Sunday, March 22, 2009

Why gold bulls shouldn't buy gold stocks

In light of the recent stories of hedge funds piling into gold and gold related plays (see this and this), I am still shaking my head over the fact that investors were buying gold stocks instead of gold and other inflation hedge vehicles.

Maybe the purchase of gold stocks was justified by the analysis of the history of the PHLX Gold & Silver Index (XAU) to gold ratio, which is near all-time lows:



Perhaps it was bullish calls on gold stocks like this. Maybe it was the Fed's bombshell announcement last week, which whacked the USD and sent gold and other commodities soaring.

Maybe it was analysis like this, which recalled the degree of leverage that gold stocks have enjoyed over bullion.


Gold stock leverage to bullion is falling
The trouble is, gold stocks aren’t just a simple leveraged play on the gold price.

As I pointed out before, a gold company could be simplistically thought of as a call option on the price of gold, with the strike price being the cost of production. My analysis also showed that most senior gold producers were raising production costs by mining lower grades of ore. Gold mining shares consequently did not perform as expected because of earnings disappointment.

Moreover, as the gold price has risen from about $260/oz. in 2000 to over $1,000/oz. seen this year, the leverage of gold stocks to gold has diminished as a result of the rise. The scatterplot below, which charts the monthly change in the Gold Bugs Index (HUI) against the monthly change in gold, illustrates my point. I split the sample in two: when gold was below $500 and when it was above $500. As you can see, the degree of leverage shown by the period when gold was above $500 is lower than the period when gold was below $500.

(click on chart for larger picture)

The chart below also tells the same story by showing leverage of HUI to gold in a different way, where

Leverage = % monthly change in HUI / % monthly change in gold

The average leverage of HUI to gold has been falling more or less steadily as gold prices has risen.


It’s all rather simple once you think about it. If you hold an at-the-money call on gold, which is roughly what an investor did with gold stocks in 2000, the option's leverage to gold is relatively high. As the gold price advanced, the call option got deeper and deeper in the money and the degree of leverage declined.


Gold stocks are not a good alternative to gold
Once you throw in other considerations such as political risk (e.g. wars, etc.), operational risk (fires, floods, strikes) and developmental risk (such as the Galore Creek fiasco), are gold stocks really worthwhile investment vehicles? More importantly, if commodity inflation does surface with a vengeance, then we will likely see negative surprises in the form of increased mining costs stemming from rising material and energy prices, which will squeeze gold mining margins.

Of course, it depends on why you are buying gold. If the gold holding is a hedge against disaster, then some physical gold in the form of coins and bullion may be better choices.

If you are looking for a pure inflation hedge, then perhaps inflation-linked bonds, gold ETFs like GLD, or a closed end fund like Central Fund of Canada (CEF), could be your vehicle.

If you are looking for a leveraged play on gold, then you may want to look at silver (the metal, not the silver stocks), which is traditionally thought of as a leveraged play on gold. Another alternative could be the purchase long-dated options on gold bullion for investors.

Buy gold stocks? The fact is, they are overly erratic and unpredictable vehicles as to be effective leveraged plays on gold bullion.

5 comments:

Josh said...

Interesting insights relating to the shares as call options. However I believe that gold stocks were heavily naked shorted on the run down to last October. This could have caused an artificial dilution in a number of those stocks. The SEC and its Canadian counterpart were woeful in policing the market, and still are.
If the correction has bottomed out, is it not possible that leverage could be back ? Since October many of the shares have out run the price of gold by a long way. A lot of them are up over 300% since then. GoldCorp up 238% since October, KGC 261%, ABX one of the worst nearly double, SA nearly 400%........whereas Gold up about 40% ! So I do not agree with your analysis because the facts are that leverage is back !
The other thing I need to mention is GLD is an entity absolutely not to be trusted. Its sub-custodians cannot be audited. JPM is the main one but all are the same technically insolvent bullion banks that are heavily under water in massive gold short positions. These banks never have to put up margin and also expect to be rescued by the Fed who actively encourages the suppression of the gold price. Who knows if they have swapped, leased or loaned the gold in their custody ? Have a good look at its prospectus; it is FULL of holes.
When you see declining volume in GLD, it could simply be that more and more people are waking up to the fact that this is definitely one to keep away from !
The other one CEF by all accounts is trustworthy and allows itself to be open for inspection. The fact that there are premiums on CEF and GTU says it all !

Josh said...

I would like to add about SA (Seabridge Gold)..you really got me going here !!...This is one of the ones that was constantly being naked shorted and had huge amounts of FTDs from time to time on its way down to $6/share last October.
Now it is going parabolic so dangerous to buy if you haven't already got it, without some correction, but the reason it is going parabolic is because it is not a miner but simply has a huge deposit (40m oz + huge copper deposit) which it goes on and on proving by drilling. Now a share of the company commands well over 2oz gold. It is an obvious take over target and the price action may suggest that is now happening. I don't know. It is very attractive for anyone wanting to buy gold on the cheap. It is in the ground with no storage costs or worries about theft. As or if the POG rises, this is definitely a one for leverage !

Gold said...

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Nexpider said...

Some excellent ideas here I don’t have a news blog as such but there are some great tips that I plan to use.
Nexpider

GOld Bullion said...

save your future by saving your wealth physically best choice is gold bullion

Thanks for the great reading, we buy gold bullion in a recession. I will pass this on to our ira clients to read