A Critical Look at the Gold Mining Stocks

May 23, 2005 – In the last letter I drew attention to two charts that presented conflicting pictures. The first chart (last presented in Letter No. 362 but included and updated here) shows that the XAU Index of major gold mining stocks has broken its 4-year uptrend line. Clearly, that’s not a good sign for the mining stocks.

The second chart I used presented the price of the XAU in terms of gold, which is of course the main product of the stocks within the index. For this chart I calculate the price of the XAU in terms of goldgrams.

The goldgram is a gram of gold and the unit of account of my company, GoldMoney.com. There are 31.1034 grams per troy ounce. Therefore, at $417.40 (Friday’s closing price in ounces), one goldgram is equal to $13.42.

I presented in the last letter a monthly chart showing the XAU’s price in terms of goldgrams. Included below is a weekly chart, basis the Friday close.

By this measure, it presently takes approximately, six goldgrams to purchase one XAU. The exact price is determined as follows.

The XAU closed Friday at 80.73, which divided by $13.42 equals 6.016gg per XAU. Based on historical comparisons, this price is very cheap. Consequently, because they are so low priced, the gold mining stocks represent good value.

After presenting these two conflicting pictures in the last letter, I then asked what does it mean? My conclusion was “that gold stocks are cheap, but they may get cheaper still.” That is exactly what happened.

The XAU declined from 83.51 when the last letter was written to Friday’s close of 80.73, a decline of about 3.3%. In fact, the XAU actually rose this past week. Its low on May 16^th was 78.73, a 4.8% decline from the last letter.

I would like to take a closer look at this analysis in order to more clearly resolve the conflict between these two pictures of the gold mining stocks. Upon which point of view should we place the greater credence?

Being by nature a value investor, I’ll let you know right upfront that I put greater stake on the second chart. Value is more important to me than price trends. But even the first chart can be seen as potentially positive.

Looking at this chart, we can see that the 4-year uptrend in the XAU has clearly been broken. The decline over the past few weeks has been relentless, which has caused the XAU to slice through its uptrend line. However, I would like to note a few key points that are potentially very positive.

Most importantly, the XAU has not broken (at least not yet anyway) its May 2004 low of 78. This point is significant. Until 78 is broken, no one can claim that the XAU is in a new long-term downtrend. Indeed, the worst the bears can claim (so far at least) is that the XAU is in a 112-to-78 trading range. By this analysis the XAU is at the bottom of the range, which is bullish for traders and investors alike, assuming of course that support at the bottom of the trading range holds.

Second, note the similarity in the pattern formed over the past several months to what happened after the January 2004 peak. There was a short, sharp drop immediately after the peak, and then a bounce. A sharp drop to 78 then followed this bounce in both of these instances.

This analysis therefore begs the question, is the XAU about to repeat what it did after touching 78 in May 2004 and climb over the next several months back to the top of its trading range at 112? We don’t of course know the answer to this question, but we do know that the gold mining stocks are cheap, which brings me back to the second chart.

In my view, it is not enough to say that the gold stocks are ‘good value’ and ‘very cheap’ when the XAU costs less than 6gg. It’s not enough because it is of course possible that stocks can stay cheap for a while, and not generate any return from price appreciation (I’m excluding dividends from this analysis). We can see on the above chart several instances when the XAU reached and then fell below this 6gg price, the most recent being last week. The important point is what happens after this 6gg price has been achieved. In other words, does it make good investment sense to buy the XAU when it is less than 6gg?

To answer this question, I analyzed the data used to compile the page 1 chart. In the 699 weeks since January 2, 1992, the XAU cost less than 6gg on only 46 weeks, based on the Friday closing price (excluding the two latest weeks in April and May when that price level was achieved). That’s only 6.6% of the time; so clearly, it is rare for the XAU to cost less than 6gg.

That result in itself shows that the XAU represents exceptional value when it costs less than 6gg. In other words, it rarely happens. But the important point is what happens thereafter. I therefore analyzed the results after the XAU was less than 6gg in order to obtain the annual rate of return fifty-two weeks later, and the results are stunning.

In 45 of the 46 instances, the XAU when measured in dollar terms was higher one year later. What’s more the average dollar gain was 21.6%. The only one losing period was -5.1%. The biggest single gain was 52.6%, and equally remarkable was the fact that in 22 of the 46 instances, the 52-week gain was greater than 20%.

These results offer great news for both investors and traders. While past results never guarantee future returns, the former nevertheless know that they are purchasing cheap mining stocks when the XAU is less than 6gg. The latter know that purchasing the gold mining stocks when the XAU is less than 6gg represents a great trading opportunity – buy the mining stocks and sell them one year later because if history continues to repeat the same pattern of returns as it has in the past, they will generate attractive rates of return in 45 of 46 instances.

So in conclusion, regardless whether you are an investor or a trader, I recommend buying the gold mining stocks that are on my list of top picks. Just like past experience suggests, I expect that looking back one year from now it will have proven to be a good and profitable recommendation.