On June 19, I commented favorably about gold mining stocks versus gold bullion in Dealing with Financial Repression. I stated that gold was the paramount way to deal with the repression of short-term interest rates to well below the pace of price inflation and that gold in the ground via decent quality mining stocks was cheaper than gold bullion above ground. Since that time, the well-followed HUI index has risen from 497 to 578, which is a 16% rise. The popular ETF that tracks gold, GLD, is up 4%. What are the prospects for the miners now that this outperformance of the senior mining stocks has already occurred?
Let’s answer the question by looking at a simular index to the HUI that has a much longer history, namely the XAU. Here is a long-term chart of XAU, beginning in 1984, with GLD added. GLD was initiated in 2004.
You can see how much GLD has outperformed the XAU. The XAU began tracking major gold miners in late 1983, when bullion was around $380/ounce. Bullion has more than quadrupled since then, but that is only a 5.3% compounded rate of return. This rate of return is far below that achieved from the NASDAQ during that time (8.7% per year). The NAZ in turn lags the return from a 28-year Treasury purchased then, at 12%.
Gold mining stocks offer both fundamental and speculative advantages over bullion for the individual who has “enough” bullion. Mining stocks have never been confiscated. They can pay dividends. If gold goes mainstream, Wall Street will push stocks over boring bullion. Most important to me, all but the very earliest stage gold explorers are dealing with production or late-stage site development that was thought to be economical at much lower gold prices.
Some analysts argue that gold miners have profit margins that are “too high” already. I would disagree. Apparently they are unaware that pharmaceutical marketers have gross margins that are typically in the 95-99% range. Probably every cosmetic, soap, consumer dental product, etc. has gross margins in the 95% range.
More to the point, I am in gold because I believe that it is gaining steam to regain primacy in the global financial system, and thus the best comparison of the “proper” margin for gold miners is the margin that central banks and national treasuries have in their operations. What is the cost to the Treasury to raise a billion dollars in the debt markets? Almost nil. What is the cost to produce currency? I have heard that a dollar bill costs about 8 cents to produce, so that has a margin of 92%. But that means that a $10 bill also costs 8 cents, for a margin of 99.2%.
So given that the point of having a significant investment in gold is because of its past, present and potential future monetary characteristics, I see nothing about the economics of gold mining that makes me think that the miners are fundamentally overpriced.
The dean of stock market newsletter writers, Richard Russell, recently wrote that “There’s no fever like gold fever”. Our gold “patient” has not even gotten warm yet. If the pols and central bankers continue as they have the last several years, it’s hard to see an end to negative real interest rates in the US. Of course, a liquidation event such as we saw in late 2008 would hit the gold miners harder than the price of bullion, but as the above chart shows, the stocks are already underperforming bullion because of that event.
The controlled bull market of the last decade for gold has not even begun to reverse the underperformance of gold since 1983 (or later years) versus plain old Treasurys or the NASDAQ. Gold mining stocks have seriously underperformed gold. I am betting on reversion to the mean of gold against bonds, and of gold miners against gold. In the meantime, my mining stocks pay me more in dividends, which I expect to rise, than a 3-year Treasury pays in interest.