Tuesday, August 23, 2011

Stop buying gold stocks!

Here we go again. Gold has hit all-time highs again. As you can see from the chart below, bullion remains in a well-defined uptrend.

On the other hand, gold mining stocks performance is disappointing as the group is struggling with technical resistance and has underperformed gold (again). What happened to the story about a better leverage to the gold price?

I wrote about this before here. Gold stocks are underperforming because their cost of production is going up, which creates a headwind for earnings - a driver of stock price. Yes, the value of what they have in the ground has gone up, but so has the cost of what it costs to take it out of the ground.

I wrote the following in December 2009 and it has proven to be true:
Supposing that you had a crystal ball that told you the price of gold were to triple within two years. Given this piece of information, what should you buy in order to maximize your gain?

Buying gold by itself will give you a gain of 200%. Buying a two-year call on gold with a $600 strike will give you a projected gain of about 300%. If you change the strike to $900, the projected gain is about 550%.

If you buy gold stocks given its poor fundamentals of rising production costs and their resultant pattern of disappointing leverage, gains are likely to be 200% or less. An investor would be taking on more volatility risk but at the price of little or no incremental gain.
If you are a gold bull you should either buy GLD or physical bullion, not gold stocks.

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