Kaeppel's Corner: Don't Give Up On Gold Stocks Just Yet
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February 2, 2010
There are few markets - if any - that hold peoples' fascination more completely than the gold market. The yellow metal has had for years an almost mystical effect on the populace - ""for all the gold in Fort Knox," "worth his weight in gold," "follow the yellow brick (get it, yellow brick?) road," and so on, are well entrenched in the popular lexicon. From early 2001 to late 2009 the price of an ounce of gold advanced from around $250 to over $1225 an ounce. The gold bugs are now beside themselves with joy. Of course now that gold has been advancing over a several year period while stocks have been down, the number of radio ads touting an "investment in gold" is running at the, ahem, "high end of the historical range." And now that gold has experienced a pullback to under $1,100 the "gold touts" are well, touting gold. What else?
The reasons given for buying gold are typically the same - a hedge against inflation (probably true), limited and/or declining supply (depends on how much gets mined), and the ultimate store of value in a "worst-case scenario" (personally I'm thinking canned food and shotgun shells more than I am gold bars, but hey, that's just me). In essence, part of the mystique of gold is the vision that if all hell breaks loose one day, people holding gold will somehow fare better than those who do not. I suppose it's possible, but when it come to basic investing I tend to be slightly less "big picture" (and a whole lot less fatalistic) in nature, and a tad more focused on the "here and now." As a result, I prefer to trade gold mining stocks rather than gold bullion. Especially now.
One of the least noted market related achievements of the past 15 months has been the performance of gold stocks. While the focus has been on gold bullion and the performance of the overall stock market, gold stocks have enjoyed a fairly remarkable run.
Figure 1 displays the performance of the Dow Jones Industrials Average, the gold ETF (ticker GLD) and the gold stock ETF (ticker GDX), from 10/27/08 through 1/29/10.
Index | % +(-) 10/27/08 to 1/29/2010 |
Dow Industrials | +22.8% |
Gold ETF (GLD) | +46.8% |
Gold Stocks (GDX) | +144.7% |
Figure 1 - 15-month performance
Interesting, no? While the financial media and any manner of market pundits have marveled at the rally in stocks and the new highs reached by gold, relatively little attention has been paid to the huge rally that took place in gold stocks. Of course, some of the bloom is "off the rose" in light of the fact that since early December gold stocks have plunged over 20%. While investors can get quite excited about a given asset when it is rising in price, the enthusiasm can vanish pretty quickly in the face of a "down 20% in less than two months" decline. Same as it ever was. But is this loss of faith in gold stocks justified? Let's take a closer look.
The Case for Gold Stocks
Back in the mid-1980s (or as I refer to it, the "Hair Era" in my life) and for no particular reason, I one day divided the Barron's Financial Weekly's Gold Mining Index (heretofore the GMI) by the price of gold bullion. This simple measure was ultimately dubbed the "K-Ratio" by Nelson Freeburg, the renowned Editor of "Formula Research." The results have been and remain quite useful. In a nutshell and at its most simplistic:
- Low readings suggest that gold stocks are cheap relative to gold bullion and are thus likely to advance, and;
- High readings suggest that gold stocks are expensive relative to gold bullion and are thus likely to decline.
Like every other indicator ever created the results are far from perfect. But they are nevertheless useful, as we will see in a moment.
Figure 2 displays the weekly GMI and gold bullion readings since 1975. Figure 3 displays the ticker GDX (a proxy for gold mining stocks) on the top and the ticker GLD (which tracks the price of gold) on the bottom.
Figure 2 - Barron's Gold mining Index (GMI) versus Gold bullion since 1975
Figure 3 - Gold Stocks (GDX) versus Gold Bullion (GLD)
In a nutshell, what these graphs illustrate is the tendency for gold stock to overreact on both the upside and the downside whenever gold bullion makes a meaningful move.
Now consider the results displayed in Figure 4. To calculate these numbers I broke roughly 35 years of weekly K-Ratio readings data into 10 increment, from highest (gold stocks theoretically most overvalued) to lowest (gold stocks theoretically most undervalued), then measured the performance of gold stocks in the ensuing 13, 26 and 52 weeks. We will focus here on the 52-week returns. The results are "enlightening."
K-Ratio Greater than or equal to | K-Ratio less than | % of times GMI higher 52 weeks later | Ave %+(-) for GMI 52 weeks later |
>=2.141 |
| 2.7% | (-23.5%) |
>=1.979 | <2.141 | 15.8% | (-14.7%) |
>=1.863 | <1.979 | 37.2% | (-5.4%) |
>=1.753 | <1.863 | 46.4% | (-5.8%) |
>=1.631 | <1.753 | 57.4% | (-0.5%) |
>=1.531 | <1.631 | 67.2% | +7.8% |
>=1.44 | <1.531 | 69.9% | +25.6% |
>=1.293 | <1.44 | 72.7% | +31.3% |
>=1.13 | <1.293 | 61.2% | +35.9% |
| <1.13 | 70.7% | +47.4% |
Figure 4 - Gold stock performance following various readings for the K-Ratio
As you can see from the results displayed in Figure 4, the "buy 'em when they're cheap" and the "sell 'em when they're expensive" theory appears to hold water. To illustrate this fact, simply consider the readings at the two extreme ends:
- When the K-Ratio has registered a reading of 2.141 or more, gold stocks have only been higher one year later a mere 2.7% of the time, with an average 12-month performance of minus 23.5%.
- At the other end of the spectrum, when the K-Ratio has registered a reading below 1.13, gold stocks have advanced over the ensuing 12 months 70.7% of the time, with an average gain of a stunning +47.4%.
So the obvious question then is "where are we now?" If history proves to be a useful guide, then the apparent answer to that question would be "on the launching pad."
The Current Status
As of 1/29/10 the Barron's Gold Mining Index stood at 1080.84, with the price of gold bullion at 1078.50. This results in a K-Ratio of 1.0022. Where does this current reading stand within the historical range? In the immortal words of whatever blues singer sang them first, "Way Down Low."
In my database of 1831 weekly readings I find only 60 weeks that had a lower reading (including 8 in the previous year). If we look at the 52-week rate of change in the Barron's Gold Mining Index following each of these readings (not including those registered in the last year) two things stand out:
- 52 out of 52 (i.e., 100%) of these lower readings were followed by higher gold stock prices 52 weeks later.
- The average 52-week gain for gold stocks following all readings below the current level of 1.0022 has been +46%.
SUMMARY
So at this point, some portion of readers is saying, "Wow, I'd better get into gold stocks right away!" Another portion is saying, "Wow, this look's too good to be true - I'm staying the heck away from gold stocks." Still another portion is saying, "Wow, how did I get to this article? I must have clicked the wrong link." No matter.
The fact is that just because all previous lower readings from the K-Ratio have been followed by higher gold stock prices twelve months hence, in no way guarantees that things will be the same this time around. If one were to consider buying gold stocks now, proper position sizing, risk management and a stop-loss point all remain essential elements of a trading plan. Still, if one was going to bet, the odds presently appear to favor the bullish side of the argument.
As always, time will tell.
Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site
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