A Not So Minor Problem: Why Gold Miners Are A Poor Bet On Gold

| About: VanEck Vectors (GDX)

Summary

For some investors looking for increased exposure to gold, miners themselves may seem like the preferred bet.

Yet in theory the price of miners are driven by far more than gold prices and may provide investors with undesired leverage to gold.

History validates the theory- miners have historically not been a good bet on gold prices.

Among investors who are currently looking to increase their exposure to gold- either as a hedge or a speculative play on rising prices- there is some debate about the best investment vehicle and method for gaining this exposure. As the savvy investor knows, a bet is no better than its implementation. With the wrong investment vehicle, you can be 'right' and still feel like you were wrong.

Henry Hub Natural Gas Spot Price Chart

Henry Hub Natural Gas Spot Price data by YCharts

For the majority of investors, sizable purchases of physical gold (and the storage, security and management of this bullion) is not a practical option- most businesses and liquidity makers that sell gold to retail investors do so at steep premiums to the spot gold price (this is afterall how they make their money).

Traditionally, when investors have wanted exposure to gold, two of the most frequently considered options are in the form of ETFs: GLD which tracks physical gold, and GDX which tracks gold miners. The numbers reflect these ETFs' wide range of acceptance, with their total net assets weighing in at $30.9 billion and $6.3 billion respectively.

With gold's most recent rally, the debate was been rekindled, with some touting miners as the superior play. But for investors who are looking for exposure to rising gold prices, there is quite a lot of evidence that miners are not the ideal investment vehicle.

Drivers of Miner Prices

Gold mining companies are- at the end of the day- equities, and the price of equities are driven by two factors: earnings and equity risk premiums.

  1. Earnings

    All else equal, the higher a company's earnings the higher the value of its stock. Gold miners are no exception to this general rule, even investors who tout miners as the optimal bet for rising gold prices are acutely aware their theory depends on higher gold prices translating to higher earnings.

    But what many investors may not be considering, is that because everything above their costs to produce gold is pure profit, a rise in gold will lead to a proportionally larger rise in miners' profit bases (and visa versa for a fall in the price of gold).


    In the above illustrative example, a 10% rise/fall in gold prices leads to a 1.7x times larger rise/fall in miner earnings. The specific numbers are not important, what is important is demonstrating the principle at hand: in terms of earnings- the first driver of equity prices- miners are essentially a leveraged position in gold itself, potentially leading investors to taking on more gold exposure than desired.

  2. Equity risk premiums

    In other words, how much of a premium/multiple investors are willing to pay for a given rate of earnings. All else equal, a higher risk premium demanded by investors translates to a lower valuation multiple they are willing to pay, and therefore a lower stock price.

    Once again, it would be foolish to think gold miners are somehow magically exempted from this rule. It is entirely possible for gold prices to stay constant or rise and at the same time for equity investors to become more risk averse, leading to falling valuation multiples and prices. Such a situation would unexpectedly punish the holder of gold miners who may have only desired to bet on the price of gold itself.

You might be saying: "that's all fine in theory, but it wouldn't actually work that way because of X." Alright, let's see what the hard data and history tell us.

History Confirms Expected Behavior Based on Drivers of Price

To begin with the hidden bet on equity risk premiums implicit in miners- we can in fact see this play out in history. In 2008, gold prices were flat to slightly up on the year while miners tanked over 30% and had max-drawdowns near 70%! Why? Gold prices didn't change, but equity risk premiums and valuation multiples sure did.

Gold Price in US Dollars Chart

Gold Price in US Dollars data by YCharts

In fact, if you had bought GDX at the beginning of 2008, as of eight years later, at no point following the crash would you ever have broken-even with an investor who bought GLD instead!

GDX Total Return Price Chart

GDX Total Return Price data by YCharts

Gold Price in US Dollars Chart

Gold Price in US Dollars data by YCharts

This highlights just how much of an effect factors outside the gold price can have on miners, chiefly the equity risk premium investors demand. This should not be misinterpreted or confused as saying GDX is not highly correlated with GLD and largely driven by gold prices. The price of gold directly impacts miners' earnings and miners' earnings directly impact their share prices, but that is only one of two fundamental drivers- as 2008 demonstrates it can be extremely costly to underestimate the equity risk premium component.

GLD Chart

GLD data by YCharts

Correlation between GDX and GLD typically fluctuates between .75 and .95. It's interesting to note the all-time-low of correlation between GLD and GDX also marked the all-time-highs for GLD. In the future this correlation may be something to watch for an indication of gold prices making an unsustainable break with fundamentals.

As the above chart indicates, in periods where equity risk premiums are not fluctuating wildly, GDX and GLD are very highly correlated, and if our 'drivers of price' theory about earnings is correct, GDX should act like a leveraged position in GLD. To test if this holds true in practice we can look at GDX's Beta with regard to GLD.

As a refresher:

Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.

Read more: Beta Definition | Investopedia http://www.investopedia.com/terms/b/beta.asp#ixzz43W5x8rha

In this case we're using GLD as the index to get an idea of how much GDX fluctuates for a given change in GLD. To do this, I looked at the data post 2008 (to avoid data from a financial crisis period) to today, and also looked at it broken into two distinct parts: from 2009-2012 in a secular bull market for gold and from 2012-2016 secular bear market for gold. It turns out results are pretty consistent and don't differ much from period to period.

Click to enlarge

Click to enlarge

How do we interpret this data? The Beta of 1.7 tells us that day-to-day GDX has in fact acted like a leveraged position in GLD. All else equal if GLD rises/falls 1%, GDX rises/falls about 1.7%. However the R-squared value of this regression of ~.6 suggests that only 60% of GDX's daily performance is explained by moves in GLD- once again demonstrating that GDX is a bet on much more than spot gold prices.

Perhaps most interesting of all though is the consistently negative Alpha value. Alpha is the intercept of the regression line, and represents the returns above the index (you know, 'Alpha' as in 'SeekingAlpha'). The fact that GDX exhibits a consistently negative alpha suggests that it will systemically underperform GLD and is not a better vehicle for rising gold. With an alpha of -.045%, all else equal, even with a 0% change in GLD, one would expect GDX to decline by .045% daily.

In Conclusion

Theory tells us miners may not be the best method of betting on rising gold prices, and if we look at the history of equity valuation multiples in 2008 and the daily behavior of gold prices in 2009-2016, we see our theory is historically validated. A strategy of buying miners to bet on gold itself has suffered two predictable problems:

  1. Miners are a leveraged bet on gold prices which underperforms gold on a risk-adjusted basis in both gold bull and bear markets
  2. Miners are also a bet on equity risk premiums and valuations multiples can fall (such as in a crisis) without significant changes to the price of gold

Thus, investors who are looking to increase their exposure to gold- especially as a hedge against a fall in broad equity prices or another crisis- historically would have been much better off taking a position in GLD directly rather than gold miners. If it's desired, there are other ways to get the day-to-day leverage effect GDX gives you, the simplest of which would be to invest ~$1.7 in GLD for every $1 you would have invested in GDX.

Thanks for reading and please post in the comments your thoughts on gold and the best vehicle for your bet.

Disclosure: I am/we are long GLD.

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.