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The Case For Gold Miners

|Includes: VanEck Vectors Gold Miners ETF (GDX)

Gold miners GDX has been falling the past two months and seems to represent some nice value. Meanwhile the price of gold has remained relatively flat since the beginning of the year. This dichotomy is unlikely to persist. Let's examine.

(Image from Marketwatch)

Reasonably thinking, I am bullish on gold for three reasons. First, gold is a safe haven asset, and investors can flock to it in times of turmoil. Europe anyone? Second, US real interest rates are negative. That is, a ten year investment yields an investor only 1.88% per year, whereas inflation will be more than this. A ten year investment in a US Treasury Bond will lose real purchasing power in ten years. With fixed income securities and stocks offering unattractive returns (think 1970s), gold has historically appreciated as an alternative. Third, gold price increases over the past decade have been driven by buyers in emerging asia. Buyers in India and China represent permanent demand as investors suffer from capital outflow controls (financial repression), which I view as unlikely to abate in the upcoming years.

Gold miners extract gold from the ground and sell it at market prices. So, if gold rises, then the revenue for gold miners increases. To ensure that the increased revenue is captured by shareholders (and not employees' wages or governments' taxes), we can examine companies gross margins. The top three companies have margins that are either stable or increasing. Thus, increased gold prices should be flowing through the income statement as increased earnings to shareholders.

With a solid thesis for gold, and some assurance from gold miners income statements, a divergence of the metal and stocks seems illogical. One area of blame is that analysts are forecasting gold prices at $1600 an ounce or lower. If this is the case, then long gold miners and short gold would be a prudent position. However, given my arguments, I'm happy to be a gold owner, even if the price fluctuates downward in the interim.

I am already long gold miners in the form of GDX, GDXJ, NEM, GOLD, GORO, and FNV. On Monday (5/7/12), I initiated a synthetic long position, by selling a GDX Dec12 $39 Put and buying a GDX Dec12 $44 Call. See the options-basic page for the derivation of this strategy. The trade cost me $200.00. I am on the hook if GDX falls below $39 and have unlimited upside if GDX advances beyond $44.

Top Five is updated to reflect my increased GDX exposure.

Disclosure: I am long GDX, GDXJ, NEM, GOLD, GORO, FNV.