What’s Wrong With Gold Stocks?
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. Bottom-line-focused
management also was stingy about equipment and labor investments.
In 2005, extraction costs for large operations averaged about $200 per ounce. Thus, gold’s early upticks had a dramatic – and positive – impact on producers’ bottom lines. One miner, in fact, estimated that a $10 rise in the price of gold back then translated into a $50 million boost to its earnings.
As the higher-grade ore was taken out, though, second-tier deposits had to be targeted and equipment updated to get at it. Hiring and training also had to be stepped up, further increasing production costs. The most recent report from Goldcorp. (NYSE: GG), Canada’s second-largest producer, for example, puts extraction costs at $300 per ounce now. For marginal producers, extraction costs may be even higher.
Keep in mind that the refurbishment of productive capacity is taking place in an environment of rising inflation and a generally weaker dollar. That cranks up cash costs further.
Then there’s the impact of exchange-traded vehicles. The increasing popularity of ETFs and ETNs based upon gold bullion or futures has siphoned off more and more of the demand for mining stocks. GLD, for example, posted an average daily volume of 2.5 million shares between May 2005 and January 2006. Volume has more than quadrupled. Over the past nine months, 11.6 million GLD shares change hands on an average day. Investors thirsty for a slug of gold exposure can now obtain it cheaply and efficiently without running it first through an equity filter.
Gold ETF (GLD) Volume
All this makes the current market decidedly different from 2005.
So, are gold stocks cheap or not?
Well, you can’t put the ETF genie back in its bottle. And you’ll just have to wait to see if there’s actually been a turnaround in investors’ sentiment for equities. As for mining stocks themselves, spiraling production costs, and the consequent pinch on margins, can’t be good.
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