Gold is Moving, Time for the Miners

In our previous paper (“Gold Ascending”, May 2024) we discussed the rising gold price, and the role of central bank purchases, which at the margin are material and help to explain the apparently sudden upward adjustment in price. Our conclusion was that central banks are having such an effect not only because of their size but also because they are buying for policy reasons and not trading profits, which motivates private sector buyers. The result is the presence of large buyers who may persist even despite rising prices. This appears to be occurring:

An implied subject of interest to investors is a related question of how this is likely to affect the share prices of gold mining firms. Those have been relegated to virtually dead last in the stock market in recent years, for multiple reasons, one of which is the very strong business models of the leaders in the tech sector.

But it is not only the broad stock market that has made the gold mining stocks look bad, it is somewhat surprisingly, gold itself. In the next chart we show the performance of the HUI Index, which is composed of the shares of gold mining firms. We go back some decades to put this in perspective:

This rather astonishing behavior needs historical explanation. Until the development of exchange traded funds (ETFs) that could own physical gold, mining stocks were the only way for most investors to have access to precious metals. The result was that any such demand was focused on the rather small sector of the stock market that was available, and thus inflated valuations. Introduction of the ETFs put an end to that.

This suggests another reason to own the mining stocks—their undervaluation measured against their own product to an extent that appears to have reached an extreme. The index itself has in fact risen modestly over the time period, while gold (the denominator in the ratio) itself is up almost sixfold.

There are other favorable factors for the miners as well. The first, of course, is that the gold price has taken wing, as the first chart shows. After grinding northward for a period time, the price broke through $2,000 quite decisively. At the same time, the rapid cost inflation that characterized many businesses during the Covid epidemic has receded. A common gauge of commodity prices is the Commodity Research Bureau price index, which is one way of measuring changes in the operating costs of mining. The next chart is that index relative to the gold price, which is an indication of a rise or fall in the profitability of mining:

This relationship is behaving reasonably well, it would appear. The sharp improvement at the beginning of the Covid episode was due not only to the gold price increase, but also to a significant drop in the CRB index as demand for many goods declined. The current improvement in profitability may be more sustainable as the supply chain issues are being addressed.

Another component of the price behavior of gold and gold miners is the demand from important participants in the gold market. China is an important participant . Their activity is sometimes opaque, but in the last two years it does appear that their presence has been a factor in gold’s performance. Chart 5 shows the activity in recent years:

This helps explain the recent rise in the price, but also suggests the reason for the disconnect between gold and the miners’ share prices. China is buying the metal, but not shares of the mining firms (certainly not those in the west, which characterize the HUI index). A similar disconnect has appeared in the performance of gold and the gold ETFs, which have not seen investment inflows in this recent period, which is unusual since funds usually flow into the ETFs when prices are rising. Are flows going into the gold ETF? Or just not at all to the ETFs?

This is therefore an unusual period if we consider historical behavior, but how long it persists is doubtful. After a long period in which the gold mining stocks have been regarded poorly, we may be approaching a period of recovery, particularly if gold prices remain elevated or even rise further. It is fair to ask why this should occur, and the answer is likely to be an end to the Federal Reserve’s program of higher interest rates that began in March 2022. It is already aged, it would seem, but years ago Milton Friedman observed that monetary policy acts upon the economy with “long and variable lags”. A reversal is likely, and sometimes it pays to wait.