The drop in the price of gold bullion has surprised many investors. With the level of monetary stimulus provided by the Federal Reserve and other central banks, many had believed that gold bullion would continue rising. The drop has not only impacted investors in gold bullion, but those in the associated mining stocks as well.
While central banks have been buying gold bullion, investors in exchange-traded funds (ETFs) have been selling a massive amount. The total amount sold by investors in ETFs is approximately 467 metric tons so far this year.
At this point, mining stocks have become quite oversold in relation to the price of gold bullion, according to my analysis. There is the potential that this spread will narrow over time. It is true that gold bullion mining stocks face significant headwinds, specifically higher costs, but it appears much of this is now priced into the stocks. To combat the higher costs with the combination of lower gold bullion prices, many mining stocks are reducing production and cutting costs.
The chart below shows the ratio between an index of gold bullion mining stocks (the Market Vectors Gold Miners) versus the price of gold bullion. This is not an indication on the direction, but a representation of the shift in valuation between mining stocks and gold bullion.
Chart courtesy of www.StockCharts.com
In the chart above, notice the area circled during the last part of 2008. At this point, the gold bullion mining stocks became extremely oversold versus the price of gold bullion itself. Since gold bullion and the mining stocks are closely correlated, a move to either extreme will tend to revert or bounce back.
This is exactly what occurred, as the relationship between gold bullion and the mining stocks then reverted back to a more normalized level by the spring of 2009. Currently, the relationship between gold bullion and the mining stocks is once again becoming extremely stretched. This could potentially be a situation in which mining stocks close the gap between them and gold bullion.
Of course, we are talking about correlation and not direction. This means that this spread can narrow, even if both gold bullion and the index of mining stocks continue dropping. My analysis simply indicates that if they both continue to fall, the index of mining stocks is closer to the bottom and will fall less in comparison to gold bullion. Conversely, they could both move up; if they did, my analysis again indicates that the index of mining stocks could outperform gold bullion.
In the lower portion of the above chart showing the relationship between gold bullion and the mining stocks index is the price chart of the Market Vectors Gold Miners Index (NYSE/GDX) and gold bullion itself. The vertical lines correspond to points of extreme valuation and a more normalized level.
From the fall of 2008 until the spring of 2009, gold bullion went from approximately $700.00 to $1,000 an ounce, a nice return of over 42%. However, mining stocks went from less than $20.00 to approximately $40.00, a return of over 100%.
Note that I am not recommending simply buying mining stocks based on this cursory analysis. I am simply pointing out that this relationship is now at a fairly extreme level and has the possibility of narrowing. As I stated earlier, both gold bullion and the index of mining stocks might continue falling in price, yet this spread could narrow. They could also both begin rising. Perhaps this is an indication that much of the bad news is now priced into gold bullion mining stocks. In my experience, these types of stretched correlations tend to revert to the mean.
This article Mining Stocks Appear Cheap Versus Gold Bullion: Is Now the Time to Buy? was originally published at Investment Contrarians