Why gold bullion is still a better buy than gold equities

Posted on 24 June 2011 with 1 comment from readers

Gold bugs are very upset that the stocks of mining companies have not kept up with the rising price of the precious metal. They sense a buying opportunity for gold stocks and promote it at every opportunity. But they are wrong.

There is a very simple reason why gold bullion will continue to be a better investment than gold equities, at least for the next few months. That is because global stock markets are still on the way down, and a sinking ship takes everyone down with it. Yet the divergence between the price of gold and the miners is clear:

You do also have to think about the impact of rising energy costs on mining companies. Energy is the biggest single cost factor for any pure mining operation. Ergo rising fuel costs will be squeezing profits and offsetting the impact of rising precious metal prices.

The time to buy gold and silver stocks is surely when global stock markets hit a new bottom. We don’t have a crystal ball but October is the traditional autumn month for such market conditions to emerge, certainly not June, although we take the point that precious metal prices do normally weaken in July and August.

Look at this graph from our old friends at Agora Financial, and you can note that the greatest bargains among gold stocks are to be found when stock markets crash:

We don’t imagine it will be any different this time, unless Ben Bernanke pulls QE3 out of his hat like last August and the possible autumn crash disappears into another rally. The Greeks and their fellow PIGS in Europe might be a fly in that ointment this year.

But will gold stock prices one day accelerate away ahead of the rising price of gold bullion? ArabianMoney knows full well that this is what happened in the late 70s. But it may not be the same this time.

Golden rules

First, stock market investment itself may go deeply out of favor after another big fall, and the market could go nowhere for years (like in the past decade). Second, gold stocks have a new competitor in the shape of ETFs, with some even offering leverage to the gold and silver price for additional downside risk as the next issue of the ArabianMoney newsletter investigates (sign-up here).

The smart money could choose to stick with the actual physical commodity, and the ETFs that are audited as holding it. Certainly the junior mining stocks have taken a pasting, particularly the junior exploration companies.

In the late 70s these tiny companies were a forerunner of the dot-com stock boom of the late 90s. They similarly owned no real assets, made losses not profits, hugely exaggerated their potential and conned investors out of fortunes. Very, very few actually found gold!

Gold bugs think that in the final phase of a precious metals bubble the same sort of companies would prosper again. However that will not happen if all the liquidity goes into ETFs which do seem to have an unquenchable thirst for capital.

Sticking the word ‘gold’ on any equity might therefore not be a passport to fortune. Then again Facebook.com is presently valued more highly than all the silver reserves of the world, so never say never again.

But if the major gold producers become even more seriously undervalued in a stock market correction then that does look a very good entry point.