You might think that gold stocks would be the place to be these days: The price of gold is strong and investors are desperate for safe havens as the global economy crumbles.
Curiously, though, a rally in the shares of gold producers has been AWOL. Since the start of 2008, gold has risen a respectable 2.6 per cent. Over the same period, however, the Philadelphia Stock Exchange gold and silver index – a 16-member collection of precious metals producers, including Canada's Barrick Gold Corp., Goldcorp Inc. and Kinross Gold Corp. – has tumbled 32.6 per cent after factoring in dividends.
That's not much better than the dismal performance of the S&P 500 and is in line with the steep decline of the S&P/TSX composite index.
It shouldn't be this way. Investors turn to gold producers, as opposed to physical gold, because the producers are seen as leveraged plays on the underlying commodity: Since producers' costs are fixed, substantial gains in the price of gold are pure profit.
The longer-term discrepancies between gold and gold stocks look just as dismal. Over the past five years, to the end of 2008, gold's price has surged more than 110 per cent; gold stocks, as represented by the Philadelphia gold and silver index, have risen just more than 20 per cent. Over the past 10 years, the performance gap has been similar, with gold outperforming gold stocks by 80 percentage points.
The natural conclusion here is that gold stocks simply aren't worth the effort – especially when you consider that they come with the extra risk of management performance, hedging strategies and the political risks of mining in unstable parts of the world.
However, as ugly as the past decade has been, some observers believe that the relative performances of gold and gold producers move in cycles, and a switch could occur. Gold outperformed gold stocks in the second half of the 1990s. Gold underperformed gold stocks from about 2000 until 2003 – and the two were duking it out until the disastrous performance by gold stocks last year.
There is some evidence to suggest that gold stocks could start to shine. John Hussman, of Hussman Funds, compares the price of gold with the Philadelphia gold and silver index to come up with a ratio. Right now, that ratio is more than 7, which is exceptionally high by historic standards.
According to Mr. Hussman, when the ratio is above 5, gold stocks follow with average annualized gains of almost 90 per cent. When the ratio is above 5 and the U.S. economy is weak (as determined by manufacturing activity, or the purchasing managers index, which is in the ditch these days), gold stocks have risen at an average annualized rate of more than 125 per cent.
Gold producers certainly have some explaining to do for their abysmal performance. Perhaps they can redeem themselves in 2009.
