Gold Stock Indicator: The Big Picture

Article Summary

• Start accumulating gold stocks now
• select gold stocks from those in the XAU Index
• at minimum, investors must allow for 25% downside risk before reinvesting more funds

Our Take

On November 2, 2011, we posted an article which highlighted the fact that gold stocks routinely underperform the price of gold (found here). Also in that article, we introduced our Gold Stock Indicator to show that the timing of when to buy gold stocks was more important than the fact that prices and valuations appear to be low.

To demonstrate the significance of our indicator, we’d like to contrast it to the widely used Gold/XAU ratio. According to noted market commentator and fund manager John Hussman:

“…since 1974, the Gold/XAU ratio has been greater than 5.0 about 15% of the time. When the ratio has been this high, the XAU has followed with annualized gains of 89.6%, on average.” (Hussman, John. “Gold/XAU Ratio Signals Buy for Gold Stocks”. Seeking Alpha. March 13, 2007.)

Below is a chart of the Gold/XAU ratio since December 12, 1983:

Unfortunately, as gold has transitioned to a secular bull market cycle, the Gold/XAU ratio since 1999 has not provided a consistent signal of when to buy and sell gold stocks. In fact, on July 15, 2008, the Gold/XAU ratio indicated that gold stocks should be bought even as the XAU Index was about to fall an additional –66%.

Also popular among gold investors is the inverse chart of the same ratio known as the XAU/Gold ratio or gold stock/gold ratio. Many variations of these ratios are carelessly used by market commentators with the hope to prove that gold stocks should be acquired. So far, the Gold/XAU ratio has incorrectly indicated that gold stocks are a “buy” for the past 998 trading days in a row. Few who make reference to these ratios are willing to show the full history of these gold and gold stock ratios. In all cases, the ratio is the same and since July 15, 2008 has failed to steer gold stock investors away from significant loses in gold stocks.

In stark contrast, our Gold Stock Indicator had been able to consistently identify long-term opportunities of when to buy and sell gold stocks. Below is the most updated version of our Gold Stock Indicator:

At the current level, our indicator suggests that gold stocks should be accumulated. The last time that gold stocks were at the exact same level, gold and gold stocks posted the following returns:

While we recommend accumulating gold stocks at this time, it is important to understand and accept the possible downside risks. Below is the percentage loss that was experienced after each indication to buy gold stocks and before any gains were realized:

The 1987-1989 period was excluded from our downside risk data simply because it did not have any loss before moving to the sell indication. If we included the decline after the 1987 buy signal the average loss would have been –19.57% for all five buy signals since 1983. However, we’d like to opt for the more conservative figure of –24.46% to keep our expectation more realistic.

Those who wish to participate in the eventual run up in gold stocks should consider those that are a part of the XAU index. The members of the XAU index are ranked below based on the percentage from the 52-week low:

In theory, the stocks that have the largest weighting in the index contribute the most movement either up or down. However, this may not result in the largest percentage gains that are possible as compared to other stocks in the XAU index. We prefer those stocks that are nearest the low, so we’d opt for NEM, ABX and GG ahead of FCX, BVN and GFI.

Gold stocks that are a part of the XAU index have the benefit of institutional support and the risk of individual implosions. Also, as we’ve explained in our article titled “Why Gold Stocks Will Decline More Than the Markets,” gold stocks are tied strongly to the performance of the general stock market. This was graphically demonstrated in 2008 when gold stocks declined –68% in the period from March 14th to October 27th. Many claim that 2008 was an aberration, our analysis of gold stocks from the 1924 to the present clearly indicates that 2008 was not a fluke. Keep in mind that a –68% decline in the stock index means that individual stocks within the index likely fell much lower, on a percentage basis.

Investors should take their time in acquiring gold stocks as there is some downside risk. However, if 10%-15% of the portfolio is set aside for such investing, there are good opportunities if the purchases are done in stages.