Did GLD And Other Gold ETFs Kill Gold Stocks?

Tyler Durden's picture

In a just released piece by Goldman's Eugene King which explains the firm's justification for why gold will peak at over $1900 in 2012, and which we will discuss in greater detail shortly, Goldman brings up a very interesting point, namely that the ongoing weakness in gold stocks, and the broad decoupling of gold miners from gold price can be attributed to one primary thing: the emergence of synthetic means of expressing a position on the gold market and "bypassing" direct gold cost pass thru exposure in the form of gold stocks. Supposedly this is a good thing, although we would caution that this is potentially a very insidious scheme to allow the world's cash-rish entities (read banks full of those ones and zeros that these days pass for "money") to procure real gold assets at very cheap prices and valuations, even as the broader retail investors proceeds to chase paper gold in the form of "synthetic CDOs" such as GLD (which as we first noted over a week ago may well disappear when the paper claims collapse and suddenly everyone has a claim on the underlying physical), only after the fact realizing they merely used gold as a paper pass thru equivalent. In other words, as the broader population continues to realize that gold is the real safe asset, yet invests in legacy forms of exposure, i.e., paper, the real hard assets: firms that actually extract gold from the ground and process it, remain out on the auction block to be snapped up quietly by all those who want exposure to the primary source of the metal, which they can then throttle at will in order to manipulate the supply side of the equation post facto.

From Goldman which notes one of the primary reasons for gold equity underperformance compared to the spot gold price:

Increased ability to access physical gold: The introduction of ETFs, growth in the transport, storage and insurance industries to support secure warehousing, and development of a liquid, reliable options market meant that investors who previously had to buy equities to gain access to the underlying commodity could now just buy gold directly. Up to 2003/04, gold equities traded at a premium multiple, reflecting the relatively higher demand from mining and gold investors who wanted to access the gold price, but had limited other means to do so. Therefore, even as the amount of capital invested in gold has increased, it is being fractured into multiple channels for investment.

And the chart that speaks a thousand essays:

To be sure, in our day and age of quarterly expectations, gold miners have not been very good at keeping the investor base happy:

But that is to be expected - input costs move far faster than the cost of the underlying product. And when dealing with a secular shift away from paper and to physical exposure, the transition will take a long time. Which begs the question - shouldn't investors be more patient when dealing with gold miners?

Because as the following chart shows, Gold miners have obviously decoupled:

And in the meantime input costs have been rising far faster, which further makes gold equity investors uncomfortable

Goldman summarizes all of this as follows:

In 2H2011, three factors have made this phenomenon all the more noticeable to investors:

  • the speed of the gold price move in 3Q2011 created a lag, as investors needed to see the price sustained at higher levels;
  • a strong belief in a higher gold price meant there was no need for equity exposure to get the upside; and
  • given the economic uncertainty, sector rotation out of equities took place throughout 2011 and gold equities were not immune.

…and the gold multiple premium is going, going, going – we think it’s gone

Looking at the reasons we identify for gold equities lagging the gold price – the rise of ETFs/physical investing options and declining returns – it is hard to imagine a time in the future when these two issues will reverse and investors flock back to gold equities. In our view, it is more likely that returns continue to decline as capital intensity increases, cost inflation comes through and tax/royalty structures enacted by governments around the world extract more from the mining industry. As the gold price has increased, consensus earnings have risen, yet the stocks have underperformed on a relative basis – the only explanation for this is that the stocks have de-rated. Looking only at the stable producers in our coverage, P/E multiples have fallen (Exhibit 3). Production underdelivery and higher capital intensity leading to lower returns are key factors behind this de-rating.

So while we appreciate the fundamental and technical reasons for why gold stocks are underperforming, the sinking feeling we have is that as synthetic exposure in the form of CDOs has surged in the past decade, allowing more and more retail investors to foolishly believe they are invested in "actual gold" (and not paper claims thereof), this has acted as a grand distraction preventing those who want real exposure in the form of controlling the underlying asset from expressing their interest in the right way. Because all it would take is for banks with a glut of credit money to bid up all the gold miners, and thus control the entire physical gold supply chain, at which point the "distraction" of precious metal ETFs can simply go away.

Our advice, as always, stay away from ETFs: they are nothing short of what synthetic CDOs were back during the credit bubble years. And take advantage of relative mispricing between fake (ETF) and real (miner) asset representation.