Gold is a great investment asset for the long term and has been that way for thousands of years. The attention paid to gold recently is legitimate and in no way a bubble as some pundits suggest. However, recognizing the value of gold as an investment, does not mean that buying the shiny metal directly is the best way to profit from the emerging long-term bullish trend.
Many factors are involved with establishing a market, and various relationships can be measured against gold to determine which is the best way to invest in the trend. In addition to the physical metal itself; there are ETFs, gold mining companies and sister metals like silver, platinum and palladium. Each relationship should be somewhat correlated to the overall trend with gold itself, however the variations of that correlation can give the investor some very good insight.
The two relationships that matter most at this inflection point are:
1. Gold Significantly Outperforming Platinum
While gold prices have risen 30% in the past 200 days, platinum is essentially flat at +2 1/2%. Gold outperforming platinum by such a wide degree illustrates that the demand for gold is predominantly due to its function as a currency hedge in uncertain times. While this is significant and understandable with central bankers around the world racing to print more money, we think this indicates fear of currency debasement versus a good play against precious metal demand or supply tightness. In fact if you look at where the majority of the divergence occurred, you will see it started at the end of April (Japan earthquake demand contraction) and gone parabolic in the last 30 days (debt downgrade discussions).
(Click to enlarge)
2. Gold Significantly Outperforming Gold Sector and Large Mining Stocks
Gold and the precious metal mining sector usually move in a somewhat correlated fashion, for obvious reasons. However, since late April the movement of gold has continued unabated while the companies that produce it have been lethargic at best. In fact when looking at the chart 2 below, you will see that over the past 200 days the S&P Gold Mining index (DJUSPM) is exactly unchanged while gold is up 30%. The DJUSPM essentially splits the middle of performance of the more positive trending producers like GG and ABX versus the more negative trending companies like Newmont Mining Corp. (NEM) and AngloGold Ashanti (AU). This divergence between gold and the miners signifies a market belief that the dramatic move in gold is more short term in nature, and thus unsustainable.
(Click to enlarge)
While we don't necessary believe that the market is right, we do believe that either gold must come down or miners must go up. We also believe that either gold must come down or platinum must go up. The continued outperforming of gold relative to the mining sector, the large individual miners, or even its sister metal platinum is unlikely. The real reason to own gold is the protection of buying power over a sustained period of time, and gold has served that purpose well over many generations. We believe in the true long-term demand of precious metals, but we also believe that the gold in the ground (miners) or the equally precious metal (platinum) are currently out of balance with gold.
Actions To Take
Pairs Trade Strategy: This strategy seeks to profit from the disparity between Gold and other correlated assets.
- Buy Market Vectors Gold Miners ETF (GDX)($57.71) and sell equivalent dollar amount of gold or SPDR Gold Trust ETF (GLD)($168.66). GDX is an ETF of big cap gold miners and is a way to diversify your individual company risk versus either gold or GLD (with is another ETF which intends to mirror gold's direct movement).
- Buy Goldcorp (GG) and sell equivalent dollar amount of gold or GLD. GG has performed the best among the major miners in the past 200 days. They are currently trading at $48.13 and are up 12% over that time. GG pays a dividend of 0.9%, has a total market cap of $39 Billion, and trades at 22x 2011 earnings estimates.
- Buy Barrick Gold (ABX) and sell equivalent dollar amount of gold or GLD. ABX $47.74 is the second best performer over the last 200 days with a return of 2%. ABX pays a dividend of 1.1%, has a total market cap of $48 Billion, and trades at 10x 2011 earnings estimates.
- Buy Newmont Gold (NEM) and sell equivalent dollar amount of gold or GLD. NEM $55.40 is tied with Anglo Ashanti for the worst performer among the top four (down 7 1/2%). NEM pays a dividend of 2%, has a total market cap of $27 Billion, and trades at 13x 2011 earnings estimates.
- Buy Anglo Ashanti (AU) and sell equivalent dollar amount of gold or GLD. AU $42.86 also is down 7 1/2% and cheap relative to the other producers. AU pays a dividend of 0.5%, has a total market cap of $16.5 Billion, and trades at 11x 2011 earnings estimates.
- Buy platinum or ETFS Physical Platinum Shares ETF (PPLT)($173.48) and sell equivalent dollar amount of gold or GLD. As real demand for precious metals materializes and future inflation takes hold, we believe that the ratio between platinum and gold will revert to its historical premium of platinum over gold. As the metals get close to parity and the premium diminishes, platinum becomes a better hedge on future inflation due to its higher scarcity and other industrial demand applications.
Using a pairs strategy is meant to be a non-directional view of the market. We do believe that the overall trend for gold, the miners, and other precious metals will continue to rise over time. As the central bankers continue to print, the incremental dollars will eventually lead to a severe inflationary environment that should benefit all three investment methods. By focusing on which form of precious metal ownership is optimal at any given point in time, we believe that the forward risk/reward relationship can be enhanced. Gold will indeed shine, but the precious metal mining stocks will shine brighter as the long-term conviction of the market catches up to the short-term fear-driven rise we see today.
Disclosure: I am long NEM, ABX.
