The recent major rally in gold is now experiencing a correction, so it is time to take a look at how gold stocks compared to a number of other gold trading vehicles. Quite frankly, it was abysmal. The argument that gold stocks are still the best gold trading vehicle is absolutely absurd. That being said, this article is in no way trying to discredit any gold mining, exploration companies or the efforts of the industry. The aim of this article is to simply show that gold stocks in general are unsuitable when trying to benefit from rising gold prices.
The main argument used when discussing the benefits of gold stocks is that higher gold prices equate to higher profits, however it is not quite as that simple. The reason it is not this simple is that in reality the costs of mining often increase with the price of gold. An example of this is the price correlation between gold and oil. Over the past ten years gold and oil prices have moved in sync leading to higher production costs. Also, if you are using gold stocks as an inflation hedge, then this will be offset by the fact that the gold producers costs will also be inflating. To top this all off, gold is getting much harder to find and much more expensive to extract when it is found.
Another argument is that gold stocks outperform the gold price. As we have seen in the latest surge in gold prices, gold stocks have not been able to keep up. This means that not only do they not outperform but they also fail to offer leverage to the gold price. Leverage used to be a good reason to invest in gold stocks before ETF's came along, however now they do not outperform and they do not offer leverage. In fact even if gold stocks offered leverage to gold this is not enough. Leverage is cheap in the modern financial world and easily created using margin or derivatives, even for the retail investor.
Some may argue that having a knack for picking potential boomers or undervalued gold stocks is a profitable strategy, however this is a completely different ball game. Picking undervalued companies if different from trading fluctuations in the gold price. At SK OptionTrader we use various option strategies to trade gold and we have been able to outperform other trading vehicles.
After reading these arguments advocating gold stocks, one has to also look at the negative side. There are many risks you have to take into consideration when buying gold stocks. These risks include geo-political risk (Eg: Nationalisation of mines, disruption of mines due to conflict), managerial risk (Eg: Poor management decisions effecting stock price), labour risks (Eg: Labour cost increases and strikes), technical risks (Eg: problems with the deposit and difficulties mining), environmental risks (Eg: adverse weather and natural disasters) and tax risks (Eg: Negative changes in tax structures and higher royalties being imposed that hamper mining profits). We believe that the risks of owning gold stocks are not properly compensated by their performance when the price of gold is rising.
Regardless of the fundamental discussions above, the evidence against gold stocks is irrefutable. In May 2008 we first posted an article about the demise of gold stocks as a gold trading vehicle. One way to measure the true performance of gold stocks is to look at a Long Gold & Short Gold Stock (HUI) pair trade. If gold stocks were truly outperformers and a good investment vehicle then such a trade would have been disastrous.
However since we wrote about the end of gold stocks such a pair trade would have resulted 58.65% gain (92.12% gain in gold minus 33.47% loss by short HUI position).
To further discredit the leverage argument, a Long DGP (200% leverage gold ETF)/Short HUI Index pair trade which would have resulted in a 127.35% gain (160.82% - 33.47%)
Gold stocks do not outperform and don’t even offer leverage.
If one is confident that the miners will outperform gold then one should be comfortable placing a Short Gold/Long Gold Stocks trade. Despite the many advocates for gold stocks, we do not know of any who have placed such a trade.
However, the difference between outperformance and leverage is vast. If you were to invest in gold stocks because it is slightly leveraged on the gold price then this reason is simply not enough. You can receive up to 400% leverage on ETFs by using margin and with this method you do not take on all the extra risks of gold stocks that were mentioned earlier in the article. To outperform, gold stocks need to go up by more than gold when gold prices rise, but fall by less when gold prices fall. By looking at the pair trades alone and forgetting all the other strong indicators, one can see that gold stocks simply do not outperform in this market, and haven’t performed for years.
In conclusion using gold stocks as a way to invest or trade in gold is a severely sub optimal strategy. We use options based on GLD when we wish to trade gold and our model portfolio is up 407.38% since inception, an annual return of 113.83% with an average return of 42.43% per trade. Please visit our website www.skoptionstrading.com to view our full trading record. However options trading can carry increased risks and isn’t always for everyone, but one’s aversion to risk doesn’t change the fact the gold stocks have been a poor investment vehicle for gold, and we see no reason to change our view on this. Our conviction has actually grown progressively stronger as the underperformance has continued, with the last couple of months being glaring examples of why gold stocks are not the place to be.