Gold Vs. Gold Stocks - Part III

Includes: GDX, GLD
by: Tim Iacono

Apologies are in order for taking nearly six months to offer up the third and final installment in this series on gold vs. gold stocks, however, not much has really changed over that time.

For the most part, gold and gold stocks are still doing the same thing they were doing last summer -- the gold price is attempting to edge higher, while the miners flirt with another move down to fresh multi-year lows.

It's been a tough stretch for gold stocks going back more than two years now, and cumulative percentage losses are well into double-digits, while the metal has seen modest annual gains in both 2011 and 2012.
That situation is not likely to change over the near term, but under the conditions detailed below, there is new hope for shareholders beginning as soon as this summer.

Recall that in "Gold Vs. Gold Stocks - Part I", the historical relationship between the metal and the miners was detailed, and reasons such as the introduction of metal ETFs were cited for the former outperforming the latter in recent years.

In "Gold Vs. Gold Stocks - Part II", the last eight years or so were broken down into two distinct parts corresponding to before and after the 2008 financial crisis and, unfortunately, little hope was offered for a return to an era that favors mining shares over gold.

As shown in the updated graphic below from the second article, the pessimism expressed in the statement "we may have entered a new phase in the relationship between gold and gold stocks, where gold stock underperformance is the new norm" was clearly not misplaced.

But there was some hope offered up for a brighter future for gold stocks, and that's the subject of this third and final part of the series.

After giving this a good deal of consideration in recent months while pondering whether or not I really wanted to continue holding mining shares in my own portfolio or recommending them to others, it seems there is one very important case where gold stocks could outperform gold in the years ahead, and perhaps by a very wide margin -- if we enter a high inflation environment.

Rising inflation in the U.S. of 5, 6, 7 percent or more in the government's official measure of consumer prices would likely rekindle interest in gold stocks, along with just about every other risk asset, and gold stocks may just turn out to be one of the star performers. Here's why.

We've had dire predictions of hyper-inflation for some time now as a result of central bank money printing, but aside from an energy price spike now and then, recent years have seen nothing like the inflation of the 1970s, since most of the newly printed money has simply gone to plug holes in bank balance sheets.

However, if a bigger share of newly printed central bank money does work its way out into the global economy, then we could develop much higher levels of inflation, and much higher gold prices that could easily lead to a return to the pre-2008 relationship between gold and gold stocks.

All one has to do is look back to 2002 to see the potential for gold shares -- a year when a 20+ percent move in the metal produced gains of three or four times that amount for mining stocks. Shown below are the long-running Fidelity Select Gold Fund (MUTF:FSAGX), along with the gold price, but had they been around at the time, more popular ETFs of today such as the Market Vectors Gold Miners ETF (NYSEARCA:GDX) and the SPDR Gold Shares Trust ETF (NYSEARCA:GLD) would have exhibited the same relationship.

As it turns out, except for when they were coming off their secular bear market lows in 2001, gold stocks don't seem to do much unless the gold price is rising at 20 percent a year or more, and based on where the global economy finds itself today, that may not happen again until there is a resurgence in consumer prices.

Granted, we'll never again have inflation rates like those seen in the 1970s, since government economists have radically changed how the consumer price index is calculated, but inflation rates in the mid- to high-single digits will feel about the same as 14 percent inflation felt back in 1980.

In such an environment, you might see the gold price again rising 20-30 percent a year for a number of years -- to well over $2,000 an ounce -- and investors will quickly search for even bigger returns to compensate for the lost purchasing power of the dollar.

Mining companies with a strong production history, as well as exploration companies with proven reserves, will quickly capture the attention of investors again, as P/E multiples will be even more attractive than they are today. Big mining companies will then set out to acquire smaller ones to lock in future production.

As shown in the chart above, the last time that gold stocks outperformed gold was in 2009/2010 at a ratio of roughly 1.3-to-1, but this could go sharply higher on a sustained move higher for inflation and the gold price.

One scenario that might lead to this outcome would be if central bankers around the world took overt steps to generate higher levels of inflation in the belief that there were no other options to restore growth.

While its effects are not yet being felt in global metal markets, this is already underway in Japan, where the gold price recently reached new all-time highs in terms of the yen.

What once seemed far-fetched -- central banks taking steps to achieve higher inflation -- no longer is.

Moreover, as prominent economists such as Ken Rogoff here in the U.S. recommend higher levels of inflation to spur growth and make the nation's debt load more manageable, this thinking may become part of the Federal Reserve's overall approach to monetary policy, however, unlike the Bank of Japan, they are not likely to ever acknowledge it as such.

Given how ineffective austerity measures have been in pulling economies out of their slump of recent years, and with the prospect that things are about to get worse, not better, this year due to more budget wrangling in the U.S. and a reappearance of the European sovereign debt crisis, I wouldn't be surprised if central bank policy makers ultimately conclude that "a little more inflation might do us all some good."

In this case, the world may discover that the "inflation genie" is not so easily put back in the bottle, and elevated levels of inflation could quickly compel investors to look anew at gold mining shares. Then they'll bid share prices higher.

Absent this sort of development, however, the miners may continue to under-perform the metal for many years to come.

Disclosure: I am long GDX, GLD, and I also own FSAGX and gold coins. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.