Eric Sprott: Time to Buy Gold Stocks

A few weeks ago, I made the case for Gold Miners vs Gold bullion. This month, Eric Sprott published his monthly newsletter Market at Glance (September 2011) entitled "Gold Stocks: Ready, Set,…"

First, he makes the observation that since 2008, the HUI index has lagged the performance of Gold:

If you review the chart below, you’ll notice that while the gold price has almost doubled since early 2008, the HUI Index has appreciated by a mere 22% over the same period (see Chart A). If the HUI was justified at 500 in early ’08, it should surely be justified at 1,000 today, given the appreciation of the gold price over that time. So why have the equities lagged?

Then, he explains that the difference is due to investors gold price expectation that are as low as 1000 USD in 2014 (average expectations;:1340 USD per ounce) and the stock market being forward looking that would explain the performance difference between gold miners and gold bullion. However, the future markets say at different story with a 2013 gold price at 1909 USD.

Third, in 2008, Gold stocks are been hammered (some have gone bankrupt) following the sharp drop in the price of Gold, so investors may be wary of increase their Gold stock positions.

However, as recently as August 2011, the trend has changed. We have seen day where gold dropped and gold stock went (slightly) up. The price divergence is massive when bank stocks and compared to gold stocks (See chart comparing KBW bank index vs HUI gold index).



He carries on explaining that the current production price is 800 USD, and if Gold is 1800 instead of 1200, this would represent an increase of 150% in profit margin. He is amazed that – despite this new reality for gold producers - they are still finding opportunities in select gold and silver mining companies that can be purchased today at 2-3 times their 2-year-out forecasted cash flow and it would even become cheaper if Gold price continue to rise as Sprott Asset Management forecasts.

In conclusion, he believes the equities will offer more upside than the bullion over time and the prospects for gold stocks look extremely bright.

You can subscribe to Sprott Asset management's Market at Glance newsletter free of charge or download the PDF version.

The case for Gold Miners vs Gold

Gold has been on a roll for many years but has especially gone up in a parabolic manner recently even though the expected correction seems now underway, actually a bit earlier than initially expected.

Gold miners have also gone up, but in no way as fast as the gold itself, as you can see from the 5-year chart below with SPDR Gold Trust (GLD) in Green , Market Vectors Gold Miners ETF (GDX) in Blue and AMEX GOLD BUGS INDEX (^HUI ) - the underlying tracked by GDX - in Red (Source: Yahoo Finance)


As you can see gold itself has clearly outperformed gold stocks in the last 5 years. Another important thing is that GDX tracks the HUI index pretty well. Whether an ETF can properly tracked the underlying index should be always be checked before investing in an ETF as some ETFs are poorly constructed and only designed to make money for their manager(s) or short term traders.

We can look back in history with the BMGI (Barron Gold Mining Index) to Gold price ratio and clearly see that relative to the price of Gold, Gold mining shares are historically still very cheap as you can see on the chart below (Source: 321gold.com).


This chart only shows the ratio until Q1 2010. In August 2011, the BMGI stands at 1394 and the Gold Price is around 1750 USD, so the ratio is around 0.80 which is close to historical lows (around the lower red line).

However, you can also notice that in early 80s, the ratio was also very low during the gold spike. That means that during the 1980 Gold bubble, Gold miners stocks did not go up as fast as gold either.

To conclude, if the current Gold bull market is not over, it could be a very good time to buy gold miner stocks. But if the Gold bull market is over, gold miners could still lose value albeit less than gold bullion.