Gold Bulls Should Stay Away from Gold Stocks

In light of the recent stories of hedge funds piling into gold and gold related plays (see this and this), I am still shaking my head over the fact that investors were buying gold stocks instead of gold and other inflation hedge vehicles.

Maybe the purchase of gold stocks was justified by the analysis of the history of the PHLX Gold & Silver Index (XAU) to gold ratio, which is near all-time lows:

Perhaps it was bullish calls on gold stocks like this. Maybe it was the Fed's bombshell announcement last week, which whacked the USD and sent gold and other commodities soaring.

Maybe it was analysis like this, which recalled the degree of leverage that gold stocks have enjoyed over bullion.

Gold stock leverage to bullion is falling
The trouble is, gold stocks aren’t just a simple leveraged play on the gold price.

As I pointed out before, a gold company could be simplistically thought of as a call option on the price of gold, with the strike price being the cost of production. My analysis also showed that most senior gold producers were raising production costs by mining lower grades of ore. Gold mining shares consequently did not perform as expected because of earnings disappointment.

Moreover, as the gold price has risen from about $260/oz. in 2000 to over $1,000/oz. seen this year, the leverage of gold stocks to gold has diminished as a result of the rise. The scatterplot below (click to enlarge), which charts the monthly change in the Gold Bugs Index (HUI) against the monthly change in gold, illustrates my point. I split the sample in two: when gold was below $500 and when it was above $500. As you can see, the degree of leverage shown by the period when gold was above $500 is lower than the period when gold was below $500.

The chart below (click to enlarge) also tells the same story by showing leverage of HUI to gold in a different way, where

Leverage = % monthly change in HUI / % monthly change in gold

The average leverage of HUI to gold has been falling more or less steadily as gold price has risen. (click on chart to enlarge)

It’s all rather simple once you think about it. If you hold an at-the-money call on gold, which is roughly what an investor did with gold stocks in 2000, the option's leverage to gold is relatively high. As the gold price advanced, the call option got deeper and deeper in the money and the degree of leverage declined.

Gold stocks are not a good alternative to gold
Once you throw in other considerations such as political risk (e.g. wars, etc.), operational risk (fires, floods, strikes) and developmental risk (such as the Galore Creek fiasco), are gold stocks really worthwhile investment vehicles? More importantly, if commodity inflation does surface with a vengeance, then we will likely see negative surprises in the form of increased mining costs stemming from rising material and energy prices, which will squeeze gold mining margins.

Of course, it depends on why you are buying gold. If the gold holding is a hedge against disaster, then some physical gold in the form of coins and bullion may be better choices.

If you are looking for a pure inflation hedge, then perhaps inflation-linked bonds, gold ETFs like GLD, or a closed end fund like Central Fund of Canada (CEF), could be your vehicle.

If you are looking for a leveraged play on gold, then you may want to look at silver (the metal, not the silver stocks), which is traditionally thought of as a leveraged play on gold. Another alternative could be the purchase of long-dated options on gold bullion for investors.

Buy gold stocks? The fact is, they are overly erratic and unpredictable vehicles as to be effective leveraged plays on gold bullion.

Comments

[sharkboy:]

I agree with the premise that the stocks may of lost some juice. But lumping them all together does not take into account the differences between the companies themselves. Some are SO much better than others.

Mar 22 05:32 AM

[sjgold:]

you are correct UP UNTIL THIS WEEK! The Golds are now and will continue to LEAD the metal UP...

This week was a major turning point and the gold stocks leading the metal has proven it...

Mar 22 07:47 AM

[DONE_SONZ:]

The gold miners are the way to go.They will catch fire soon enough.This article is lame.

Mar 22 08:57 AM

[bullpasture:]

Very informative...... One of the most straightforward artcles I've seen on the topic of physical gold v. miner. Now all the loosely correlated relationships makes sense to me .

Mar 22 09:17 AM

[arlin:]

The GDX,(gold stock etf) is near a breakout area of 37 with a tgt in the 50 area.The costs of miners/producers is much lower then in the near past.......Energy which is 25% of the cost to mine has receeded from $145 bbl,Many gold companies are not in the US and are making good money on the currency exchanges.The supply of gold is decreasing, as the demand is increasing.Gold metal recently rejected the 883 area and rallied in minutes to the 930 area courtesy of Bernake.....AUY and other gold stocks rallied 20%....Like any other investment,gold stocks need careful attention.
a recent John Doody article on seeking alpha is well worth the time for any who are interested in gold stocks...regarding the etf GLD,there are many questions concerning the actual quantity of gold they are holding.however CEF has no such questions and is in a country (Canada) that has a very good track record and currency that will benefit from increasing gold and silver prices.....It also doesn't hurt that Canadian banks are much better positioned,for the future.
Silver,may actually be a better percentage gainer in the coming months,but only as long as silver is thought of as a precious metal.
As a timing mechanisim the COT report on tuesdays is good to watch,normally when the traders who are short gold goes over 200k contracts its good to understand that many large bets are going against your long positions;once that is reversed however and these large traders are on your side,the results are generally pretty good.Good chart work is also important.There are many theories that manipulation and intervention are a continuing burden.
I think with all the world running from one quickly diminishing fiat currency to another,gold is not a bad place to be.
I am long AUY,MFN,SLW,and have some silver eagles.

Mar 22 09:40 AM

[Brekeen:]

Gold is always a great investment as it is a store of value. You may wish to consider a new profession after this next rally that is going to rival anything seen in the last 70 years......we will then in late Summer/Fall begin a slow and tedious downtrend lasting almost two years....it continues to amaze me the repetitive mistakes that the majority of editorialists make and that the "sheeople" continue to heed your advice....don't fret you like the many others have a completely inside the box approach to analysis and that is one of the reasons why the vast majority lose in the markets the other reason is they are too lazy to do their own due diligence...

Mar 22 09:51 AM

[arlin:]

xactly


On Mar 22 09:51 AM Brekeen wrote:

> Gold is always a great investment as it is a store of value. You
> may wish to consider a new profession after this next rally that
> is going to rival anything seen in the last 70 years......we will
> then in late Summer/Fall begin a slow and tedious downtrend lasting
> almost two years....it continues to amaze me the repetitive mistakes
> that the majority of editorialists make and that the "sheeople"
> continue to heed your advice....don't fret you like the many others
> have a completely inside the box approach to analysis and that is
> one of the reasons why the vast majority lose in the markets the
> other reason is they are too lazy to do their own due diligence...

Mar 22 09:53 AM

[waldipup:]

This article is an epochal one -

It represents what is probably the best indicator that it is time to -

BUY GOLD STOCKS!

With the stocks beaten down and , historically to gold , cheap ,

It is not surprising that gold stock epitaph's will be written.

And that is usually just about when (Hallelulljah!!) - they rise .

Of course , this does not mean to blindly buy anything -

As is always the case , the greater return potential is fraught with the greater risk of choosing the correct ones.

Some have , just since the recent bottom , acheived greater returns than the gold has in its entire bull run !

But IMO , the real answer is just so very simple -

It's the same as it always is -

If you want to play a sector - ANY sector -

You must diversify within it -

That means some gold and silver, diversified in various forms , and some gold and silver stocks , carefully chosen .

Who can disagree with this overall theory!

Mar 22 10:35 AM

[Bruce Pile:]

So the average HUI to gold leverage goes from about 4 1/2 to 2 1/2 as gold went from $300 to over $700 according to the chart. Well, is 2 1/2 times leverage so terrible? If you select well, you should garner much better than the average of so many mining companies run by gangs who can't shoot straight and never make a dime of positive cash flow.

Your point about silver being a better leverage investment on gold is a good one. Silver is likely near an upside explosion that may dwarf the rise in gold.

The inflation adjusted price of gold from the last time we had any significant currency problem (30 years ago) is about $6000. It has been trading around $800 to $900 - about 16 % of its inflation adjusted price from 30 years ago. How many things can you think of that now trade at 16% of their inflation adjusted price from 30 years ago? TV sets, computers, a McDonald's dollar menu hamburger, and gold. That's incredible when you consider that there is no Moore's Law working for gold (just "more" investment money out there left over from the boom and looking for a home) and considering that the currency problem we face now makes the last one look like a nonevent.

Mar 22 10:45 AM

[petyaczar:]

In 1970's when Nixon decoupled the U.S. Dollar from Gold. Turing the Dollar into a Political Fiat currency to pay for the Vietnam War.

1971 : 1 Oz of Gold = $35
2009 : 1 OZ of Gold = $900

SOOOOOOO the 2009 dollar is worth only 4%+/- of the 1971 Dollar as measured against the Gold Standard of 1 oz of Au.

This destruction of the U.S. Dollar has occured over my working lifetime.

In the Obamanation, just wait, going forward the U'S' Dollar will become truly worthless and we will wistfully dream of the days when a "dollar was a Dollar" and worth 4 cents when measured in 1971 dollars.

Watch for a "new currency" and a reverse split on old dallars of at least 1:10 and maybe 1:100 One NEW dollar = 10 old dollars, or one hundred old dollars. Watch for old dollars to be "called in" 6 months or so after NEW dollars are issued.

Watch for hyperinlfation. Borrow LONG and fixed. Buy and take possession of HARD assets such as the metals.

The Obamanation will mark the end of U.S. ascendancy and it will turn real ugly before it finally turns any better.

IMO

Mar 22 11:19 AM

[Reinhard:]

There are several factors why sometimes mining shares can be good investments, and sometimes gold itself.
- Falling oil prices have been mentioned above, and more generically, any deflationary wave can be good for mining stocks. Imagine the current period lasts for two years, where gold drops 10% and other prices drop in the aggregate by 20%. Here, mines actually make you money, while gold not. And the observed leverage can change in a hurry.
- Tax considerations, availbility in IRAs, safety of your investment are other considerations. Especially if the U.S. government goes hostile. Under certain circumstances, I rather trust mining executives.
- Mining companies seem risky, but therefore one should receive a "required rate of return" for lending mining companies money for their operations. If not, nobody would lend them eventually. So, if mines make a profit in the long-run, the investor should be able to earn a real return in the long run. Gold itself just preserves its real value in the long-run. In adverse times for gold, e.g. when it went from $850 to $250, large mining companies might not have lost 70% (including dividends), but could hold their ground.

So best is to own mining shares as well as gold, and rebalance occasionally between them.

Mar 22 01:27 PM

[nmelendez:]

Funny article. Problem is if there are no other positive earnings at the gold miners level, where do you go? Can you say the miner's.

Mar 22 02:39 PM

[The Geoffster:]

Good analysis as far as it goes but this is not a technical market and traditional analysis fails in periods of crisis. If you believe we are headed toward massive inflation, hard assets are the way to go.

Mar 22 03:10 PM

[Sakata:]

The article is not lame, and it does make some valid comments. But I think the main point is a little off the mark. The scatter plot shows that, even when gold is above $500, gold stocks go up quicker than gold itself. They also go down quicker. All it says is that a random selection of gold stocks has a create volatility than gold. None of this is surprising. Note that the scatter plot is misleading because the scale is different on each axis.

What the author fails to point out (and sharkboy does) is that if you pick the best companies then gold stocks will out perform gold more often than not in a gold bull market. The last year or so has, as a whole, been an exception to this, but the last four months have proven it to be very true. Since the beginning of Decemeber HUI has increase 54% against gold's 28%. My personal portfolio of junior mining stocks has gone up 49%.

Blanket statements about whether or not to hold a certain class of stock are bound to be controversial. An experienced investor knows which ones to pick and will be able to make more with stocks than with gold in a large percentage of cases.

Mar 22 04:04 PM

[guru987654321:]

Wow, the misinformed continue to spout nonsense. Gold stocks have just begun a new outperformance leg relative to gold and the general stock market and are the best speculative investment out there!

If you want the truth, read this:

goldversuspaper.blogsp...

Mar 22 04:05 PM

[bozzy:]

Sharp observation. Clever distinction of the role which gold plays in your portfolio, which is critical.
I liked this.

Mar 22 04:52 PM

[AdamSmith37:]

This article opens up a very creative approach to viewing some different aspects of metals analysis. While it is an excellent approach under certain conditions, now does not seem to me to be one of those. Gold stocks will outperform the metal this time around and naturally some better than others. This should hold true for up to six months to one year after energy prices reach a sustained level of say $65-$75+ per barrel, assuming today's level of dollar valuation. Silver stocks will outperform gold ones in the same fashion. Actual metals will still do nicely and there is always a place for them in one's portfolio. Reversing the thought process whereby one purchases paper items including fiat currency with the actual metals is the true way to view. I.E. : If one's entire wealth included only gold and silver metals (real money) in one's possession, would one purchase the various other things available and at what price in terms of ounces would the items be acceptably valued at? Charts and various analyzes are sometimes helpful, but one also needs to take a hard look at what else is happening in the world and then balance the total perspective so as to have a combination of security, ROI, and still some overall peace of mind. The metals themselves cannot be optimally manipulated except through the collective mining process which includes all of the input costs and therefore implies an overall value to the marketplace. Papers including currencies can be extremely manipulated and can change value instantly and in tremendous proportions, whereas an ounce is an ounce today and 5000 years ago or from now. Many real things including metals and consumptive energy have in fact reached their earthly peak production and will begin to dwindle as the worldwide economy continues to use them up. Silver by far and away will dry up quicker than many as it becomes known for its true values. It is much more than a precious metal because it is used and used up and the economic elasticity is such that even when it exceeds the value of gold which will eventually happen (probably within the next 10-15 years), the amounts used per application are so small that the end products which use it go up only slightly. Silver is the real sleeper along with other strategic substances and will be required to purify water and the nanotechnology approach to cure all known medical viruses among other things. When the economy begins to rebound in earnest within the next couple of years, the platinum group will also go up with palladium and platinum equaling each other out perhaps as soon as within six to twelve months. Bear in mind that despite the extreme efforts to re-inflate, there is always the real possibility that the whole thing could still backfire and deflation could still result. That is much scarier than a bout of super inflation because inflation can eventually be controlled whereas deflation takes its toll for many years and causes untold worldwide consequences. The Federal Reserve is doing the right things by trying to re-inflate and they need to have some support from the masses this time. Why? Because the alternative is unthinkable and totally unacceptable if it can be in any way avoided. If we go through a period of mass worldwide currency re-valuation, then some huge question marks arise as to what is worth what and lots of confusion ensues -- that will for sure be the period when one wants to have some silver and gold in possession since they will allow one to transfer wealth from the before to the after, along with daily essentials such as food, clothing, shelter, security, etc. Personal due diligence is called for as to how and where one wants to do this. Some feel the need to have these in their own possession while others feel a bank safe deposit box is best. Each must sort these matters out according to their own situation.

Mar 22 11:17 PM

[przem23:]

The reality is that the current macroeconomic environment is most advantageous for gold stocks and then gold. However, if and when inflation begins to take root the precious metals complex will underperform and your funds will best be utilized elsewhere.

seekingalpha.com/artic...

Mar 23 09:20 AM

[Cam Hui:]

I would like to thank everyone for their comments.

For the holdings of gold stocks: I never said that they wouldn't go up. In fact, given the technical position of the group it appears that they have good upside. However, if you look at the first chart here (humblestudentofthemark...) the more important question is "why aren't gold stocks near all-time highs?" This is like going to a casino and knowing that the house has an edge on you. It doesn't mean that you can't win, but how long are you going to put up with this poor relative performance before you give up and use another levered vehicle?

For the hard asset crowd: Again, I am not saying that gold stocks won't go up but if you believe in hyperinflation or economic collapse you should hold the physical metal or proxies that hold the phyiscal (like CEF).

For those who believe in stock selection: No doubt stock selection can add value. This analysis was based on the index averages (HUI and XAU). On average, we only get average returns. You can go down from the senior producers into the intermediate producers and junior explorers. The more junior you go, the more the play looks like some form of lottery ticket. Good analysis can give you an edge but the market is pretty efficient overall.

In conclusion, I believe that given the political, operational and developmental risk in the gold stocks, the risk-reward ratio is favorable enough when there are other alternative leveraged vehicles on gold.

Mar 25 04:44 AM