Earlier this year ("Gold Stocks Pay Off"), it seemed like the
stars had lined up for gold stock investors. Gold equities looked cheap relative
to bullion in mid-March, at least on the basis of the GLD/GDX
ratio. The ratio, representing the price multiple of the SPDR
Gold Shares Trust (NYSE: GLD) over the Market Vectors Gold
Miners ETF (AMEX: GDX), had dipped to 1.75, its lowest
level in three months. The chart pattern traced by the ratio reminded gold
traders of market conditions three years before.
In mid-May 2005, gold had gotten ahead of mining stocks, according to
watchers of the Philadelphia Gold/Silver Index (PHLX:
XAU), a benchmark tracking the performance of a baker's dozen mining
outfits. Gold's price, as a multiple of XAU's, had advanced to a historic
plateau that rather predictably signaled a reversal point in the past.
Apparently, they were right. Those who bought mining equities and held them
through early January 2006 watched their investments gain value at a pace nearly
three times as fast as gold itself. XAU raced ahead 73.6% against bullion's 26%
gain.
But there was no such move set up by this March's pattern. At least not yet.
The GLD/GDX ratio, instead of falling, rose to new highs. It closed at 2.12
Friday.
Gold Bullion's Price Vs. Mining Stocks
(GLD/GDX)
What went wrong?
Well, three things really. First and foremost, let's not forget that gold
mining stocks are stocks. Though their issuers are engaged in the
business of finding and producing a commodity, they're not commodities
themselves.
In 2005, the equity environment wasn't ideal, but it was definitely better
than now. We're currently looking forward to a low- or no-growth environment
seasoned with high inflation. That's a noxious atmosphere for equities - even
for gold stocks.
Mining stock prices are inherently more volatile than those of bullion. Since
2005, Axe's standard deviation (a measure of volatility), at 34.6% per annum, is
nearly twice that of gold's. The outsized riskiness arises from the enormous
influence gold's market price has on a mining company's earnings. That's where
the second factor - production costs - comes in.
During gold's 20-year bear market, miners learned to survive by controlling
costs. Using higher-grade and easy-to-find ore, producers tried to wrest profits
from sub-$300 market prices.
