I am not now, nor have i ever been a gold bull.
I have never been convinced that gold provides insurance against economic Armageddon. If the global economy collapses under the weight of a currency crisis (the collapse of paper currency is the latest fear-mongering strategy intended to boost gold bullion’s value), my preference would be to own a farm. Better to have access to food than to “precious” metals.
Investors may not understand the implications of a full-blown currency crisis. Gold is not likely to become a medium of exchange simply because currencies are devalued. Bullion prices would rise but that is a reflection that it takes more dollars to buy the same quantity of goods during the crisis. In other words, consumables and hard assets would increase in value for the same reason!
There is a case to be made that the gold price will rise in an inflationary environment. Witness its performance in the late ’70s and early ’80s. Unfortunately for gold bulls, there is no inflation now, arguably because “transitory factors” – such as the fallout from lower oil prices – have offset higher costs for food and lodging. The thinking is that stable oil prices and ultra-low unemployment will lead eventually to higher prices across the board. Despite all recent evidence to the contrary.
The reality is that trying to predict the price of gold is like trying to forecast the path of an oncoming tornado. You would think – given the global debt tsunami, zero to negative short-term interest rates, instability among the worlds’ largest banks and mounting economic uncertainties – that gold would shine. Yet, until this year, gold bullion and gold stocks have been in a five-year bear market, as witnessed by iShares S&P/TSX Global Gold Index ETF (trading in mid-March at $11.12 a share). You could argue that even with this ETF’s recent surge, its price is bumping up against resistance to a $12 price that goes back three years.
Biases aside, a case can be made for holding a small amount of gold as a diversifier in client portfolios. If that’s the goal, I prefer using shares in gold miners because, in a perverted way, they think much like I do about the future value of their bullion stockpile. Mining companies sell gold at the margin rather than holding it as insurance.
The appeal of gold stocks is that they tend to be non-correlated to other sectors of the economy. As such, gold stocks can be excellent diversifiers within a portfolio if you are mindful of the risks. And there are many!
A higher gold price does not always translate into above-average performance of miners’ share prices. Higher bullion prices mean higher revenue, but that can also mean higher costs. Not to mention flooding, war and labour unrest, which can render mines useless.
Hedging also is a risk. If the mining company is hedging the price of gold using forward contracts, that can be very damaging in a rising gold market. The point: when it comes to gold stocks, timing is everything.
As for timing, there are some positive fundamentals unrelated to the crisis insurance thesis. Margins for gold-mining firms are improving and there is some evidence that drilling efficiencies may sustain better margins despite a volatile bullion price.
There also appears to be a supply/demand deficit caused by a pickup in demand for jewelry, mainly from India. Demand for jewelry constitutes 55% of the 4,200 tons of global supply. Add to the mix the aforementioned instability of some large European banks and negative interest rates, and we have the makings of a melting pot that could support bullion prices over the near term.
The price action looks decent. Without trying to find bottoms, the best we can do for clients is work with what the market is giving us – in this case, a technical reversal, which the market performance in January implies.
The other consideration is the volatility of gold stocks, which translates into above-average premiums on related options. If you buy into the bull scenario for gold, writing covered calls on gold stocks can provide portfolio diversification and yield decent returns.
Consider Goldcorp Inc. (trading in mid-March at $20.88 a share). When Goldcorp was at $20.88, the Goldcorp July 22 calls were trading at $2 a share. If you buy the shares and write the July 22 calls, the return, if exercised, is 14.9%. If Goldcorp remains unchanged until the July expiration, the return is 9.6%, not counting the monthly dividend. As for downside protection, the sale of the call option reduces your cost base to $19.88 a share. That’s important, given the inherent volatility of gold stocks.
Other examples include Agnico Eagle Mines Ltd. (symbol: AEM; trading in mid-March at $45.75 a share). At the time of writing, the AEM June 48 calls were trading at $3.50 a share. Buying the stock and writing the June 48 calls yields a return, if exercised, of 12.6%. The return, if unchanged, is 7.6%; the downside break-even point is $42.25 a share for AEM.
Gold bulls generally do not support any strategy that limits the potential upside. And, for firm believers in the crisis insurance argument, covered calls would be counterintuitive.
However, history offers a different opinion. Given that volatility within the gold sector consistently ranks in the top quartile of all stocks, plus the fact that gold stocks tend to be range-bound securities, covered calls have beaten a buy-and-hold strategy by a wide margin over long periods of time. That has been the case over the last three years.
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