Update & Strategic Outlook 21 July 2011 Gold Stocks: Still Too Volatile Sovereign debt concerns in the US and Europe have given a boost to gold in recent weeks. At the end of June gold bullion was priced at $1,502/oz. By July 18 it had crossed over the $1,600/oz mark, although at time of writing it has settled at $1,590/oz. This means gold is up 5.9% in just three weeks. In my weekly review of June 24 I said it was not the right time to buy gold mining stocks. This ran contrary to a lot of respected analysts, who argued that gold mining stocks are cheap versus gold. They may turn out to be right. But my own view is that the balance of risk is against gold mining stocks and in favor of gold for now. You can see my arguments here. Since then the Amex Gold BUGS Index has rallied 13.5%. This compares to 5.7% gain for the SPDR Gold Shares ETF (NYSE:GLD) and a 4.1% gain for gold bullion. The Amex Gold BUGS Index listed on the Amex under the symbol HUI is an index of unhedged gold mining stocks. (BUGS is an acronym for Basket of Unhedged Gold Stocks.) This means the companies included in the index don t hedge the price at which they sell the gold they produce. They don t sell it forward at a price set today, in other words. So they are exposed to changes in the gold spot price (the price for immediate delivery) when they sell. 1
Actually, HUI includes companies that don t hedge more than 1.5 years of future production. But even so, the idea behind it is that the mining stocks in the index have high exposure to changes in the underlying gold price. And most of them have gold ore reserves that will keep them producing for many years to come. Right now, there are 16 companies in the index. Over the last three weeks, investors have indeed bid up gold mining stocks more than gold bullion. But I stand by my reasoning and still prefer bullion or bullion-backed ETFs. We are long-term investors, not short-term traders. Three weeks is a short time. And the general stock market risk that could drag down gold mining stocks is still extremely high in my view. The summer period (for those in the northern hemisphere) could be a quiet one. But stock markets have a bad habit of crashing in September or October. So it s worth biding our time until our cash reserves can buy us more for our money. The Mother of Secular Bull Markets Gold has been one of the best performing investments of the past decade. Over that time gold bullion has risen from $270/oz to $1,590/oz. That s a gain of 491% equivalent to making 19.4% compound a year, with profits on the profits. This is what Chris called the mother of all secular bull markets. And if you take a look at this chart, you can see just how steady and strong this bull market has been. 2
For comparison the MSCI Emerging Markets Index has gained 280% or 14.3% compound. This figure excludes dividends. But even with reinvested dividends, I still reckon that the booming emerging market stock markets would have significantly underperformed gold. That said, gold mining stocks have done even better over the past 10 years. HUI was up from 65.41 on July 16 2001 to 568.71 on July 18 2011. That works out as a gain of 769% or 24.14% compounded. And that excludes dividends that the miners paid, though they were likely to have been quite small. For example, the three largest companies in the index making up 39.74% of the total value currently have an average dividend yield of just 0.9%. But that outperformance of the miners against bullion all happened in the early part of the decade. Later on, the miners underperformed gold. This is most likely due to higher extraction costs, as I outlined in my June 24 report. But in recent years gold, not gold miners, has been a much better investment. I ve compared GLD to HUI over five years, two years, one year, six months and three months and the result is always the same. Gold (in this case measured by the gold-backed ETF GLD) always comes out on top. Plus, it has been a much smoother rise. 3
Below, I ve put in a series of charts that show you the performance of GLD, HUI and the S&P 500, over those different time frames. At times of stock market stress gold miners get dragged down with the ship. During the financial crisis of late 2008, for instance, stocks fell hard. And gold mining stocks fell really hard. Panicked investors dumped assets of all kinds to pay off margin calls. As an aside, margin calls happen when leveraged traders discover that the value of their assets is no longer big enough for the bank to keep lending to them. So the banks call in part of the loans. And pinched traders become forced sellers. Margin calls can turn market corrections into routs. This is why investing with leverage can be bad for your health. Margin calls force you to sell at the worst possible moment guaranteeing you realize losses. On the other hand, unleveraged investors can hold on to their assets until markets stabilize and rise again, which is what usually happens. Especially if the initial investments were the kind of deep value legacy investments we favor at Bonner & Partners. GLD Outpaces HUI Getting back to gold, let s start with the five-year chart. In all cases GLD is the green line, HUI is the blue line and the S&P 500 is the red line. 4
I used a similar chart in my June 24 weekly review. You can see GLD and HUI more or less tracking each other until early 2008. Then HUI falls hard, and GLD only falls a little. And the gap never closes again. Recent events in Europe and the US remind us that the financial world is still a house of cards. As Chris explained this week, deleveraging doesn t happen in a straight line, but rather in phases. And these phases are punctuated by attempts by government and central banks to stimulate economies back to rude health. Markets are indeed inherently unstable, as George Soros put it. This means we could enter a new phase of the crisis at any moment. If 2008 is anything to go by, gold is likely to be much more defensive in such a scenario than either stocks in general or gold mining stocks in particular. In fact, I would argue that awareness of gold as protection is much higher now than it was in mid-2008. Ownership is more widespread too. Although this is still not the case for retail investors (individuals with small portfolios). Conclusion: Gold will hold up even better than before in a renewed market panic/flight to safety. 5
Now let s look at the two-year picture. GLD Still On Top Again, you can see that GLD is still out on top ahead of HUI. And they ve both left the S&P 500 for dust, despite its rally from the March 2009 low. I don t call it a bull market, because the S&P 500 is not in a bull market. It s a bear market bounce fueled by massively negative real interest rates and a devalued dollar, courtesy of two rounds of quantitative easing/debt monetization. What you ll also notice here is that GLD hasn t always been ahead of HUI during this two-year period. In fact, for most of the time HUI has been ahead. But GLD has given a much smoother ride to the top; HUI has had higher highs and lower lows. This kind of volatility is useful for short-term traders. But as long-term investors, it s rarely something we should act on. We can afford to wait for extreme market anomalies before acting and improve our chance of making the big gains we are after (and avoiding ruinous losses). 6
HUI Gets Dragged Down with Stocks Now, let s take a look at the one-year picture. GLD is on top again, although it hasn t always been. But its performance has been smooth. But here I d draw your attention to how HUI has fallen along with the broader S&P 500 on a number of occasions not just when the gold price has fallen. For example, HUI fell hard during May and June 2011, as the S&P 500 fell. But GLD (the green line) was flat or rising. The same thing happened this March. This illustrates my concerns about a stock market correction dragging down gold mining stocks even though gold prices could remain strong. HUI also fell hard in January. But the S&P 500 was rising. This time HUI fell because gold prices were also falling. This could happen again. But the point here is that we are fundamentally bullish on gold and bearish on the S&P 500 and stock markets in general. HUI can fall when either gold or stocks fall. Stating the obvious, gold can only fall if the gold price falls. 7
Conclusion: Until general stock market conditions change, I continue to favor physical gold or gold-back ETFs to gold mining stocks. We have only one factor at play with gold investments: the gold price. But we have two factors at play with gold mining stocks: the gold price and the direction of stocks in general. Same Story But Close Up Here is the same chart over a six-month period. Same story but up close. Even over three months, GLD has the higher gains. Here s the chart for that period. 8
It s only in the last month that HUI has risen higher relative to GLD. But go back and take another look at the two-year chart: HUI is far more volatile than GLD. This month s gains could quickly turn into next month s losses. For that matter, this quarter s gains could be next quarter s losses. Either way, these short-term moves aren t the kind of thing we are overly concerned with. We have our sights firmly set on the long-term beta trend of the gold market. Nothing about the macro picture signals that the long-term bull market in gold will end anytime soon. Nor do we see any evidence to suggest gold is in a bubble either. But we can see plenty of reasons to think that stocks in general could fall hard, dragging down gold mining stocks with them. What to Do: Continue to stick with gold in the form of coins, bullion or gold-backed ETFs such as GLD. We remain cautious about investing in gold mining stocks until they offer compelling value, which they will do one day. Until next week, Rob 9
Published by Bonner & Partners Family Office, Elysium House, Ballytruckle, Co Waterford, Ireland For customer service questions, please contact us here. You can also call us at 855-849-2885 or 410-454-0481. We look forward to your feedback and questions however, the law prohibits us from giving individual and personal investment advice. We are unable to respond to emails and phone calls requesting that type of information. Copyright 2011 Bonner & Partners Family Office. All Rights Reserved. Protected by copyright laws of the United States and international treaties. This newsletter, e-letter, or promotional material may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Bonner & Partners Family Office, Elysium House, Ballytruckle, Co Waterford, Ireland. 10