It looks like we’re finally nearing “put up or shut up” time for gold stocks. Any consumer of the financial media knows the case in favor of the sector: The price of gold has risen sharply this year, meaning that miners’ profit margins will rise and the stocks should move sharply higher. The story seems like a no-brainer on paper, yet the Market Vectors Gold Miners ETF (NYSE:GDX) is just barely in positive territory year-to-date, a time in which the SPDR Gold Trust (NYSE:GLD) has surged over 25%.
It’s true that part of this shortfall comes from the presence of silver miners in GDX. Still, only a handful of the largest gold stocks — most notably Yamana Gold (NYSE:AUY) and Randgold Resources (NASDAQ:GOLD) — have provided a better return than simply owning physical gold through GLD.
The gap between the gold price and performance of mining stocks has made the call for mean reversion a popular one — but this trade may not be as easy as it looks. As Simon Maierhofer pointed out in his article last week, it’s equally likely that the gap could close because of a correction in gold rather than a rally in mining stocks. Wells Fargo sounded a similar alarm Tuesday when it issued a report stating gold is in a “bubble that is poised to burst.”
Despite the near-universal positive sentiment toward gold stocks, a lot still has to happen for the sector to stage the rally that the pundits have been predicting throughout 2011. Since there is an extremely low likelihood of gold stocks moving higher as the price of the metal falls, a prediction for mean reversion also is a bet that gold prices will keep climbing. This might prove a tall order given the nearly universal positive investor sentiment, the recent stabilization of the U.S. dollar and the prospect of further increases in margin requirements. A breakout in mining stocks also will require stable energy costs and a steady performance for the broader equity market. A loss of any of these pillars of support will make the long-anticipated mean reversion trade a much more difficult prospect.
Further, the trend of underperformance for gold stocks is fairly recent compared with their substantial performance advantage over the metal since both touched bottom in November 2008. In other words, it’s all how you draw the chart:
For argument’s sake, let’s assume the rally in gold does in fact continue. Even in this scenario, the onus is on the gold-stock bulls to answer the question, “Why now?” as it relates to outperformance for mining shares. The current environment couldn’t be better, with the gold price rocketing, energy costs declining and hedging policies long abandoned by the major producers. With the positive story so well known, it seems as though gold stocks should have taken off already — yet most are well below their year-to-date highs. The underperformance of gold stocks might therefore represent a warning — rather than a buy signal — for those considering a long position in GDX or of one the larger producers, such as Newmont Mining (NYSE:NEM) or Barrick Gold (NYSE:ABX).
The clue as to the future direction of gold stocks probably lies in the charts. GDX has traded in a range of $52 to $64 for almost 10 months now. At $60.74, the ETF is 5.4% away from a breakout and 14.4% from breaking down. Although GDX is closer to its upside boundary, the chart also has some bearish elements to it — most notably, a series of lower highs and a 50-day moving average currently below the 200-day. Although the breakout scenario is the popular prediction, the chart presents a more neutral picture.
To be clear: This discussion isn’t a recommendation to establish short positions in the gold miners. The proximity of the $64 breakout point for GDX makes betting against this sector a dangerous proposition right now. Instead, consider this a warning to take the bullish predictions with a substantial grain of salt. And watch the 200-day moving average for GDX, currently at $58.02, very closely. Another breach of this level — particularly one that is accompanied by weakness in bullion — could indicate that the gold-stock story has run out of steam.
