Gold Stocks Will Continue To Underperform Gold Bullion

May 03, 2012 3:00 AM ETGLD, IAU, SGOL, GDX6 Comments
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By Amine Bouchentouf

Volatile equity markers, environmental regulations and rising costs for miners create head winds that physical gold doesn’t encounter.

One of the big debates of 2011 was whether the performance discrepancy between physical gold prices and gold equities was going to diverge back to normal. As you may recall, gold equities grossly underperformed gold bullion throughout 2011. For most of the year, gold prices traded anywhere between 15 to 40 percent higher than their equity counterparts.

Many commentators predicted the performance divergence between bullion and equities would narrow. As the end of the first half of 2012 comes near, let’s take a look at the relative performance measures between bullion and equities, try to understand what happened and attempt to determine the outlook as we enter the second half of the year.

Diverging Performance

As 2011 closed, the market experienced a gaping difference between gold stocks and physical gold. Specifically, while gold bullion prices in 2011, as measured by the SPDR Gold Shares ETF (NYSE: GLD), were up 11.64 percent, gold equities, as measured by the Market Vectors Gold Miners ETF (NYSE: GDX), were down 14.50 percent.

Fast-forward to today, and the divergent performance between GLD and GDX still exists: While GLD is up 6.14 percent year-to-date, GDX is down 9.71 percent. Going forward, expect this divergence to continue. And for the reasons below, gold bullion will continue outperforming gold equities for the rest of 2012.

Volatile Stock Markets

Gold stocks are just that, stocks that are traded on global capital markets on a daily basis. As such, they are treated by investors first as stocks, and then as physical gold proxies. Ever since the financial crisis of 2008, global capital markets have never fully recovered their previously steady state of affairs. Since 2008, markets have been characterized by extreme and unpredictable volatility.

Let’s use initial public offerings (IPOs) as a measure of market stability. Prior to 2008, the NYSE and Nasdaq had a steady and certain stream of IPOs coming to market. Since 2008, the number of IPOs has dropped off a cliff, down some 40 percent. Even more alarming is the number of canceled IPOs — companies who were prepared and geared up for an IPO but were forced to postpone or even cancel their stocks sales due to volatile markets.

For example, in August 2011, eight out of the 11 companies scheduled to go public canceled their offerings; even The Carlyle Group, one of the pre-eminent global investors, was forced to postpone its offering due to market conditions.

Canceled and postponed IPOs provide a dramatic and clear view of the volatility that has been plaguing financial markets. Very few segments of the market have been spared, including commodities and mining. Mining equities, especially gold miners, have been depressed by this market volatility, fueling the underperformance relative to gold bullion.

In addition to volatile markets, economic conditions for mining companies have also created head winds for earnings and revenue growth. Even though demand for physical bullion has remained steady, operational costs have been increasing as well.

Specifically, input-cost inflation has held mining company earnings down. Labor costs are increasing due to a lack of qualified mining engineers, workers and operators. Secondly, energy costs, which can make up more than 50 percent of operational costs, have been steadily increasing as well. Finally, many mining jurisdictions are tightening environmental standards so that mining companies are spending more on environmental permitting and licensing.

These extra operational costs are eating into mining company earnings; when you couple that with volatile global equity markets, it’s no surprise that gold equities have underperformed gold bullion.

Gold Bullion

On the other hand, demand for physical gold has been very steady and has even experienced a persistent increase on a quarterly basis.

Demand for bullion is driven by several factors, and demand has been robust across the board. Gold is seen as a safe haven by investors. In an environment where governments are printing lots of money to stimulate stagnant economic growth, investors are turning to the yellow metal as a reliable store of value.

Ironically, volatility is at the heart of gold-stock underperformance and strong demand for gold bullion.

Two other factors are propelling gold bullion. Demand from Asia, especially China and India, has been increasing as rising incomes in the region are causing more physical purchases. And central banks have become large purchasers of bullion, which results in large purchases that create a floor for prices.

All in all, gold bullion will continue to outperform gold equities for the rest of 2012. One way to benefit from this trend is to go long GLD while simultaneously shorting GDX.

Disclosure: The author is long physical gold and long GLD.

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