gold stocks, the weak gold action actively discouraged it.  Yet GDX still powered a very impressive 10.3% higher last month, ranking gold stocks among the best-performing sectors in all the markets.

This young sector uptrend may be nearing a major technical breakout too.  That sharp January rally in GDX collapsed at this ETF’s 200-day moving average.  That’s an important level that many technically-oriented traders watch closely.  GDX’s sinking 200dma has now converged with this ETF’s young uptrend channel.  So even a conservative within-trend rally could easily break GDX back above its 200dma.

And once that buy signal triggers, contrarian traders sitting on the sidelines waiting for a clear catalyst to buy gold stocks are going to start redeploying capital.  It’s hard to believe, but there is still a small group of investors and speculators interested in this ultimate contrarian sector.  This is evidenced by the sharp GDX rallies that erupt whenever gold shows signs of life.  Gold-stock buying will surge on a GDX 200dma breakout.

This sharp buying also emerged the last couple times GDX retook its 200dma in February and June 2014.  And those strong gold-stock rallies would have kept running if not for big gold-futures shorting soon slamming the metal.  But given the extreme levels of gold-futures shorting in recent years, that trade is gradually exhausting itself.  Financial markets are forever cyclical, no price runs in one direction forever.

It’s this very core tenet of contrarian investing that strongly argues why gold stocks’ recovery has likely only just begun.  This next chart looks at the key fundamental relationship between gold-stock prices and the price of gold which drives their profits.  The GDX gold-stock-ETF price is divided by the flagship GLD SPDR Gold Shares gold-ETF price.  This GDX/GLD Ratio shows the extreme anomaly in gold-stock pricing today.

When this GDX/GLD Ratio is rising, gold stocks are outperforming the gold price.  This is normally the way gold stocks act when gold prices climb, due to their inherent profits leverage to gold.  Consider an example.  If a miner can produce gold for $1000 per ounce, and sell it at $1200, it earns a $200-per-ounce profit.  If gold rallies 25% to $1500, this miner’s costs are still $1000.  So its profits greatly leverage gold’s gains.

They soar to $500 per ounce, which is a massive 150% increase compared to gold’s 25% increase!  All throughout the stock markets, stock prices are ultimately dependent on earnings.  So gold-stock price levels are bid up to reflect their much-higher profitability fueled by higher gold prices.  Naturally this is a double-edged sword though, when gold prices drop gold miners’ profits fall far faster amplifying its losses.

When the GGR is falling, gold stocks are underperforming gold.  And as this chart reveals, incredibly this happened on balance between late 2007 and late 2014.  Around 7 years is an extraordinary span for any market to move in one direction!  Markets are forever cyclical, sentiment and therefore price levels ebb and flow.  Gold stocks can’t fall out of favor relative to gold forever, they are overdue for a massive recovery.

And it looks to be already underway!  The past half-year’s stealthy gold-stock uptrend has broken this GDX/GLD Ratio back above its long-term secular resistance that dominated since late 2007.  This is a major trend change that is likely to prove pivotal.  Back in mid-December, the GGR fell to its lowest level ever at 0.149x.  A share of GDX was worth just 0.149x a share of GLD, an extreme never before witnessed.

But since then the GGR has been regaining ground despite deeply-out-of-favor drifting gold prices.  The GGR climbed to 0.185x in late January after that sharp gold-stock rally, a 24.2% gain in a single month.  And despite gold drifting sideways to lower since then, the GGR had clawed back up to 0.179x as May dawned.  Gold stocks are showing impressive relative strength in the face of hyper-bearish gold sentiment!

And with gold-stock price levels still at such fundamentally-absurd extremes relative to gold, their mean reversion higher is only just starting.  Before 2008’s stock panic, the GGR averaged 0.591x.  In the initial post-panic years between early 2009 and mid-2011, it averaged 0.419x.  Both baselines of gold-stock prices relative to the metal which drives their profits are far higher than prevailing levels.  But let’s be really conservative.

Gold stocks’ current woes began in early 2013 as the Fed ramped up its wildly-unprecedented open-ended third quantitative-easing campaign.  As that goosed already-toppy stock markets, while short-circuiting all meaningful selloffs, demand for all alternative investments including gold withered.  In fact in Q2’13, gold suffered its worst quarter in an astounding 93 years!  It was essentially a hundred-year storm.

So the last “normal” years in the markets ran between 2009 to 2012.  Over that span, the GDX/GLD Ratio averaged 0.381x.  Merely to mean revert back up to those average post-panic levels relative to the gold price, GDX would have to soar 120% higher from today’s levels!  The upside from here given how far gold stocks are out of favor is massive.  No other sector has such great potential in today’s overvalued stock markets.

And this conservative comparison greatly underestimates gold stocks’ upside for a couple reasons.  First after any price and sentiment extreme, a sector tends to not only mean revert but overshoot towards the opposite extreme.  So once gold stocks really get powering higher again and excite traders, they are going to pour far more capital into this sector than is necessary merely to regain average levels relative to gold.

Although exactly where the GGR could peak in this highly-likely gold-stocks-regaining-favor scenario is impossible to predict, mean-reversion overshoots tend to be inversely proportional to the extreme that triggered them.  So the GGR could easily temporarily shoot as far above average levels as it has been below them in recent months.  That effectively doubles the upside potential of the gold stocks from here!

And we can’t forget that gold prices drive gold-stock earnings, which ultimately determine gold-stock price levels.  There’s no way gold is going to stay around $1200 once the super-toppy global stock and bond markets roll over in the face of the coming rate hikes.  Gold itself is going to mean revert far higher as demand for alternative investments and prudent portfolio diversification comes roaring back in a stock selloff.

So what’s an average gold price?  Between 2009 and 2012 before those extreme Fed-fueled distortions, gold averaged $1361.  That’s 14% higher than today’s levels.  But in 2012 alone, the last normal year prior to QE3 and its associated jawboning ramping up, gold averaged $1669.  That’s 40% above current prices.  Let’s just take a midpoint around $1500, which again is merely a relatively-small 27% gold upleg.

While gold too is almost certain to proportionally overshoot in its coming mean reversion back into favor, even $1500 drives home gold stocks’ vast upside potential.  $1500 gold equates to about $144 in GLD terms, since this ETF’s operating expenses have required a 0.4% annual fee since its inception back in late 2004.  Using that 2009-to-2012 average GGR of 0.381x, $1500 gold yields a GDX target near $55.

That’s a whopping 178% higher than today’s gold-stock price levels, nearly a triple!  And it is based on the unlikely assumption that neither gold prices nor the GDX/Gold Ratio overshoot on their long-overdue mean reversions.  Whatever reasonable assumptions you make about future gold prices and gold-stock price levels relative to the metal they mine, the gold stocks are epically undervalued today.

And I suspect the past half-year’s impressive contrary gold-stock buying is coming from a small fraction of contrarian investors’ growing realization that gold stocks are exceedingly cheap with amazing upside potential from here.  Gold stocks’ recovery is already underway, and the capital flowing into this sector and bidding it higher is going to mushroom once gold itself finally starts moving decisively higher as well.

Investors and speculators can certainly play gold stocks’ young upleg with GDX, which is a fine gold-stock ETF containing the world’s best gold miners.  That’s certainly the easiest way for traders of any size to gain gold-stock exposure in their portfolios.  But as always, a carefully-handpicked portfolio of the best of the gold miners should see gains well exceed this sector’s as a whole.  That’s what we specialize in.

The bottom line is gold-stock prices are recovering.  Despite gold drifting sideways to lower for the most part, gold stocks have carved a strengthening uptrend over the past half-year.  This loathed sector is just starting to outperform gold again, driven by hardcore contrarian buying.  The gold stocks have broken out of their exceedingly-old downtrend relative to gold, and a massive mean reversion higher is inevitable.

Since gold stocks were forced to such extreme lows relative to gold, their upside potential from here is vast.  This forever-cyclical market will gradually see trader sentiment shift from today’s despair to neutral to eventually greed.  And every step along the way, more investors and speculators will buy in to ride the growing upleg.  There is no other sector in these overvalued stock markets that’s as undervalued and bullish.