All that glitters is gold - if you can dig it

When the market recovers, producers of the precious metal should prove to be worth their weight. By David Potts.

By InvestSMART · 5 Aug 2012

By InvestSMART ·
5 Aug 2012

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When the market recovers, producers of the precious metal should prove to be worth their weight. By David Potts.

Imagine my disappointment when I learnt that Olympic gold medals aren't made of gold. I mean, why bother?

They're made mostly of silver, in case you're interested, but the whole affair did get me wondering whether the gold price might be running out of puff.

Buying bullion would have been about the best investment you could have made last year, at least if you'd bought early on, yet goldmining shares were the worst.

You can never accuse the market of predictability. It seems the higher gold goes, the less the sharemarket believes it will stay there.

But gold stocks are also being dragged down with everything else, not that they've helped their cause in a market desperate for income - or for anything, really - due to an unfortunate tendency to pay as little in dividends as possible, and preferably not at all.

The three-year rush into gold has been founded on the fear of inflation taking off, despite there being neither hide nor hair of it.

On the contrary, if you want a good fright, try deflation. That's what's keeping central banks up at night. Take the US, which has been pumping money into an economy where the official interest rate is almost zero, so it's just about giving it away.

The reason there's no inflation is that the big banks are just hoarding the money. Well, it's really the central bank crediting their balance sheets - a sort of Bpay in reverse - due to having nobody to lend it to.

Those central bank credits, by the way, can be just as quickly reversed when the time comes. Mind you, printing money devalues the US dollar, so naturally anything priced in it rises, along with other currencies. Since the price of gold rising in US dollars but falling locally cancels out, the currency shouldn't be a problem for gold stocks. Rather, it all boils down to how much they can dig up.

But they sure are helped by the fact that the price has about doubled in three years, which puts it way above the average cost of mining it.

That's why the goldminers should be among the first to take off when the market comes to its senses.

But hang on. Wouldn't a market recovery mean that confidence has broken out, in which case the panic run into gold would stop or, indeed, reverse? Surely, then, the gold price would fall.

Maybe, though the shaky state of the euro and Europe's banks suggests its price will stay elevated for years.

Don't forget the US dollar would also recover when money flowed into Wall Street and the country's interest rates rose, in which case our dollar would drop and the Australian gold price would rise.

Besides, the miners are already priced for a substantial drop in the gold price.

That's why I figure digging for gold will be better than holding it.

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Frequently Asked Questions about this Article…

Should everyday investors buy gold bullion or gold mining shares right now?

The article notes bullion was one of the best investments last year if bought early, while gold mining shares were among the worst. Bullion offers direct exposure to the gold price, whereas gold mining shares are affected by the broader sharemarket (and tend to pay little or no dividends). The author suggests miners could outperform when the market recovers because the gold price is well above average mining costs — but cautions this depends on market confidence and currency moves.

Why did the gold price rise but gold mining stocks fall?

According to the article, gold bullion rose — roughly doubling over three years — while gold mining shares fell because they were dragged down with the rest of the sharemarket and are penalised by investors seeking income (miners pay minimal dividends). The market also seems sceptical that the higher gold price will persist, so miners did not benefit proportionally.

Are gold mining stocks likely to rebound when the market recovers?

The article argues goldminers should be among the first to take off when markets regain their senses because the current gold price sits well above the average cost of mining. However, it also warns a market recovery could reduce the panic-driven demand for gold and potentially pressure the gold price, so the rebound is not guaranteed.

How do central bank actions and inflation or deflation affect the gold price?

The piece explains central banks have been pumping money into economies with near-zero interest rates, which can devalue currencies and push up dollar-priced assets like gold. But the bigger worry for central banks is deflation, not runaway inflation. Money being hoarded by big banks and limited lending can mute inflation despite the stimulus, making the gold-price outlook dependent on future monetary and lending behaviour.

Will a stronger US dollar or rising interest rates hurt the price of gold?

The article says a recovering US dollar and rising US interest rates would likely result from money flowing back into Wall Street. That could reduce dollar-priced gold, but in Australia it could cause the local dollar to fall and the Australian gold price to rise. So currency moves and rate changes can have mixed effects on gold depending on which currency you measure it in.

Do gold mining companies pay good dividends for income-seeking investors?

No — the article points out goldminers have an unfortunate tendency to pay as little in dividends as possible, and often none at all, which makes them less attractive to investors looking for income.

How important are mining costs when evaluating gold stocks?

Very important. The article highlights that the gold price has roughly doubled in three years and now sits well above the average cost of mining, which improves margins for producers. That cost-to-price gap is a key reason miners might outperform if market sentiment improves.

What risks should everyday investors consider before investing in gold or gold stocks?

The article suggests several risks: broad sharemarket weakness can drag down gold stocks even when bullion is rising; miners often pay little or no dividends; the gold price could fall if market confidence returns and the panic into gold reverses; currency fluctuations (USD and AUD) also change local gold returns; and central bank actions or a shift between inflation and deflation can alter gold’s appeal.