It’s Only Getting Worse for Gold Stocks

by Daniel Putnam | April 12, 2013 6:30 am

No matter how you slice it, gold stocks have been a one-way ticket to wealth destruction in the past five years. While gold itself has provided steady returns in the past three and five years — as gauged by the SPDR Gold Shares (NYSE:GLD[1]) — gold stocks have cratered far beyond what even the staunchest bears could have anticipated.

In just the past year alone, the Market Vectors Gold Miners ETF (NYSE:GDX[2]) has lagged the S&P 500 by more than 41 percentage points, while the Market Vectors Junior Gold Miners ETF (NYSE:GDXJ[3]) has fallen short by 46:

1-Year 3-Year 5-Year Since Inception
GDX -24.7% -10.1% -6.3% -0.7% (5/23/06)
GDXJ -29.3% -14.3% n/a -9.9% (11/11/09)
GLD -5.4% 9.9% 10.4%
SPDR S&P 500 ETF (SPY) 17.3% 12.2% 5.4%

At this point, the reasons for this massive underperformance are well known: Not only has gold been in a steady — albeit mild — downtrend since topping out in August 2011, but gold miners also have been pressured by rising costs, bad investment decisions and, in some cases, stock-specific problems such as labor disputes and unfavorable currency translation.

Beyond this, there’s another factor at work: the near-universal agreement in recent years that gold stocks are undervalued and due to play catch-up with the price of gold. The weakness in gold stocks has therefore been self-reinforcing, with money managers forced to sell as it has become clear that this “mean reversion” thesis isn’t working.

The resulting selloff has caused the year-to-date performance of the Dow Jones U.S. Gold Mining Index to fall to last place among the 99 industry groups tracked by the Dow Jones Indices.

Things can only get better, right?

In the short-term, that’s entirely possible. Certain gold stocks have been absolutely hammered in the past few days, among them Barrick Gold (NYSE:ABX[4]), Franco-Nevada (NYSE:FNV[5]), Kinross Gold (NYSE:KGC[6]) and El Dorado (NYSE:EGO[7]). Since gold stocks are known for extreme counter-trend rallies that can bring returns of 10% to 15% in a matter of a day or two, be on alert to take advantage of such a move in the coming week. Look to Barrick — the largest stock in the sector and therefore the one most likely to receive inflows from larger players — as the best bet for a trade.

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For those looking ahead a few months rather than just a few days, extreme caution is still warranted because of the current technical status of gold itself.

A look at GLD shows that gold is sitting right at long-term support. A break below $150 is meaningful, but $148 is the real level to watch since that would mark a new two-year low. Such a move could lead to substantial additional downside and would likely touch off yet another downleg in gold stocks. Gold has found support at this level many times, but the first-quarter breakdown in GDX could well be a leading indicator of what’s in store for the metal.

The good news is that if gold does in fact break down, the likely result would be the long-awaited capitulation bottom in gold stocks. Those who get long at this point could, if they get their timing right, capitalize on one of the best position trades of the year.

Longer-term, however, gold stocks remain challenged due to tame headline inflation and the increasing costs associated with pulling each incremental ounce of gold out of the ground. What’s more, the idea that gold stocks are an inflation hedge just doesn’t add up. The two main input costs for miners are labor and energy, but wage pressures — and rising energy prices — are both precursors to inflation. This means gold miners could see margins pinched well before they catch any bid from investors’ demand for a hedge against rising headline inflation.

The Bottom Line

Gold stocks remain an outstanding trading vehicle, and bulls might get their chance to take advantage of on an excellent trading opportunity before the quarter is finished. But as a long-term investment, there is still no reason why investors should risk their capital on this troubled sector.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. GLD: http://studio-5.financialcontent.com/investplace/quote?Symbol=GLD
  2. GDX: http://studio-5.financialcontent.com/investplace/quote?Symbol=GDX
  3. GDXJ: http://studio-5.financialcontent.com/investplace/quote?Symbol=GDXJ
  4. ABX: http://studio-5.financialcontent.com/investplace/quote?Symbol=ABX
  5. FNV: http://studio-5.financialcontent.com/investplace/quote?Symbol=FNV
  6. KGC: http://studio-5.financialcontent.com/investplace/quote?Symbol=KGC
  7. EGO: http://studio-5.financialcontent.com/investplace/quote?Symbol=EGO

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