This post is a modified excerpt from a commentary posted at TSI a few weeks ago.

At its recent low the HUI was trading at the same price at which it traded way back in 2003-2004, when the gold price was $350-$400/oz. On the surface, this suggests that at their recent lows the senior gold-mining stocks that dominate the HUI were absurdly under-valued relative to gold, given that gold was trading at around $1150/oz at the time. Just how extreme was the under-valuation?

According to the article posted HERE, the HUI’s under-valuation was so extreme it was completely irrational. For example, the article contains the following statements:

“While gold stocks indeed should’ve been sold with gold weaker, the magnitude of selling they suffered was far beyond anything justifiable fundamentally. This ultimately culminated in the latest gold-stock capitulation where the HUI plunged to 11.3-year lows! Think about that a second. Gold stocks were just trading at prices not seen since July 2003. Pretty much the entire secular gold-stock bull had been fully erased.”

And: “… [the] entire not-widely-followed gold-stock bull was based on the massive fundamental boost to gold-mining profits that gold’s own secular bull created. So if the recent gold-stock price levels were righteous, gold too should have been pounded back down towards its mid-2003 levels. Where was gold trading back then? Merely right around $350!”

And: “Do gold stocks deserve to trade today as if gold was at just $350? Heck no! Last week when gold stocks’ latest capitulation low was carved, the gold price was up near $1150. That was 3.3x higher than the last time the gold stocks traded at recent levels! It makes no fundamental sense whatsoever for gold stocks to trade as if gold was at $350 when it was actually $1150. Their core fundamentals are now vastly better.”

The analysis encapsulated in the above excerpts is superficial and misleading, for two main reasons. First, production costs are vastly higher now than they were in 2003-2004. Second, although the stock prices of the senior gold miners are, on average, not much higher now than they were when gold was trading at $350-$400/oz, their market capitalisations are hundreds of percent higher thanks to massive inflation of share quantities. Consequently, a good argument can be made that the “core fundamentals” are now worse than they were when the gold price was $350-$400.

I’ll now consider the specific case of Goldcorp (GG) to back-up my point. During the quarter ended 30th September 2003, GG managed to achieve a net profit of $0.13/share, a net operating margin of 44% and a return on invested capital (ROIC) of 22%. These results were achieved at an average realised sale price of $364/oz. During the quarter ended 30th September 2014 GG’s average realised sale price was $1266/oz, but the company reported a net LOSS of $0.05/share and was too embarrassed to highlight the ROIC. Note that there were no large asset writedowns in the latest quarter. GG was simply not profitable at $1266/oz in Q3-2014 after being very profitable at $364/oz way back in Q3-2003. And by the way, from Q3-2003 to Q3-2014 GG’s share count rose from 183M to 814M, so although its share price is up by ‘only’ about 50%, its market cap is up by about 580% over the period in question.

I selected GG for my quick-and-dirty case study because it has been one of the best-managed of the senior gold producers and has had less company-specific problems than some of its brethren. Had I chosen either Barrick Gold (ABX) or Kinross Gold (KGC) my point could have been made even more clearly, because the amount of wealth destroyed by these companies via ill-conceived acquisitions and project developments is mindboggling.

It’s important that fundamentals-oriented speculators who buy gold-mining stocks have their eyes wide open and understand the reality of the current situation. There are some good reasons to anticipate large gains in gold-stock prices over the coming 2 years involving a rising gold price, declining production costs and improving sentiment, but at the current gold price and with their current cost structures most gold producers are NOT particularly cheap by traditional valuation standards.

Therefore, don’t be hoodwinked by superficial comparisons into believing that gold stocks are now priced for a hundreds-of-dollars-per-ounce lower gold price and, as a consequence, that massive gains lie ahead for gold stocks even if the gold price flat-lines or continues to trend downward.

The historical record indicates that the gold-mining sector performs very well during the first 18-24 months of a general equity bear market as long as the average gold-mining stock is not ‘overbought’ and over-valued at the beginning of the bear market. Unfortunately, the historical sample size is small. In fact, since the birth of the current monetary system there have been only two relevant cases.

The first case involves the general equity bear market that began in January of 1973 and continued until late-1974. This bear market resulted in peak-to-trough losses of around 50% for the senior US stock indices.

The following chart comparison of the Barrons Gold Mining Index (BGMI) and the S&P500 Index shows that the gold-mining sector commenced a strong upward trend near the start of the general equity bear market. During the bear market’s first 20 months, the BGMI gained about 300%.

The second case involves the general equity bear market that began in September of 2000 and continued until early-2003. This bear market also resulted in peak-to-trough losses of around 50% for the senior US stock indices.

The following chart comparison of the HUI and the NYSE Composite Index (NYA) shows that the gold-mining sector commenced a strong upward trend about 2.5 months after the start of the general equity bear market. Despite the fact that the HUI suffered a substantial percentage decline during this 2.5-month period, it still managed to gain about 200% over the course of the bear market’s first 20 months.

The gold-mining sector is currently a long way from being ‘overbought’ and over-valued. In fact, by some measures it was recently as ‘oversold’ as it ever gets. The historical cases cited above would therefore be relevant if a general equity bear market were to begin in the near future.

On a related matter, the only times when the owners of gold-mining stocks need to fear a general equity bear market are those times when the gold-mining sector has trended upward with the broad stock market during the 6-12 months prior to the start of the general equity bear market. Consequently, in the unlikely event that the current bull market in US equities continues for one more year and gold-mining stocks trend upward during that year, the gold-mining sector will then be vulnerable to the downward pull of a general equity decline.

There is an excellent interview about China in the latest edition of Barrons magazine. The interviewee is Anne Stevenson-Yang, who, having spent the bulk of her professional life in China since first arriving in 1985, is extremely well-informed on the topic. She is fluent in Mandarin and is currently the research director of J Capital, a company that works for foreign investors in China doing fundamental research on local companies and tracking macroeconomic developments. Anyone interested in finding out what’s really going on in China should click the above link and read the full interview, but here are some excerpts:

“People are crazy if they believe any government statistics [such as the 7%+ GDP growth figures], which, of course, are largely fabricated. In China, the Heisenberg uncertainty principle of physics holds sway, whereby the mere observation of economic numbers changes their behavior. For a time we started to look at numbers like electric-power production and freight traffic to get a line on actual economic growth because no one believed the gross- domestic-product figures. It didn’t take long for Beijing to figure this out and start doctoring those numbers, too.

I put much stock in estimates by various economists, including some at the Conference Board, that actual Chinese GDP is probably a third lower than is officially reported. And as for the recent International Monetary Fund report calling China the world’s biggest economy on a purchasing-power-parity basis, how silly was that? China is a cheap place to live if one is willing to eat rice, cabbage, and pork, but it’s expensive as all get out once you factor in the cost of decent housing, a car, and health care.

I’d be shocked if China is currently growing at a rate above, say, 4%, and any growth at all is coming from financial services, which ultimately depend on sustained growth in the rest of the economy. Think about it: Property sales are in decline, steel production is falling, commercial long-and short-haul vehicle sales are continuing to implode, and much of the growth in GDP is coming from huge rises in inventories across the economy. We track the 400 Chinese consumer companies listed on the Shanghai and Shenzhen stock markets, and in the third quarter, their gross revenues fell 4% from a year ago. This is hardly a vibrant economy.”

And:

“The giant government economic-stimulus programs since 2008 are rapidly losing their effectiveness. The reason is simple. Much of the money has been squandered in money-losing industrial projects and vanity infrastructure spending that make no economic sense beyond supplying temporary bump-ups in GDP growth. China is riding an involuntary credit treadmill where much new money has to be hosed into the economy just to sustain ever-mounting bad-debt totals. Capital efficiency, or the amount of capital it takes to generate a unit of GDP growth, has soared as a result.”

And:

“The Chinese home real estate market, mostly units in high-rise buildings, is truly bizarre. Many Chinese regard apartments as capital-gains machines rather than sources of shelter. In fact, there are 50 million units in China that are owned but vacant. The owners won’t rent them because used apartments suffer an immediate haircut in value.

It’s as if the government created a new asset class that no one lives in. This fact gives lie to the commonly held myth that the buildout of all these empty towers and ghost cities is a Chinese urbanization play. The only city folk who don’t own housing are the millions of migrant laborers continuously flocking to Chinese cities. Yet, they can’t afford the new housing.”

And:

“All of China’s major corporations are speculating on residential real estate with either cash reserves or borrowed money. Who wants to build, say, a shipbuilding plant when a company thinks it can make a lot more speculating in the housing market?”

And:

“…liquidity seems to be a growing problem in China. Chinese corporations have taken on $1.5 trillion in foreign debt in the past year or so, where previously they had none. A lot of it is short term. If defaults start to cascade through the economy, it will be more difficult for China to hide its debt problems now that foreign investors are involved. It’s here that a credit crisis could start.”

And:

“As for Xi’s much-ballyhooed anticorruption campaign inside China, it offends me that international media depict it as a good-governance effort. What’s really going on is an old-style party purge reminiscent of the 1950s and 1960s with quota-driven arrests, summary trials, mysterious disappearances, and suicides, which has already entrapped, by our calculations, 100,000 party operatives and others. The intent is not moral purification by the Xi administration but instead the elimination of political enemies and other claimants to the economy’s spoils.”

China is an economic disaster happening in slow motion, but it is not a good idea to be short the country’s stock market.