The topic of gold inspires a charged reaction from individuals seeking fiscal and monetary responsibility of their respective governments. This article is an attempt to establish the risks of gold stock ownership in an investor’s portfolio. We will cover the topic of risk by showing the critical periods of correlation and inverse relationship between the stock market, precious metals and gold stocks. We will outline the potential rewards to gold stock investing when gold stock risks are put in the proper perspective.
Personal Bias
As a child of a parent who grew up during the “Great” Depression, the themes of that experience were a constant. Therefore, it goes without saying that it was easy to establish a bias toward the value of gold and its role as money. In addition, reading the work of Richard Russell, publisher of the Dow Theory Letters, as a teenager only re-enforced a sense of the way things should be in the financial world. A recurring theme of Richard Russell, a product of the “Great” Depression, is the importance of the role of gold in establishing a fiscally responsible government.
Risks
Investors in precious metal stocks could benefit from a distinction between popular notions and the reality about the stocks that mine precious metals. One popular notion is that there is an inverse relationship between gold and gold stocks with the stock market. As popular as this idea might be, it does not explain a simple phenomenon that has been present in the markets throughout history. This issue is with the fact that gold stocks tend to decline whenever the stock market experiences an extended decline.
First, in a broader context, the idea, that gold and silver as commodities would confirm the direction of the general stock market was recognized in commentary by Charles H. Dow, co-founder of the Wall Street Journal, when he said:
“For the past 25 years the commodity market and the stock market have moved almost exactly together. The index number representing many commodities rose from 88 in 1878 to 120 in 1881. It dropped back to 90 in 1885, rose to 95 in 1891, dropped back to 73 in 1896, and recovered to 90 in 1900. Furthermore, index numbers kept in Europe and applied to quite different commodities had almost exactly the same movement in the same time. It is not necessary to say to anyone familiar with the course of the stock market that this has been exactly the course of stocks in the same period ( source: Dow, Charles. Review and Outlook. Wall Street Journal.February 21, 1901.)”
As an example, in the following table, whenever the Dow Jones Industrial Average declines by –10% or more, investors could expect that the price of gold stocks would decline as well. The table compares the performance of the Dow Jones Industrial Average to the Barron’s Gold Mining Index (BGMI) from 1939 to 1983 and the Philadelphia Gold and Silver Stock Index (XAU) from 1986 to the present.
| Trade Date | DJI | BGMI |
| 3/10/1939 | -38.19% | -67.33% |
| 5/29/1946 | -23.95% | -25.24% |
| 2/2/1953 | -10.77% | -16.86% |
| 7/12/1957 | -19.39% | -30.27% |
| 4/21/1966 | -22.04% | -13.77% |
| 11/29/1968 | -35.93% | -37.71% |
| 4/28/1971 | -11.76% | -29.40% |
| 1/11/1973 | -45.08% | 56.80% |
| 7/15/1975 | -11.07% | -29.72% |
| 9/21/1976 | -26.87% | 3.02% |
| 9/11/1978 | -13.49% | -16.82% |
| 10/5/1979 | -11.25% | -10.63% |
| 2/13/1980 | -16.01% | -24.00% |
| 4/27/1981 | -24.10% | -52.64% |
| 11/29/1983 | -15.59% | -14.13% |
| Trade Date | DJI | XAU |
| 9/29/1986 | -10.36% | -15.06% |
| 4/27/1987 | -10.20% | -28.12% |
| 10/20/1987 | -40.35% | -46.54% |
| 10/16/1989 | -11.08% | -10.27% |
| 1/30/1990 | -11.30% | -29.27% |
| 10/11/1990 | -22.48% | -37.89% |
| 4/4/1994 | -10.87% | -27.66% |
| 7/16/1996 | -10.57% | -23.60% |
| 3/10/1997 | -10.61% | -25.97% |
| 8/6/1997 | -15.94% | -43.15% |
| 7/17/1998 | -20.99% | -47.97% |
| 8/25/1999 | -12.22% | -36.31% |
| 1/14/2000 | -17.18% | -25.05% |
| 8/28/2000 | -15.31% | -24.35% |
| 2/1/2001 | -17.47% | -19.80% |
| 5/17/2001 | -24.11% | -24.82% |
| 3/19/2002 | -26.80% | -37.13% |
| 8/22/2002 | -19.52% | -21.91% |
| 11/27/2002 | -15.27% | -24.32% |
| 10/9/2007 | -42.28% | -33.40% |
| 4/26/2010 | -13.55% | -1.58% |
| 4/29/2011 | -16.82% | -16.94% |
(Note: In instances where the DJI declined greater than the gold stock index, the percentage change is indicated in black.)
The table above showcases the short-term challenges with the perspective that gold stocks have an inverse relationship with the stock market. It is worth pointing out that the period from 1933 to 1980 was a bull market in the price of silver (a proxy for the price of gold if freely traded), however, 66% of the times when the Dow experienced a decline of –10% or more so did gold stocks and by a greater degree than the Industrials. (see: The Hidden Story of Gold)
In addition, there is the pervasive argument by some that the decline in gold stocks is not a reflection of the precious metal itself. However, the period from 1924 to 1933 highlights the reality in stark detail below.
In a period when stock markets were crashing and the economy was going into deep recession, gold and silver stocks were not able to counteract the forces of market participants. Not to be outdone, the price of silver declined in the exact timeframe. The absence of freely floating gold has allowed the myth that gold is a safe haven when markets decline and by extension gold stocks as well.
The purpose of drawing out the correlation between the price of silver with the price change of precious metal stocks in the period from 1924 to 1933 is to demonstrate that even with a gold “standard” in place, the reality of the market reflected what was not possible to see when, by government decree, gold was not allowed to freely float. Many investors of today could not know that only in a period when there was a gold “standard” can there be unimpeded protection in gold. Without such a scenario, investments in precious metal stocks carry all of the risks associated with the general market.
Long-term declines in the Dow Industrials also left gold stock investors in a lurch even when the price of gold managed to maintain or increase in price. The bursting of the internet bubble from January 2000 to October 2002 did not seem to spare the rout that was experienced by gold stock investors.
Anyone who was prescient enough to recognized the overvaluation of the stock market and believed that gold stocks were a safe haven would have experienced, at minimum, a –34% decline before seeing any meaningful appreciation, 2 years later. Those who might have mistakenly missed the November 2000 low in gold stocks but got in near the breakeven level in 2001 would have seen a decline of –15% or more. Any investor who got in near the May 2002 peak had to sustain a –36% decline shortly afterwards. The XAU index now sits at the exact same level as the 2002 peak, 12 years later.
As recently as 2007 and 2008, investors seeking shelter from the impact of the housing crisis were drawn in by the temporary rise in the price of gold and gold stocks from October 9, 2007 to March 2008. However, while the price of gold managed to retain a break even stance by late 2008, and subsequently rising as much as +25% by March 9, 2009, gold stocks ultimately declined as much as –62% by October 2008 and ended up leaving no indication that there is safety in the ownership of gold stocks by registering a –33% loss by March 9, 2009.
It should be noted that when the Dow Industrials peaked in October 2007, and had it been recognized to be a market top, the natural inclination would be to buy gold and gold stocks as a hedge. However, this realization would not occur for a majority of investors until after the subsequent rise in the metals confirmed the “conventional wisdom.” This means that the majority of investors who arrived on the scene for a safe haven play ended up buying precious metal instruments at or near the peak in the price in the period from March 2008 to July 2008. As gold stock prices ultimately confirmed the Dow Industrials declining trend in 2008, it becomes difficult to expect an investor to sit on average losses of –62% or greater.
False Signals and Possible Solutions
When put in the proper context, the investment in gold stocks can appear to be a high risk proposition offering little in the way of reward even in a gold bull market. In addition, some tools meant to improve the timing of the purchase of gold stocks has proven to be ineffective. One tool is the gold/XAU ratio or the XAU/gold ratio (variations include gold/HUI, HUI/gold, GDX/gold or gold/GDX ratios). The short comings of these tools have laid waste to gold stock investors as they have given false signals when reviewed from a long-term perspective.
According to famed market analyst John Hussman, the Gold/XAU ratio signals that gold stocks are a buy whenever it reaches five or above and effectively a sell when the indicator is at three or below, as indicated on the blue axis on the right. Hussman has suggested that this buy indication for gold stocks has worked since 1974. Unfortunately, the Gold/XAU ratio has not been effective since 2007 when it went from 5 to as high as 15 in December 2013. Likewise, the use of the XAU/Gold ratio has been proven ineffective to deal with the timing of gold stock purchases.
In an attempt to remedy this problem, we have constructed a Gold Stock Indicator which we believe is more consistent and reflective of when to buy gold stocks. Unlike the Gold/XAU ratio, our Gold Stock Indicator is consistent from the 1970’s to the present. This indicator is shown below using two gold stock indexes, the XAU and Barron’s Gold Mining Index.
The Gold Stock Indicator applied to the XAU is traced back to the earliest days of the index in 1983. The present level in the indicator is on par with the 1986, 1992, 1998 and 2008 lows. The performance of the Gold Stock Indicator for the XAU had the following returns:
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May 15, 1986 to April 7, 1987: +86.83%
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November 27, 1992 to July 12, 1993: +85.18%
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August 11, 1998 to January 20, 2006: +131.42%
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October 7, 2008 to December 1, 2010: +109.85%
The Gold Stock Indicator applied to the BGMI goes back to 1973. The current level on the BGMI is equivalent to the 1973, 1976, 1982, 1986, 1997 and 2008. The BGMI had the following returns for the given dates:
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June 6, 1973 to January 14, 1974: +102.60%
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August 13, 1976 to September 2, 1980: +336.86%
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June 7, 1982 to December 15, 1982: +103.28%
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July 23, 1986 to June 3, 1987: +102.15%
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December 22, 1997 to March 21, 2006: +144.17%
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November 26, 2008 to October 13, 2010: +137.30%
These returns are the conservative numbers for the respective indexes excluding the absolute peaks and troughs. In fact, the current level in each index is well below any of the date ranges given, which assumes that an investor were not able to purchase gold stocks at the exact low in the indicator.
Either of the Gold Stock Indicators provide a generalized view of where gold stocks are relative to the price of gold. In both cases, gold stocks are worthy of accumulation only if investors are willing to accept the downside risk associated with the stock market in general. Any gold stock investor who believes that the Dow Jones Industrial Average is about to decline must account for the likelihood that gold stocks could suffer a substantial decline as well.