GLD And GDX: Don't Buy Gold, Buy Gold Miners

Includes: GDX, GLD
by: AsiaInvestor

Gold had an amazing run in the last 5 years. It has moved from $600 to a price of around $1700 today. Prices have almost tripled. This year gold prices reached a high of $1900, before dropping back to the $1600 – 1700 range (Graph 1).

Graph 1: Gold Price Overview

Gold is a unique precious metal. Its usage for industrial purpose (around 10%) is relatively low compared to silver and platinum (more than 40%). Gold behaves more like a currency and has a relatively low correlation with other precious metals. This is the reason that gold prices held up very well during the 2008/2009 crisis. It is a much better hedge against extreme market conditions than any other precious metal.

Annual gold demand is met through a combination of mining and recycling. Mining happens in almost each region of the world. The biggest regions, each accounting for around 20% of the mining supply, are Latin America, Asia and Africa. Most of the gold mined, estimated at more than 160,000 tons, still exists in accessible form (bullions, coins & jewelry). The gold price is not that much set by consumption, more by people looking at gold as an investment in the form of jewelry, physical gold or physical gold equivalents. Sentiment plays a big role in setting the price direction. This has been driving the price of gold in the last 5 years and will continue to drive the price upwards in the foreseeable future. The economic uncertainty and the monetary support being deployed by almost all governments and central banks around the world will keep on supporting higher prices. Even the central banks, after years of selling parts of their gold inventories, have become net buyers again. It’s difficult to come up with a scenario in which prices will not go up.

An easy and simple way to participate in the gold bull market is through ETFs. Investors can choose to invest in physical gold, through the SPDR Gold Trust ETF (NYSEARCA:GLD), or can invest in gold miners, through the Market Vectors Gold Miners ETF (NYSEARCA:GDX). Both ETFs are among the biggest in the gold space. Graph 2 gives an overview of the price of the GLD & GDX ETF in the last 5 years (based on the closing price of the first day of the month).

Graph 2: GLD & GDX Price

Should you invest in GLD or GDX? To determine the relatively more attractive investment option, I prefer to look at the GLD/GDX ratio. The median ratio for the last 5 years is 2.3. Currently the ratio stands at 2.8. An indication the miners are undervalued relative to gold. Graph 3 shows that the ratio is getting close to the peak reached during the 2008/2009 crisis.

Graph 3: GLD/GDX Ratio

I expect that the profit margins of the miners will continue to increase. The current gold price is around $1700 and the average cost to mine gold is around $600. For example, if gold prices go back to the $1900 level, then that will result in a profit increase of around 20% for the miners. This should push up the miner’s stock price and eventually drive back the ratio between GLD and GDX to the historical average. If you’re looking for an investment in Gold, then consider the Market Vectors Gold Miners ETF GDX.

Disclosure: I am long GDX.