MorningWord 12/4/13: All That Glitters is Not Gold, $GDX, $GLD

by Enis December 4, 2013 8:23 am • Commentary

MorningWord 12/4/13:  GDX hit its lowest level since November 2008 yesterday, and is now down 69% from its peak in September 2011.  Quite a picture of wealth destruction.

While the descent in the gold miners has of course been accompanied by precious metals weakness, precious metals prices have held up better than the stocks.  Gold is down 37% while silver is down 62% from their 2011 peaks.

Perhaps most surprising has been the GDX / GLD ratio overall, which has made new all-time lows:

GDX/GLD ratio chart, Courtesy of Bloomberg
GDX/GLD ratio chart, Courtesy of Bloomberg

Back in November 2008, when GDX was last trading around $20, GLD was trading around $70, 40% lower than where gold is trading today.

I did touch on one reason for the underperformance of GDX in a detailed post in early July, noting:

The real risk in the sector lies with those companies that have near-term liquidity risk as gold prices decline.  ABX is one such large cap name, but many of the small cap names (and the majority of the names in the GDXJ ETF) are of that nature.  If gold prices stay here, many will go out of business.

Not all precious metals miners are created equal.  Among the big three, GG and NEM both look investable, particularly if gold prices do actually turn higher, but even if they just stabilize and don’t go lower.  I am not sure if that happens or not, but for a short-term trade, they might be of interest as trading vehicles.

Gold miners have broadly underperformed gold because many of them took on high-cost projects with leveraged financing, leaving them doubly exposed to a decline in gold prices.  In the case of the junior gold miners represented by GDXJ, the risk is even greater given their riskier balance sheets and more speculative projects.  As to be expected, GDXJ has been an even worse investment than GDX over the past few years, down around 85% from its peak.

However, there are companies with better balance sheets and cost structures, such as GG and NEM which I citied above.  While precious metals prices have declined, many of the companies own valuable assets that will still yield cash flow over the long run.  Moreover, as the less competitive projects are forced off of the market (junior miners go bankrupt, other companies shelve projects), supply will of course lessen, and the remaining miners will have a healthier market in which to compete.

Some bargains are being offered in the current selloff in the sector (as hard as that may be to believe at the moment).  GG is at the top of my list given the low cost of its outstanding mines and its obvious staying power.  GDX is still the best proxy for those wanting the simple macro exposure.  Most importantly, though, is whether gold is close to a near term bottom, or has more room to move lower.

On that front, sentiment is very negative, the technical situation is better than it was at the low of the year in late June, and potential end-of-year rebalancing could lead to some buying as well after the major underperformance.  While catching a falling knife is risky business, we’re looking at options structures on GDX that can make the exercise much less risky, and set up for a bounce in the next few months.