Predicting Gold Stocks

The price of gold goes up, but gold stocks don't, and you don't know why. Or the price of gold stays steady, but gold stocks go down, and you don't know why.

In earlier articles, you may have read some thoughts on predicting the price of gold and predicting the price of equity stocks. Here are some thoughts on what turns out to be an even bigger challenge, predicting the price of gold stocks.

The Price of Gold

When it comes to predicting the price of gold stocks, it is already known that the primary factor is the price of gold. When the price of gold goes up, this has a tendency to push gold stocks up substantially, and when the price of gold goes down, this has a tendency to push them down substantially. This principle is demonstrated below in two charts comparing the percentage change in the price of gold to the percentage change of the Philadelphia index of certain gold stocks (XAU); the first chart covers the last five years, and the other is a closer look at the last six months or so:

As you can see, a small rise in the price of gold is often matched by a large rise in the XAU index, such as during the time periods marked "B" and "C." Similarly, a small drop in gold, such as during the time period marked "A," is often matched by a large drop in the XAU. In short, if you follow either chart, gold (the dark blue line) is almost always matched by a bigger swing in gold stocks (the pink line) in the same direction.

The above correlation makes sense because the price of gold affects a gold company's profitability by affecting revenues without necessarily affecting costs; it also affects company's balance sheet or book value by changing the value of the company's gold reserves and gold on hand. Small changes in the price of gold can make a big difference - but not always.

Do Gold Stocks Move In Lockstep with Gold?

Despite the above-mentioned obvious connection between gold and gold stocks, the above charts also demonstrate the problem mentioned in the introduction: the extent to which gold affects gold stocks is Not always the same, nor do they always move in "lockstep" with each other. Some movements seem hard to understand. Sometimes a 2% rise in gold is matched by a 5% rise in the XAU while other times it is matched by a 10% rise or more. Even more perplexing, a small rise in the price of gold is sometimes matched by a Flat reaction in gold stocks, or even a Drop in such stocks. For example:

• looking again at the above five-year chart, in the period between "A" to "B, from late 1998 to mid 1999, gold fell substantially but the XAU index of gold stocks did not fall as dramatically as usual, choosing instead to bounce around a lot;
• during period "D," which is from just before, to a few trading days after, September 11, 2001, gold jumped up a good 7% in reaction to those events but the XAU barely matched it (rising only from about 55 to 59 on the index);
• looking at the above six month chart at the time period marked "E" in July 2002, we see gold had a good run up but gold stocks actually went down; and,
• in the period marked "F" later on in 2002, we again see gold going up with gold stocks going down instead.

Do Gold Stocks Anticipate Gold?

If gold stocks don't always move in lockstep with gold, another theory explaining their movement is that gold stocks allegedly anticipate changes in the price of gold. In other words, a rise in the price of gold might not be matched by a rise in gold stocks if the gold stocks have already risen in anticipation of the change. However, this is not reflected in the charts above. Many of the changes in the XAU hardly anticipated the price of gold; they were in close synchronization. They are not always in lockstep, although they are often enough that it's hard to say they anticipate gold.

Thus the theory that gold stocks anticipate gold does not appear to be sound. Moreover, even without looking at any charts, why would the market be loading up on gold stocks without also loading up on gold? As soon as gold stocks made a move, gold would be undervalued and present the better bargain. It doesn't seem to make sense that the market would move gold in precise lockstep with gold stocks on so many occasions and then allow it to fall behind gold stocks on other occasions. This might be so, but the explanation for that theory is unclear.

So how to explain the above-mentioned inconsistencies to the rule that gold stocks should follow gold?

Hedging?

Some say hedging is the explanation. In other words, a big swing up in the price of gold might actually hurt a stock if the company has already pre-sold gold at a lower price, and so on. This does explain certain things, but likely not the quirky reactions to gold mentioned above. After all, other gold indices and gold stocks had similar quirky reactions to gold as did the XAU as shown above. In other words, as you must know from following gold stocks with or without hedging, there are times when the HUI and various individual gold stocks like DROOY, just like the XAU, sometimes go down even though gold goes up, or they go up but not as dramatically as they usually do. Remember the above charts compare the same index to itself; we are not comparing one index to another. If we were trying to understand why the HUI moves more dramatically than the XAU, the different amount of hedging would explain a few things. The question here is why do the XAU, the HUI and other gold stocks all follow gold fairly precisely so often, each to their own degree, but occasionally to a Different degree than usual, sometimes more modestly than usual, sometimes more dramatically than usual, and sometimes even moving in the opposite direction.

Equity Stocks

To a large extent, the explanation is simply the movement of common equity stocks. This is reflected in the next two charts covering the same time periods as the charts above but with the S&P 500 index now included.

Looking at these charts, the movement of the S&P500 (the light blue line) seems to explain many of the above-mentioned inconsistencies in the movement of gold stocks (again the pink line). What's particularly significant is, not that gold stocks were influenced in the opposite direction as the S&P500, but in the SAME direction. For example:

• in the period from about December 1998 to July 1999, recall that gold fell at least 10% but gold stocks did not fall as dramatically as usual. The explanation for the inconsistency may be the movement of equity stocks since they went up during this period, seemingly offsetting the downward effect of gold;
• at period "D" from just before, to a few trading days after September 11, 2001, recall gold went up a good 7% and the XAU barely matched it. Well the S&P was falling about 14% over that same period. It thus again seemingly tended to offset the effect of gold;
• on the six month chart, in the period marked "E" in July 2002, recall gold had a good run up but gold stocks actually fell. The S&P500 was falling too; and,
• in the period marked "F," we again see gold going up but gold stocks fell. Again, the explanation seems to be that the S&500 happened to be falling too.

One can also see that the falling S&P500 in August-September 1998 might have given gold stocks an extra push downward, the period marked on the five year chart as "A"; it might have also given gold stocks an extra boost upward in April-May 2001, the period marked on the chart as "C." Such effects might not otherwise be noticed if we just thought gold stocks were reacting to gold.

On one hand, the above theory runs counter to another common thought that, what's good for equity stocks is bad for a gold, and vice versa. But the charts show a pattern. Moreover, the fact is that gold stocks are not gold, they are still stocks.

First of all, certain equity indices such as the S&P 500 actually include certain gold stocks. For example, Newmont Mining and Freeport-McMoran are currently part of the

S&P500; other gold stocks like Placer Dome and Barrick used to be, but are otherwise still part of the Toronto TSX common index and so on. So if the market is selling such common indices, such gold stocks are also being sold, which would obviously hurt the price of those gold stocks. In addition, those particular gold stocks would, in turn, tend to affect any gold indices of which they are a component, which would in turn affect the other gold stocks which are also components of those gold indices, and so on.

The fact that the movement of common equities has an effect on gold stocks is further explained by recalling that, even apart from the indices, gold stocks are owned side-by-side with equity stocks by individual investors, institutional investors, pension funds and certain broad based or mixed mutual funds. When such investors are confident about the market or otherwise have lots of money to invest in stocks, the money will be spread around and some of it will naturally go into gold stocks; and when investors are pulling out, they are pulling out everywhere, at least to a certain extent. The more they try to maintain a balanced portfolio, the more that movements in equity stocks will affect gold stocks.

This is especially true for mutual funds as they are actually required to maintain a certain balance. So if the stock market goes down, particular mutual funds with a mixed portfolio (and which thus own some gold stocks along side equities) will eventually be required to sell some of those gold stocks in order to maintain the stipulated balance. Again if common equity stocks are going up or down, they are trying to take gold stocks along for the ride, (at least initially until the money gets re-shuffled more specifically; it may be like a stock being removed from an index or a large mutual fund, it falls only to be re-valued by other investors later).

Predicting The Price of Gold Stocks

Based on the above, in trying to understand some of the inconsistent movements of gold stocks, it would seem that they are primarily affected by the price of gold, but they do not always move in lockstep with gold, nor do they necessarily anticipate gold. Instead gold stocks, especially those which are widely-held, receive a secondary influence from changes in common equity stocks.

This is not necessarily a bad thing, as it means widely-held gold stocks are more secure. For example, if price of gold goes down and the S&P 500 goes up, the rise in equity stocks will provide some support for such gold stocks; they won't go down as terribly.

Meanwhile however the main point here is that, if gold goes up and the S&P500 goes down, gold stocks will likely still go up, BUT NOT AS MUCH AS YOU MIGHT EXPECT IF YOU WERE JUST FOLLOWING THE PRICE OF GOLD. To predict gold stocks, the equity market ought to be included too.

It especially helps to overlay the reasons for any predictions in gold price or equity stocks, something like this:

• if you think the U.S. might lower their interest rates again, this would tend to weaken the U.S. dollar, especially if all its trading partners do not lower their rates too; since gold is denominated in U.S. dollars, any weakening of the U.S. dollar would inherently raise the price of gold, which would in turn boost gold stocks. MEANWHILE, the lowering of the rates in U.S. would also tend to help equity stocks, at least in the short term, by drawing a lot of money out of interest-bearing investments into equity stocks; as discussed above, the rise in the equity stocks would give its own boost to gold stocks. So when U.S. interest rates are lowered, gold stocks get a double boost.
• if you think things will get worse in terms of war or terrorism involving the U.S., this would tend to strengthen gold as more investors look to it as a safe haven; this rise in gold would again give a boost to gold stocks. HOWEVER, the war or terrorism would tend to hurt equity stocks as investors would be less-confident about investing, consumers would be less-confident about consuming, and earnings of certain companies such as airlines would suffer even more directly. This drop in equity stocks would, in turn, seemingly hurt gold stocks, thereby tempering their rise. (Recall the mere modest rise in the XAU after the events of September 11, 2001 as discussed above; period "D" on the five year chart.)
• if you think equity stocks might go down because there will be another accounting scandal or another brokerage scandal, such events wouldn't necessarily lead to a rise in the price of gold; so all other things being equal, gold stays level. BUT the drop in equity stocks for such reasons would likely lead to an actual drop in gold stocks. (Again, gold stocks are stocks, so be careful what you wish for in terms of equities going down.)
• if you think equity stocks might go down because earnings are poor, bankruptcies are up, oil is up, unemployment may be up, consumer spending may be dropping, and the recession is around the world, such factors wouldn't necessarily lead to a rise in the price of gold in and of themselves. But combined, they would increase safe-haven investing and tend to weaken the U.S. dollar and thereby lift the price of gold even further. This would again lift gold stocks, although the corresponding drop in equity stocks due to such events would again apparently temper their rise.

The Short-Term Future?

Things get even more complicated when two or more of the above scenarios are predicted at the same time. So, while gold itself may rise, the expected rise in gold stocks may be tempered by a possible drop in equity stocks. It could be quite a crazy ride for gold stocks, so watch the equities, their movement could explain a lot.

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Nothing in this article is intended as investment or professional advice or as a recommendation to buy or sell anything. Each reader is solely responsible for doing their own due diligence or obtaining their own professional advice before making any investment. Any stocks mentioned in this article are for illustration purposes only. All information is taken from sources believed to be correct and complete.

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