Should You Hold Gold or Dig for Miners? Don't buy miners on mean reversion hopes alone

What provides the better bang for your buck: gold or gold mining stocks?

While countless pundits continue to highlight the potential of gold stocks to experience positive mean reversion after several months of underperformance versus gold, the longer-term data shows that investors have been better off owning the metal more often than not. Consider the following:

• In the 113 calendar quarters dating back to the first available data on the PHLX Gold/Silver Index (XAU), spot gold (using the London Afternoon, or PM, Gold Price Fix as the benchmark) has outperformed the XAU in 61 calendar quarters, and lagged in 52.

• Gold has provided an average quarterly return of 1.4%, compared with 1.15% for the XAU.

What is the source of this outperformance? The simple answer is that the XAU delivers its best performance when both gold and the stock market are rising. Of the 113 quarters measured, both asset classes produced positive returns in 40 — or 35.3% of the time. In these quarters, the XAU rose 30 times and fell only 10 (a hit rate of 75%), providing an average return of 10%. In the remaining 73 quarters, the XAU finished in positive territory only 26 times, while losing ground in 47 — a hit rate of 35.6%. The average return in these quarters was -2.5%.

A prime example of how the impact of broader market returns can cause gold stocks to underperform occurred during the depths of the financial crisis in the second half of 2008. Gold held up exceptionally well during this time, returning -6.5% and outpacing the -30.4% return of the S&P 500 by a huge margin. In contrast, the XAU fell -37.9% in this six-month period. As a result, anyone that bet on gold through gold mining stocks would have found themselves in the unenviable position of being largely correct in their call on gold, but losing money nonetheless. There’s no doubt this is an extreme case, but it still serves to illustrate the potential danger of choosing gold stocks over gold at the wrong time.

Click to Enlarge The chart below provides an illustration of the impact of weak stock market performance on gold mining stocks using the ETFs[1] SPDR Gold Trust (NYSE:GLD[2]) and Market Vectors Gold Miners ETF (NYSE:GDX[3]):

Other factors also come into play in the longer-term gold vs. miners debate. Gold stocks can be affected not just by the performance of the broader equity market, but also the direction of energy prices (since rising fuel costs can crimp their profit margins). Individual mining stocks also have the potential to be hurt by one-off surprises, such as floods or the expropriation of resources by foreign governments.

Click to Enlarge The bottom line: The talk about the “conversion” trade between gold and gold mining stocks persists, since the recent performance disparity is at levels that have preceded periods of outperformance for miners in the past. But it might pay to keep the historical data in mind when making trading decisions.

This is especially true now, given that GDX is experiencing lower highs, weaker volume and a 200-day moving average that has been headed lower for more than two months.