A Golden Bet: Gold Mining Equities versus Gold

Claude Erb TR

February 17, 2014

Summary If there is a long-run equilibrium between gold and gold mining equities Then the price of gold suggests gold mining equities could rise 100%, and The price of gold mining equities suggests gold could fall 50% A seeming equilibrium relationship may be fundamental or behavioral A fundamental relationship may exist over many different time periods A behavioral relationship may hold over one period or many time periods A seeming long-run equilibrium may be more apparent than real
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Historical Gold and Gold Miner Equity Indices

NYSE ARCA Gold Miners Index

Gold

$2,000
$1,800 $1,600
Monthly Price Correlation 0.84

$1,400
Monthly Return Correlation 0.77

$1,200 Price $1,000 $800 $600 $400 $200 $0

Note: Bloomberg data. If the prices of two assets are highly correlated it is common to test for cointegration. If two asse t prices have an underlying long-term equilibrium relationship then they are often said to be cointegrated. Testing for cointegration is challenging. A pair of assets that perhaps appeared to be cointegrated in the past may not exhibit cointegration in the future. The reason for the change could be fundamental or behavioral.

A Behavioral View What if One Wants to Believe That Gold Drives Gold Miners
NYSE ARCA Gold Miners Index "Gold Predicted" NYSE ARCA Gold Miners Index

$2,000
$1,800 $1,600 $1,400 $1,200 Price $1,000 $800 $600 $400 $200 $0 Actual Expected

Note: Bloomberg data. The red line shows the in-sample regression based fitted value of the NYSE ARCA Gold Miners Index conditional on the price of gold. Observing what seems to be a predictable relationship between two asset prices does not establish whether the seeming relationship is a reflection of some concrete connection between the two assets or whether it is just a reflection of the way that certain market participants active in those assets behaved at a certain time.

A Behavioral View Alternatively, What if One Wants to Believe That Gold Miners Drive Gold
Gold Price NYSE ARCA Gold Miners Index Predicted" Gold Price

$2,000
$1,800 $1,600 $1,400 $1,200 Price $1,000 $800 $600 $400 $200 $0 Expected Actual

Note: Bloomberg data. The red line shows the in-sample regression based fitted value of the price of gold conditional on the NYSE ARCA Gold Miners Index

Whats Cheap? Whats Expensive?

"Gold Mining Equities" Mispricing

Gold Mispricing

$1,000 $800 $600 $400

Price Expensive

$200 $0 -$200 -$400

Cheap -$600 -$800

Note: Bloomberg data. Mispricing is simply a fitted regression residual. For instance, the gold mining equity mispricing is the difference between the actual price of the NYSE ARCA Gold Miners Index and the expected price of the index where the expected price is : Expected Gold Miner Price = intercept + b * the price of gold. The seeming wide mispricing may be a sign of opportunity or of a regime shift

A Few Building Blocks

In order to compare gold miners to gold it makes sense to think about The actual and expected return of gold The actual and expected return of gold miners The valuation of gold The valuation of gold miners

Expected Return Should gold miners match, exceed or underperform the return of gold?

The price of gold reflects the supply and demand of already mined gold
The value of a gold miner reflects the present value of yet to be mined gold

Simplistically, what is the present value of a gold miner if

It has no reserves or its reserves consistently decline

Its cost of production is greater than the price of gold

It goes bankrupt, for whatever reason

Gold has been around for thousands of years, on-going miners have not

Gold Mining Equities: Horrible Performance Compared To Gold and Stocks

NYSE ARCA Gold Miners Index COMEX Gold S&P 500

$7.00
GDM Gold S&P 500 8.98%

$6.00 $5.00 Growth of $1 (Total Return) $4.00 $3.00 $2.00 $1.00 $0.00

Annualized Geometric Return

1.21% 6.31%

Annualized Standard Deviation 37.45% 16.32% 15.12% Time period: 9/1993 to 1/2014

Note: Bloomberg data. The backfilled inception date for the NYSE ARCA Gold Miners Index (GDM) is September 1993. The Market Vectors Gold Miners ETF (GDX) was launched in May of 2006. The since September 2006 returns for GDM and GDX are similar. How real the pre-2006 returns are is problematic. There are other gold miner indices: the NYSE ARCA Gold Bugs index (HUI) and the Philadelphia Gold and Silver index (XAU). Options have been traded on the XAU since 9 the 1980s. HUI is seemingly just an index. GDM may not be the best index but it is investable.

Gold Mining Equities: Poor Index and Index Constituent Performance

NYSE ARCA Gold Miners Index Newmont Barrick

$3.50
GDM Newmont Barrick

$3.00 $2.50 Growth of $1 (Total Return) $2.00 $1.50 $1.00 $0.50 $0.00

Annualized Geometric Return

1.21%

-1.66% 40.23%

0.25% 37.36%

Annualized Standard Deviation 37.45% Time period: 9/1993 to 1/2014

Note: Bloomberg data. The backfilled inception date for the NYSE ARCA Gold Miners Index (GDM) is September 1993. Two of the largest constituents of the Market Vectors Gold Miners ETF (GDX) are Newmont Mining (NEM) and Barrick Gold (ABX). The since September 1993 total returns for NEM and ABX are similar to those of the NYSE ARCA Gold Miners Index (GDM). 10

What Has Driven The Returns of Gold Mining Equities?

Historically, gold mining stocks have supposedly been a levered play on gold A high gold beta With a high cost of carry (negative regression intercept) The impact of traditional equity risk factors has been slight, at best No clear way to distinguish between fundamental and behavioral influences
Coefficients Intercept (Annualized) Gold Stock Market SMB HML Momentum -3.21% 0.71% 1.76 0.55 -6.55% 1.74 0.46 -2.03% -8.48% 1.73 0.55 0.48 0.48 0.29 0.28 0.32 0.14 0.05 t Stat -0.60 0.09 -1.27 -0.24 -1.64 18.76 19.40 19.34 3.62 4.92 3.30 4.63 2.23 2.14 1.23 2.21 1.01 0.59

High gold beta

Adjusted R Square Time period: 9/93 to 12/13

59.18% 4.76%

62.76%

6.16% 63.45%

Note: Gold and GDM data from Bloomberg and Fama-French factors from Ken Frenchs website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Monthly return regression. DiBartolomeos(1993) piece on the return drivers of gold mining stocks also found few influences other than gold. Tufano (1998) noted that the gold betas he observed fluctuated because mining companies varied their gold hedging policies over time.

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Gold Miner Gold Beta Declines With The Investment Time Horizon

2.00 1.80 1.60 Gold Miner Gold Beta (September 1993 to January 2014) 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 One Month 1.76

Gold may be the major driver of gold miner returns Gold miner gold beta seems to decline as the investment horizon increases Apparently gold miners may not be a levered gold play, at long horizons 1.49

1.09

One Year

Five Years

Note: Bloomberg data. Both the one year and the five year gold beta regression coefficients use overlapping return data. Th e data do not provide any information on the true underlying gold betas at any time horizon. The data provide a sense of what the estimated beta s were during a given time period. Future time periods could, of course, be different from the past. The possibility of gold betas declining with the investment horizon has multiple inconclusive explanations. Regressions of NYSE ARCA Gold Miners Index excess returns on COMEX gold excess returns.

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The Golden Constant

$2,000 $1,800 COMEX Gold Price (January 1975 to December 2013) $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 0 50 100 150 200 250 U.S. CPI Index (January 1975 to December 2013) The golden constant is an assertion that the price of gold keeps up with inflation In the long-run It can also be restated that the expected real price of gold is constant And the expected return of gold is simply the expected rate of inflation

Note: Bloomberg data. Monthly observations.

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The Golden Constant The Real Price of Gold is Like the Shiller CAPE Ratio for Gold
Gold Price/US CPI Index Average

10
9 8 Real Price of Gold (Gold Price/US CPI Index) 7 6 Golden Dilemma

5
4 3 2 1 0

Expensive

Cheap

Note: Bloomberg data. Jastram wrote about the golden constant, the idea that the real purchasing power of gold has been co nstant over some undefined long time period. Erb and Harvey (2012a) presented a short-term version of the real price of gold, the ratio of the nominal gold price divided by the US CPI index. Erb and Harvey (2012b) found that this measure of the real price of gold was essentially the same everywhere. Erb and Harvey suggested that the real price of gold could be viewed as the price-earnings ratio of gold (where the level of an inflation index was substituted for earnings).

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The Real Price of Gold and Subsequent Ten Year Real Gold Returns (January 1975 to January 2014)
20% Annualized Next Ten Year Real Gold Price Return 15% 10% 5% 0% -5% -10% -15% 0 1 2 3 5 6 Real Price of Gold (Gold Price/US CPI Index) 4 7 8 9 10

A low real gold price has been followed by high real gold returns

A high real gold price has been followed by low real gold returns

Note: Bloomberg data. The x-axis shows the real price of gold, defined as the price of gold divided by the level of the US CPI index. The y-axis shows the subsequent annualized ten year real return for the price of gold. For instance, take the real price of gold in January 1975 and match it with the real gold return for the following ten years, from January 1975 to January 1985

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Ratio Analysis and Statistical Equilibrium Ratios are common and may or may not count what counts For instance, Shillers CAPE ratio or the real price of gold Ratios are often used to frame expectations of a statistical equilibrium For instance, the fair value of the stock market or gold Belief in ratios and statistical equilibrium is an act of faith, not an act of fact

A challenge Ed Leamer: We are pattern-seeking, story-telling animals Howard Marks: its not what you buy; its what you pay for it Julius Caesar: Men willingly believe what they want to believe
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Numerous Gold Miner Price/Gold Price Ratio References Many articles that seem to assume an equilibrium miner-gold relationship Often expressed as a Gold Miner/Gold Price Ratio
Gold Stocks, the Gold Price and Market Timing The Adjusted Gold/XAU Ratio as an Indicator of Forward Returns for Gold Stocks Gold/XAU Ratio Signals Market Froth Four simple indicators for monitoring the condition of the precious metals markets

Which Index is the Best to Use: the HUI, XAU or the GDX?
This Indicator Hasnt Been Wrong in 27 Years And Right Now its Screaming Buy!

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Wasting Asset NYSE ARCA Gold Miners Index/Gold Price Ratio

NYSE Gold Miners Index/Gold Price

2.50

2.00

Historically, the passage of time has been associated with a declining price ratio This could reflect the possibility that gold mines are wasting assets Whatever the true potential of a mine, its potential does not increase with time Rather it declines with time

Price Ratio

1.50

1.00

0.50

Price Ratio = -8E-05 x Time + 4.2838 R = 0.2302

0.00

Note: Bloomberg data. Regress the price ratio (NYSE ARCA Gold Miners Index/Gold Price Ratio) on time. The trend line declines over time. There is no obvious ex-ante narrative for this downward sloping trend line. However, ex post, it is possible to imagine that gold mines are wasting assets.

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Historically, An Inverse Relationship Between Future Relative Returns and the Current Price Ratio
30% 25% Annualized Next Five Year Relative Return GDM/Gold Return 20% 15% Current Ratio 0.52 Next Five Year Relative Return = -0.2496 x GDM/Gold Price Ratio + 0.3211 R = 0.6546

10%
5% 0% -5% -10% High Price Ratio Low Relative Return Low Price Ratio High Relative Return

-15%
-20% 0.00 0.50 1.00 1.50 NYSE ARCA Gold Miners Index/Gold Price Ratio 2.00 2.50

Note: Bloomberg data. The X axis shows values of the NYSE ARCA Gold Miners Index/Gold Price Ratio from September 1993 to January 2009. The Y axis displays the annualized rate of return for the price ratio over the next five years. So, for instance, the first data pair shows the price ratio for September 1993 19 and the annualized five year price ratio return from September 1993 to September 1998.

Gold Miner Index Price-To-Book Ratio And Miner/Gold Ratio

NYSE Arca Gold Miners Index

Current

4.50
GDM Price-To-Book Ratio (Monthly Observations, 10/04 to 1/14) 4.00 3.50 3.00 2.50 2.00 1.50 1.00

0.50
0.00 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 GDM Index/Gold Price Ratio (Monthly Observations, 10/04 to 1/14) 1.60 1.80 2.00

Note: Bloomberg data.

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If Gold Mining Equities Are So Attractive, Why The Aggressive Selling?

Note: Bloomberg data. There is, of course, a nuance to the idea that there was heavy selling of gold miners. By definition there must have also been heavy buying of the shares being sold. So, the sellers possibly lost patience with their investment or were convinced that things had fundamentally changed for the worse. The buyers, rightly or wrongly, apparently did not share the sentiment of the sellers.

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Conclusion

It is possible to entertain the idea that inflation drives the price of gold It is possible there is an equilibrium gold and gold mining equities relationship It is possible to believe in the idea but there is no way to prove the belief However, given a willingness to assume such a relationship exists then The price of gold may be expensive The price of gold mining equities may be cheap

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References
Ap Gwilym, Owain, Andrew Clare, James Seaton and Stephen Thomas. 2010. "Gold Stocks, the Gold Price and Market Timing", Cass Business School working paper Asness, Clifford S. 2014. My Top 10 Peeves, Financial Analysts Journal, vol. 70, no. 1(January/February): 22 -30 Avellaneda, Marco and Jeong-Hyun Lee. 2009. Statistical Arbitrage in the U.S. Equities Market, working paper Campbell, John Y., Robert J. Shiller. 1998. Valuation Ratios and the Long-Run Stock Market Outlook, Journal of Portfolio Management, vol. 24, no. 2 (Winter): 1126 DiBartolomeo , Dan. 1993. Behavior of Gold Mining Equities: Gold Prices and Other Influences, Northfield research Do, Binh and Robert Faff. 2006. Does Simple Pairs Trading Still Work, Financial Analysts Journal, vol. 66, no. 4 (July/August): 83-95 Erb, Claude B. 2014. Gold, the 'Fear Trade' and Mr. Market, SSRN working paper Erb, Claude B. and Campbell R. Harvey. 2012. An Impressionistic View of the Real Price of Gold Around the World, SSRN working paper Erb, Claude B. and Campbell R. Harvey. 2012. The Golden Dilemma, SSRN working paper Fama, Eugene F., Kenneth R. French. 1988. Dividend yields and expected stock returns, Journal of Financial Economics, 22: 325. Ferson, Wayne E., Sergei Sarkissian and Timothy Simin. 2003. "Is Stock Return Predictability Spurious?, Journal of Investment Management vol. 1, no. 3: 10-19 Gatev, Evan, William N. Goetzmann and K. Geert Rouwenhorst. 2006. Pairs Trading: Performance of a Relative Value Arbitrage Rule, SSRN working paper

Hillier, David, Paul Draper and Robert Faff. 2006. Do Precious Metals Shine? An Investment Perspective , Financial Analysts Journal, vol. 62, no. 2 (March/April): 99-106
Leamer, Edward E. 2008. Macroeconomic Patterns and Stories. Springer Marks, Howard. 2011. The Most Important Thing: Uncommon Sense for the Thoughtful Investor . Columbia University Press Tufano, Peter. 1998. "The Determinants of Stock Price Exposure: Financial Engineering and the Gold Mining Industry", Journal of Finance, vol. 53, no. 3: 1015-1052 Valkanov, Rosen. 2003. Long-Horizon Regressions: Theoretical Results and Applications, Journal of Financial Economics, 68: 201-232

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Additional Materials

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Gold Mining Equity/Gold Price Metric Many references to a ratio of a gold mining stock index price/gold price Justification seems to be someone else said it works Generally three versions of this metric
NYSE ARCA Gold Miners Index/Gold Price Ratio (GDM/Gold) Philadelphia Gold and Silver Index/Gold Price Ratio (XAU/Gold) NYSE ARCA Gold BUGS Index/Gold Price (HUI/Gold)

A low ratio is usually taken to mean that gold mining equities are cheap Why not take it to mean gold is expensive?

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Gold and GDM Gold Miner Index

Gold

NYSE Arca Gold Miners Ix

$2,000
$1,800 $1,600 $1,400 Gold Price $1,200

$2,000
$1,800 $1,600 $1,400 Index Price 26 $1,200

$1,000
$800 $600 $400 $200 $0

$1,000
$800 $600 $400 $200 $0

Note: Bloomberg data

An Alternative Gold Miner Index

Gold

PHILADELPHIA GOLD & SILVER INDX

$2,000
$1,800 $1,600 $1,400

$250

$200

$1,000
$800 $600 $400 $200 $0 $0 $50 $100

Note: Bloomberg data

Index Price 27

Gold Price

$1,200

$150

An Alternative Gold Miner Index

Gold

NYSE Arca Gold BUGS

$2,000
$1,800 $1,600 $1,400 Gold Price $1,200

$700
$600 $500 $400 $300 $200 $100 $0 Index Price 28

$1,000
$800 $600 $400 $200 $0

Note: Bloomberg data

Somewhat Different Gold Miner Index Price Performance

NYSE Arca Gold BUGS

PHILA GOLD & SILVER INDX

NYSE Arca Gold Miners Ix

$4
$4 Price Indexed to December 1994 Price $3 $3 $2 $2 $1 $1 $0

Note: Bloomberg data

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Gold Miner Index Price-To-Book Ratios And Miner/Gold Ratio

PHILA GOLD & SILVER INDX

NYSE Arca Gold BUGS

NYSE Arca Gold Miners Ix

4.50
Price-To-Book Ratio (Monthly Observations, 10/04 to 1/14) 4.00 3.50 3.00 2.50 2.00 1.50 1.00

0.50
0.00 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 GDM Index/Gold Price Ratio (Monthly Observations, 10/04 to 1/14) 1.60 1.80 2.00

Note: Bloomberg data

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Philadelphia Gold and Silver Index (XAU)/Gold Price Ratio

XAU /Gold Price

Average

Time Trend

0.40
0.35 0.30 0.25 Price Ratio

0.20
0.15 0.10 0.05 0.00

Note: Bloomberg data

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NYSE ARCA Gold BUGS (HUI)/Gold Price Ratio

HUI/Gold Price Ratio

Average

Time Trend

0.70
0.60 0.50 Price Ratio 0.40 0.30 0.20 0.10 0.00

Note: Bloomberg data

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How Similar or Dissimilar Have the Price Ratios Been?

XAU/Gold

HUI/Gold

GDM/Gold

0.70
0.60 XAU and HUI Price Ratios 0.50

If an index is cheap, the cheapness is only exploitable if the index is tradable GDM is associated with a tradable ETF (GDX) XAU has traded options HUI is seemingly just an index

2.50

2.00

HUI/Gold 0.40 0.30 GDM/Gold 0.20 0.10 0.00 XAU/Gold

1.50

1.00

0.50

0.00

Note: Bloomberg data

GDM Price Ratio 33