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There's been a good deal of handwringing and gnashing of teeth in recent years about the underperformance of gold and silver mining stocks relative to the price of the metal, however, as will be shown in this and subsequent writings on this subject, given how the global financial system has evolved over the last ten years, this shouldn't be too surprising.

Moreover, there would appear to be only about even odds that the historical outperformance of mining stocks over the metals would resume in the years ahead and only under certain conditions that will be detailed here, however, the good news for mining stock investors is that, if that happens, the share price gains could be more spectacular than ever before.

Concern first emerged about a year ago when analysts began commenting on the gold-gold stock divergence, producing charts like the one below from U.S. Global Investors that shows in graphic detail how gold and gold stocks followed a dramatically different course in 2011.

(click to enlarge)

The picture is not much different going back another year as the gold price made steady gains in 2010 and the silver price nearly doubled, but the shares of big miners, as a group, made only pedestrian advances, many of them trading at the same level that they had been trading at years prior, back when gold was selling for $800 or $900 an ounce.

Then, of course, last fall, everything fell apart for the gold miners.

In theory, gold stocks are a leveraged bet on the metal and, when the gold price rises, gold shares are supposed to go up two or three times that amount with a similar relationship when prices fall.

But, lately, it seems that all gold stocks do is fall.

One very straightforward reason for the changing relationship between gold and gold stocks is simply that gold stocks are still stocks and, as such, they are subject to all the whims and vagaries of company management and shareholder perceptions of value.

Though gold stocks oftentimes move in the opposite direction of broad equity markets for extended periods of time (as they did from 1997 to 2003), in a world with ever higher correlations between asset classes that previously had little or no relationship, when the broad stock market suffers, so will gold shares, regardless of how fat companies' bottom lines are or how big their cash holdings have grown.

One has only to think back to the events of 2008 to recall how indiscriminate sellers were when stock prices were plummeting, cash-rich miners being sold right alongside U.S. blue-chip stocks in a panic that left gold as one of the few asset classes that managed to eke out a gain for the year. Though the gold price dipped sharply in late-2008 while other safe havens such as U.S. Treasuries and the U.S. Dollar marched steadily higher, the metal's price rebounded as investors quickly reconsidered their options going forward and investors have not forgotten this.

Clearly, the events of recent years have changed many investors' perceptions about gold and the underperformance of gold miners relative to gold is probably more a story of gold's outperformance rather than miners' lagging performance.

Gold ETFs and the Changing Role of Gold

To be sure, prior to the financial crisis, most investors had little interest in gold and, for the most part, those who did sought exposure via gold mining stocks even though metal ETFs became commonplace by the middle of the decade. In a constantly evolving financial market environment, investors have long known how to value stocks, so, gold shares were the natural choice over the metal which, as I've noted from time to time, really can't be "valued" in any traditional sense of the word.

But, gold ETFs continued to grow and the gold price was bolstered by buying in Asia via many small bar and coin buying programs (heartily endorsed by the governments of India, China, and elsewhere) and the role of gold in the financial system continued to change, the metal recently being elevated to "alternative currency" status amid record amounts of money printing by central banks and a European sovereign debt crisis that is now approaching its three year anniversary.

Of course, large investors taking physical delivery of gold has also supported the price and all of this has contributed to the outperformance of gold over gold shares that now stretches back about nine years! I had known that gold bullion was outperforming gold stocks, but I didn't think it went back nine years until I did the calculation using data in the chart below.

In looking at this graphic, where the long-running Fidelity Select Gold Fund (FSAGX) is used in place of more popular gold stock funds with a shorter track record, the first bit of information that should pop out at you is that the gold up / gold stocks down relationship that we've seen recently is nothing new.

The gold price rose modestly as gold shares fell in both 2004 and 2008, and, this pattern reemerged last year, continuing to this day.

In 2004, gold stocks had just completed a spectacular run and with a little weakness in the gold price, investors took profits.

This was back in the day when you couldn't easily buy and sell gold, so, the dramatic rise and fall in gold stocks while the metal made steady gains makes good sense.

In the bloodbath that was 2008, selling was so indiscriminate that it's hard to divine any meaning from how these asset classes moved, so, I'm not sure if there is anything to be learned from that period aside from it being a demonstration of the "safe haven" qualities of the metal that resulted in it rising as other asset classes fell.

So, does the 2001-2004 period have any meaningful lessons for today's precious metals market?

In looking at the years that followed, it surely does, and that starts with the realization that, after the 2004 gold stock sell-off, gold shares never reverted to their traditional role as a leveraged bet on the metal. Gold bullion about equaled the performance of major gold stocks from 2004 to 2007 and then, after the 2008 financial crisis came, it beat them by a mile. The only big outperformance of gold shares came immediately after the 2004 and 2008 sell-offs and they were short-lived.

Clearly, the relationship between gold and gold stocks has changed dramatically, but I'm not so sure that we'll ever see the same pre-2004 leverage between the miners and the metal since this may just be part of a bygone era - when buying bullion in the U.S. was both difficult and frowned upon and before China became such a big source of demand.

Most of the commentary that I've read over the last year or so on this subject concludes that this relationship will revert to its pre-2004 glory, but, after studying it a bit, I'm not sure why it would or should, given the precarious state of financial markets today.

Of course, many who espouse this view have a vested interest in seeing gold stocks regain their status as outperformers as they either sell gold stock funds, individual shares, or analyze gold mining companies, so, as always, "let the buyer beware".

It could well be that this bit of conventional wisdom - that gold stocks are a leveraged bet on the gold price - is just wrong and this is all the more reason to weight gold bullion much higher in an investment portfolio today than may have been common practice for natural resource investors years ago, as is the case for the model portfolio at Iacono Research.

In the next part of this series, I'll look closer at the three distinct periods referenced above - pre-2004, 2004 to 2008, and post-2008.

Source: Gold Vs. Gold Stocks - Part I

Additional disclosure: I also own FSAGX along with gold and silver coins and bars