COCKTAIL TALK : A GOLD TURNAROUND / SEEKING ALPHA ( VERY HIGHLY RECOMMENDED READING )

Cocktail Talk: A Gold Turnaround

by: Hard Assets Investor / Brad Zigler

February 04, 2010

"What's better: gold or gold mining stocks?" I'm asked this question often at cocktail parties, but people aren't always pleased with the answer I give: "It depends."

For most of the past 12 months, gold stocks had the upper hand, at least as measured by the ratio of the two most popular exchange-traded funds tracking mining shares and bullion. In February 2009, the price of the SPDR Gold Shares Trust (NYSE Arca: GLD) was nearly 3x higher than that of the Market Vectors Gold Miners ETF (NYSE Arca: GDX). But over the course of the ensuing seven months, GLD's price multiple sank in stair-step fashion toward 2x, indicating greater price appreciation in gold stocks than in gold itself.

GLD/GDX Ratio

Cocktail party revelers, I've found, aren't particularly interested in things past, but instead are usually focused on where things are likely to go. And from the perspective of the GLD/GDX ratio at least, it looks as if bullion and bullion proxies, not mining stocks, are the better bet now. The ratio has rebounded now, such that it's crossed to the upside of its 50-day and 200-day moving averages.

So does this mean you should abandon your gold stocks and buy gold grantor trust shares? Well, not necessarily. The GLD/GDX ratio only indicates relative strength. Bullion is in the stronger momentum play presently, but there could still be more upside in gold mining shares. After all, there's a 75 percent correlation between the price movements of the miners fund and the metal-holding trust.

There's another telling statistic about gold miners, though, that investors should heed: beta. Beta is a measure of relative volatility. When you compare the variance in GDX prices against GLD, you'll find that miners are a lot riskier than bullion—in fact, by a factor of 1.69. Simply put, a 1 percent change in the price of gold would likely engender, on average, a 1.7 percent shift in the price of the mining ETF.

Beta reflects the leverage obtainable in gold mining shares. So the risk measured by beta is a real wallet-stuffer when stocks are ascendant, but not so much when equities aren't favored. And right now at least, the sun is shining on bullion.

But cocktail-and-canape consumers aren't interested in the statistical niceties of portfolio theory, of course; they usually just want to know whether their mining shares are likely to suffer from any slowdown in momentum. If we look at the five largest components of GDX's universe, we can get a clue:

1)STOCK

2)Weight
in GDX

3)Period
Return*

4)Beta
vs. GDX

1)Barrick Gold Corp. (ABX)
2)16.3%
3)-6.9%
4).87

1)Goldcorp, Inc. (GG)
2)12.0%
3)12.0%
4).94

1)Newmont Mining Corp. (NEM)
2)10.4%
3)16.3%
4).82

1)AngloGold Ashanti Ltd. (AU)
2)6.2%
3)29.9%
4).94

1)Kinross Gold Corp. (KGC)
2)5.5%
3)-3.1%
4).94
*Jan. 29, 2009 through Feb. 3, 2010

Each component has a beta coefficient with GDX that expresses its volatility relationship to the portfolio. Since the index tracked by GDX is capitalization-weighted, it's not surprising that the beta coefficients of the largest issues are close to 1.00. A beta of 1.00 would indicate a lock-step relationship—one in which a 1 percent change in the portfolio's value is matched by a 1 percent shift in the value of the component stock.

Still, there is a range of betas here. The lowest is that of Newmont Mining Corp. (NYSE: NEM) at .82. Over the past 12 months, NEM reflected less of GDX's volatility than the other issues in the top tier. If there's any persistence to beta (and there often is), we might be tempted to think that NEM would be the most sluggish stock in a rising gold market.

Implied in the rebound of GLD/GDX ratio is a bolstering of bullion's strength against mining shares. The correlation, however, remains positive; that is, as gold rises, so too do gold mining shares. The miners just aren't likely to move up as dramatically as in the past few months. So barring any unusual developments, NEM may be the slowest to appreciate. That's the bad news. The good news is that the stock may also retain more of its value in a market reversal. Comparatively speaking, that is.

Now that we've gotten that out of the way, I think I'll scout out some canape. Did you see any rumaki?