July 27th, 2011
by Steven Hansen
With gold continuing to flirt with all time highs, investors have been bombarded with gold touts - buy gold, buy coins, buy, buy, buy. When an investment heats up - it is time to exit.
In the above graphic: gold price is NYSE:GLD, silver price is NYSE:SLV, gold miners is NYSE:GDX, and the S&P is NYSE:SPY.
My colleague Doug Short, in a graphical analysis, concluded that gold, while not cheap, did not appear to be in a bubble. If you look at the rapid increase of silver - this is a warning sign of a bubble. Gold has been moving up slowly. Although gold is not immune from corrections - it outperformed most asset classes during the financial collapse of 2008.
In Friday's Casey's Daily Dispatch, gold miner's were touted:
Remember, gold stocks have already demonstrated some serious leverage to gold in this bull market. From the 2001 bottom through the end of 2007, gold producers as a group rose about 1,200% (as measured by the Amex Gold Bugs Index), while gold was up about 230% in the same time frame. They outperformed the metal by five to one. Historically for the producers, the ratio is closer to three to one. Either way, my bet is that at some point, those days will return.
And maybe we’re nearing that time now.
Unfortunately, this statement is not true. While there at times has been considerable leverage, over an extended period shown on the above graphic - miners have underperformed gold. Why?
The leverage between miners and gold decreases the higher gold climbs.
The above graphic needs a little interpretation - it is showing the percent increase in the value of investments in gold and miners for each $100 increase in the value of gold.
The blue line shows the percent increase over the previous gold value for each $100 increase in the price of gold. The red line shows the theoretical increase in gross profits for miners for every $100 increase in the price of gold IF the production costs were fixed at $600. Finally, the green line is the averaged ACTUAL increase in miners stock values (expressed as the change in the price of GDX).
The reason for the variance between the red line (theoretical profits of miners) and the green line (stock value of miners) is that production costs are not constant (and are currently higher than $600). As the price of gold improves, miners are able to open previously marginal areas. In other words, the higher gold goes - the higher gold production costs go.
There are several first class professional miners out there - run by state of the art business techniques. However, as a group - these guys are cowboys who never saw the inside of a business 101 classroom. In other words, their business models will only used as examples of what not to do.
As a generalization, miner's historically make terrible investment but are great for traders because of the volatility. Gold, on the other hand makes a good cornerstone in your investment portfolio.
Note: Author invests and trades precious metals and precious metals miners holding short and long positions / options. Further author has managed construction of several gold mines / processing facilities.
China is Bullish for Silver by Keith Fitz-Gerald
Gold Does Not Fit Profile of Most Bubbles by Doug Short
Overview of the Markets by MacroTides
Gold Long-term Uptrend Remains Healthy by Erik McCurdy