The Future For Gold Miners

Includes: DUST, GDX, GLD
by: Macro Investor

In February of this year, I penned an article titled Are Gold Miners A Permashort? In that article, I recommended buying the Direxion Daily Gold Miners Bear 3x Shares ETF (NYSEARCA:DUST). This is how that ETF has done since my article was posted. It went up almost 250%, and has now settled at about a 100% gain.

DUST Total Return Price Chart

DUST Total Return Price data by YCharts

Can investors expect another doubling in DUST over the next year? I think that is a real possibility.

Let's first examine the relationship between gold prices and performance of gold miner stocks. For reference purposes, I am using the gold ETF (NYSEARCA:GLD) and the gold miners ETF (NYSEARCA:GDX). Using data going back to the start of these two ETFs, this is what the relationship looks like.

In other words, for every 1% gain in the price of gold, the GDX ETF gains about 1.6%, but there is a constant annual drag of about 20% countering it. This is because the price of gold directly impacts the revenue stream of the miners, but the cost of operations is more or less a constant as mining operations are sticky. As gold prices go up, miners do gain, but only after the price of gold crosses the cost of operations. For more details on this, I recommend reading my earlier article.

Given that, I created a chart of potential gold price next year, and the resultant price of the miners.

Note that even if gold price stays flat, miners still drop about 20%. For miners to have any returns over the next year, gold prices will have to go up by around 14%.

Next, I checked the average annual growth in gold prices since the start of the GLD ETF.

This is a promising picture. Average gain is about 19% over the last bull market in gold. At this rate, gold miners should gain about 8-11%. However, the average is heavily influenced by the financial years 2007-2009 and excluding them, the average annual gain, even in the middle of a bull market in gold, is about 15%, which means miners at best would stay flat. This is indeed the case since the start of the GDX ETF.

GDX Total Return Price Chart

GDX Total Return Price data by YCharts

In my mind, it is unreasonable anyway to expect a 15% rise in price of gold over the next year. In fact, I believe that gold price will drop in the coming year, and I had earlier written an article titled Gold Still Has Room to Fall explaining why. Assuming a 5-10% drop in the price of gold over the next year, the GDX ETF should fall by 30-40%.

What happens to DUST when the GDX drops by that amount? Being a leveraged ETF, DUST decays from volatility even as GDX goes down. I simulated DUST prices using historical GDX prices for the past 7 years, and found that on average a 30-40% drop in GDX should result on average in a 100% gain in the price DUST, but it is far from certain. The minimum gain is around 25%, and the maximum around 325%, which shows that it is not just the trend in the price of GDX that matters, but also the path it takes (volatility).

Note that as GDX falls, DUST has the potential to go parabolic. So, the more GLD drops, the higher DUST will go.

At this point, I am opening a small position in DUST and will keep adding to it periodically over the earnings season. I do believe that a potential 100% return is entirely doable over the next year, and the gold miners are still a permashort.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DUST over the next 72 hours. 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.