Left For Dead: Gold Miners May Finally Be Worth Buying

 

The best investments are often the ones that are difficult to make. Like makes you nauseous when you're thinking about it. I grimace, every time I see someone use the old "buy blood in the streets" cliche when a stock falls 10 or 20 percent. That's nothing. If you're going to talk about buying after a crash, wait until the sector in question actually crashes. As bottom-callers in oil, natural gas, and their related equities have seen recently, things can keep dropping a lot longer than you'd anticipate.

With that in mind, it's time to think about one sector for which the word hatred fails to express the sheer level of investor disgust. That sector would, of course, be gold miners, which, as judged by the Market Vectors Gold Miners ETF (GDX) is now enjoying a cool 80% decline since its late 2011 peak. From the 60s, GDX has utterly collapsed - with only a significant bounce along the way, GDX has dropped nearly continuously to the 13s now.

Individual gold miners have taken, in many cases, even worse beatings. And I'm not talking about one project in the moose pasture players either. The world's leading gold miners - formerly leading lights - such as Barrick (ABX) have seen their shares hit 24-year lows. 24-year lows! Think about that, back then George H.W. Bush was president, gold cost just a couple of hundred bucks an ounce, and there hadn't even been a dot.com crash, let alone the great financial bubble.

Gold was a near moribund asset back then, and apparently, it is once again. I'm gold agnostic, to be clear. I don't love the metal, nor do I complain about it being a relic of a past time. As an asset that hedges (albeit rather imperfectly) against a variety of ills not limited to hyperinflation, confiscatory taxation, and central banking mishaps, it serves as a useful holding in small quantities. While its overall return - roughly 0 in real terms - isn't great, it isn't terrible either. That puts it on par with residential real estate - another near-zero real returns asset most folks are more than happy to own a sizable amount of. In small doses, gold serves as an excellent way of turning down a portfolio's volatility.

Precious metals - as held by goldbugs - with gigantic 25, 50% or greater weightings of their portfolio is a deeply flawed investment strategy. The low real returns and high volatility of the asset make that at best inefficient and at worst a good way to severely miss your retirement goals. That said, many goldbugs aren't thinking about retirement - rather they're worried about protecting themselves from complete political or financial apocalypse. In the unlikely event that such events occur, goldbugs will enjoy the last laugh. In all other circumstances, a vastly overweighted gold position in a portfolio is asking for trouble.

However, when considered as a small quantity - say 2 to 5% of a portfolio, gold, and in particular, gold mining equities become a much more attractive proposition. The equities have tended to offer much (much!) higher real returns than the metal itself, and the returns are offered with extremely low correlation to the US stock market, US bond market, and other such widely held asset classes.

For a portfolio where you rebalance occasionally or at minimum trim your cyclical winners, gold mining equities have an excellent profile.

Consider that between 1963 and 2004 (data from here), precious metals equity, as an asset class, returned 9.2% per annum, trailing the S&P 500 (10.7%) only by a bit. Precious metals equities significantly outperformed long-term treasuries (7.5%), 30-day T-bills (5.9%), and inflation (4.5%).

Lest you think I'm cherry-picking data, that 40-year period includes a shocking stretch between October 1980 and December 2004 where precious metals equities returned -0.3% in real terms per year over a quarter century. Similarly, industry leaders such as Barrick have produced low to zero real returns over the past 25 years. The stock price hasn't advanced since 1991, the only return coming from the company's dividend payments over the years.

Despite the long stretches of nasty returns, gold mining equities still end up producing strongly positive long-term returns, largely due to their propensity to blast higher occasionally on financial or geopolitical trouble. Both the stagflation of the 1970s and the credit boom and subsequent financial crisis bust in the 2000s served up electrifying returns, with gold surging, and precious metal stocks rising even more quickly.

In a world populated with humans, the odds are good that alternative financial assets, such as gold, will continue to enjoy (for lack of a better word) monstrous boom/bust cycles. A buyer of, say, Goldcorp (GG) got to enjoy a 6-fold ride upward over a 10-period, and has now seen an 80% decline, sending the stock to near its 2002 levels before the boom started.

You'd still be up significantly had you bought and held Goldcorp through the whole of it (especially if you reinvested dividends), but that's not the optimal way to handle gold miners - or other highly cyclical companies.

Instead, it's generally to buy once the industry has already gotten pounded. Say, down 60% from its previous peak. Take a small allocation, maybe say 2% of your portfolio. Should the sector get to 70% down, up it a little more, and so on in tranches, until - perhaps - the sector hits 90% down and ultimate capitulation arrives. As Meb Faber showed, returns are very good for folks who buy sectors that are way down. There's no guarantees, but the gold mining sector could easily throw off a triple-digit return in the span of a year or two.

Is this the time to be buying gold miners? Maybe, maybe not. If you don't own any at all, this is a good time to start thinking about them. As a robust source of near-equity returns with very little correlation to the broader stock or bond markets, they offer excellent portfolio diversification without sacrificing nearly as much upside as you lose from, say, TIPS. Just don't fall in love with them - as gold miners rally, take profits repeatedly into the rise. It's a boom and bust sector - the portfolio diversification effect works best if you rebalance your position regularly to capitalize on speculators' whipsawing outlook.

If you already own some miners, as I do, I'd probably wait until December to buy more. Various sentiment and technical signs suggest there is a strong chance for another wave of selling. With companies such as Barrick selling near 24-year lows, you can be sure investors will take some of these companies back to the woodshed for more tax loss selling as the year closes. Basically, anyone long the stock has a loss on it - the temptation to liquidate it for tax reasons will be strong.

Regardless, the hype around gold has totally disintegrated. The cash for gold pawnshops and websites are closing down, the precious metals newsletters and radio shows have gone silent and investor sentiment is in the pits. Given precious metals mining's long history of producing near 10%/year average returns and giving strong diversification as a small component of a balanced portfolio, this is a good time to put the sector back on your watchlist. Particularly with gold miners' vast underperformance to the metal in recent years, there's a lot of catching up for GDX to do when it starts going to the upside again.