Chart 2: Internals suggest final stage of bear market
They say a bear market develops in three stages. The famous Dow Newsletter author, Richard Russell once wrote about it:
1. The first phase is the one where the bear market wipes out the optimism and excitement which existed at the preceding bull market’s top.
2. The second phase of a bear market is usually the longest phase. This is the phase where it gradually dawns on stock holders that business is deteriorating and that we are moving into hard times.
3. The third phase of a bear market is the “throw ‘em in” phase where stocks are sold for no other reason than that the sellers need to raise cash.The third stage is also the one which shows internal breadth readings hitting rock bottom capitulation levels. The common indicators that I use to track oversold levels are usually the percentage of stocks above the 200 MA and the Summation Index. Both of these show readings relative to where previous major lows have occurred.
Chart 3: Bullish Percent Index is at record oversold levels
Staying with the theme of internal breadth readings, another indicator is also currently proving to us that we are in the final capitulation phase of the bear market - the Bullish Percent Index. According to StockCharts.com "the Bullish Percent Index (BPI) is a breadth indicator based on the number of stocks on Point & Figure buy signals within an index. Because a stock is either on a P&F buy or sell signal, there is no ambiguity when it comes to P&F charts. This makes BPI a straightforward indicator with clearly defined signals." The chart above, thanks to the Objective Trader website, shows that we are currently at record low readings. In other words, not even the panic of 2008 pushed the Gold Mining sector to such depressive depths.
Chart 4: Valuations show Gold Miners at bargain prices
While we can use a variety of valuations metrics, I'd hate to fall into the value trap like so many traders recently did with Apple. Apparently the stock was extremely cheap at the $650 to $700 price range, trading at ridiculously low forward P/E ratios. Well it seems that the bubble is deflating and the stock just got even cheaper.
I do not believe that the Precious Metals sector has yet to reach an euphoric frenzy such as Apple just went through (it might one day soon), so therefore tracking its Price to Cash Flow ratio could hold some value for us. According to BMO research, valuations have now reached levels similar to that of late 2000, just as the bull market was starting. This could mean two things, either the Gold Miners are currently discounting eventual Gold price decline at which point the P/CF ratio could actually rise or truly the sector has hit rock bottom bargain value.
I understand certain traders will disagree with my subjective and bullish views here and therefore they will dismiss the valuations. The market is always comprised of bulls and bears, therefore any opposing views are always welcomed at this blog.
Chart 6: ... and could outperform in coming quarters!
The fact is, since August 2011, the S&P 500 has been on a super sprint while from a relative perspective, Gold Miners have been all but forgotten. Technically speaking, a mean reversion is now overdue. My opinion is that Gold Miners could surprise to the upside in the coming quarters ahead, at least on relative basis (chart above).
Chart 7: Gold vs Gold Miners ratio is giving us a buy signal
Gold Miners have now been under performing the yellow metal since the early parts of 2011. Theoretically, the overall Precious Metal bear market started around that time and Gold Miners served as an early indicator. Mining Juniors were the first shoe that dropped and it was followed by the huge Silver crash in May 2011. This was followed by a further sell of in Gold and Silver in September 2011 (which I happily shorted back then link 1 & link 2). The whole of 2012, we spent watching PMs move in a sideways range while Gold Miners tanked. However, looking at the chart above, the ratio between Gold (the underlying asset) and Gold Miners has now reached levels surpassing the late 2008 bottom. In my opinion, this is definitely a buying opportunity.
Chart 8: Losses are approaching historical extremes
Finally, the annual performance of the Gold Mining sector has been in the slumps for most of 2012. The price itself has gone through two mini crashes which easily rival the infamous 2008 panic. The last two major buying opportunities that reached 1.5 SDs on the downside happened in 2000 and late 2008. While we aren't there yet, we are definitely fast approaching similarities to those two extremes. Therefore, while further downside might exist in the short term (as already explained above), it is important for an investor to gauge his longer term bearings towards the bullish side.
The Bottom Line
As we judge the recent cyclical bear market within the longer term secular uptrend, we can see that Gold Miners are becoming very attractive. Whether it is the technically oversold levels that only occur a handful of times over a generation, the rock bottom valuations on nominal or relative basis, or the extreme sentiment that the overall sector is going through, all of these indicators point to one conclusion: we are fast approaching a major buying opportunity. Time to put your dry powder to work!