Forward Returns for Gold Stocks
October 4, 2011
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While the recent bull market took gold prices to new highs, the prices of gold-mining companies lagged. Some claim those companies are now drastically undervalued, and we can investigate that claim by examining the relationship between gold and gold-mining prices.
The prices of gold and the shares of companies who mine it should track one another over time. One should therefore be able to predict the returns for XAU, a capitalization-weighted index consisting of 16 precious-metal mining companies, using a trend-adjusted gold/XAU ratio and the corresponding historic returns for XAU that followed the ratio. Such an analysis shows that XAU is now significantly undervalued and should be about 50% higher over the next eight months.
Trend of the gold stocks relative to gold
The longest data set available as a proxy for gold stocks is the weekly Barron’s Gold Mining Index (BGMI), which dates back to 1939. Figure 1 shows this series along with the gold price, and the ratio of the two. The gold/BGMI ratio was scaled by a factor of 7.0 (the 1984-87 average of the BGMI-to-XAU ratio) to make it a proxy for the gold/XAU ratio before December 1983, the inception date of the XAU series.
From 1940 to 1968, when the price of gold was fixed at $35 per ounce, the trendline of the gold/BGMI ratio sloped downwards, indicating that gold stocks gained in value relative to gold over this time. Afterwards, starting in 1971, the gold price floated, and it began increasing as soon as the dollar was no longer directly convertible into gold. From then on, the trendline of this ratio sloped upwards, indicating that gold stocks lost value relative to gold over time.
In order to make the current ratio directly comparable to the historic ratios, one has to adjust for these trends by increasing the ratio’s values from 1968 to 2011, and decreasing them prior to 1968. See Appendix A for the trend-adjusted gold/BGMI ratio and results derived from it for the period 1940 to 1965.
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