Investors should remain bullish on gold, regardless of short-term gyrations in value. The price of gold could reach USD1,500 per ounce in the medium term as central banks maintain loose monetary policies.

— Yiannis Mostrous, Silk Road Investor

Last month, I wrote about the powerful diversification benefits an investor can obtain by investing between 10% and 15% of a portfolio in gold bullion. Gold is one of the few asset classes that has a negative correlation with stocks, which is the best kind of correlation to have from an asset allocation standpoint.

But gold bullion is only one of the ways an investor can get exposure to gold. The other primary way is through ownership in gold mining stocks.  Which is a better investment? It depends upon your objective. Below is an objective-by-objective matchup between gold bullion and gold stocks:

1.      Hedge Against a Stock Market Decline

The best way to answer this question is to see how each did during the bear market between October 9, 2007 and March 9, 2009:

Source: Bloomberg

During the period when the S&P 500 fell by more than half, gold bullion rose by more than 25%, an outperformance of 80 percentage points. In contrast, gold stocks fell by 32%, which was still  an outperformance over the S&P 500 of 23 percentage points, but not as good as bullion.

Advantage: Bullion

2.      Leverage

By definition, bullion can’t have price leverage on itself. In contrast, gold stocks are leveraged to gold prices. A 1998 Harvard Business School study found that the average mining stock moves 2 percent for each 1 percent change in gold prices. For example, let’s assume that a gold mining company can produce one ounce of gold at a cost of $600 and the market price of gold is $1200. The company’s profit per ounce is $600. A $100 rise in the price of gold to $1300 would constitute an 8.3% increase ($100/$1200), but would increase the mining company’s profits by double that, or 16.7% ($100/$600).  Of course, this leverage works in reverse also, so while gold stocks usually outperform bullion on the upside, they also underperform on the downside.

For example, during the January 1972 to December 1974 bull market in gold, gold stocks outperformed bullion by 23 percentage points. Similarly, gold stocks outperformed bullion during the last-gasp bull market from March 1980 to September 1980 by 82 percentage points. And best of all, between 2001 and 2003, gold stocks outperformed bullion by 250 percentage points!

But there are exceptions. Bullion outperformed gold stocks by a whopping 118 percentage points during the bull market of August 1976 to January 1980. Gold stocks can underperform bullion during gold bull markets for a number of reasons:

• Mining costs (e.g., labor, steel, electricity, diesel, new exploration efforts) increase faster than gold prices
• A bear market in stocks drags down gold stocks which are, after all, stocks.
• Management sells forward gold production at a fixed price as a hedge, which limits upside if gold prices soar
• Proven reserves of gold are depleted so that company has less — or lower-grade —  gold to sell
• Exploratory mines fail to find gold
• Mining production includes copper, which may not be increasing in price
• Increased regulation
• Labor strife – work stoppages
• Management incompetence

Advantage: Gold stocks.

3.      Relative Valuation

Between 1984 and the Lehman Brothers bankruptcy in September 2008, the bullion-to-gold and silver index (XAU) ratio had never risen above 6.4.  The ratio hit a 50-year high of 11.5 in October 2008 and is currently at 6.2:

Source: Bloomberg

The current 6.2 reading is still near the high end of the ratio range during the 1984-2008 period, so one could argue that bullion is overvalued relative to gold stocks. On the other hand, the massive deficit government spending that has resulted in the wake of the 2008 financial meltdown promises inflation down the road and may have pushed the ratio into a new, higher trading range. Furthermore, the bull market in stocks is now 21 months old and may be long in the tooth. In that case, bullion may outperform gold stocks going forward and may retest the 11.5 ratio level.

Advantage: Toss-up.

4.      Liquidity

Provided the stock markets are open, one can sell gold stocks easily. But during market declines, the value of gold stocks can decline below the intrinsic value of their gold reserves, making it an inopportune time to cash out. Furthermore, some junior gold mining stocks are exploratory only and don’t actually have any proven gold reserves yet. If stock markets are closed, very few places would accept gold mining stock certificates as tender. And most investors don’t even have possession of stock certificates.

In contrast, bullion is bullion and you get the full value of your gold (minus the dealer bid/ask spread) at all times. But if you store the gold yourself, it may take some time to transport your gold coins to a dealer for sale. There are gold banks like GoldMoney that store your gold for you and redeem it for cash immediately. And unlike stock certificates, if dealers, exchanges and banks are closed, everyone still accepts gold coins like the American Eagle, the Canadian Maple Leaf, and the South African Kruggerand as payment.

The daily turnover of physical gold is more than $20 billion, whereas the value of gold stocks traded daily is only about $3 billion, so bullion is easier to sell in large value amounts.

Advantage: Bullion.

5.      Storage Costs

Bullion is a physical object, so you need to find room to store it that is safe and secure from theft. Storage can be expensive as can the insurance required in case your gold is stolen. As mentioned above, gold banks like GoldMoney store your gold for you, but they charge you a fee to do it.

In contrast, your gold stocks are usually just electronic memory bytes in a computer that are kept in your brokerage account for no cost.

Advantage: Gold stocks.

6.      Dividends

Bullion pays nothing and costs money to store. In contrast, gold stocks often pay dividends.

Advantage: Gold stocks.

7.      Diversification

Gold miners often produce copper in addition to gold, so rising copper prices can mitigate a declining gold price. Stocks are correlated with the stock market, so a bull market in stocks can cause gold stocks to outperform bullion even if gold prices are increasing. Lastly, the value of gold exploration companies can rise based on speculation of a gold discovery, regardless of whether bullion prices are rising.

But, then again, all of these diversification “benefits” are detrimental if gold bullion prices are skyrocketing, which is the real reason you buy gold in the first place, isn’t it?

Advantage: Gold stocks.

8.      ETFs

Most of the disadvantages associated with owning bullion can be eliminated by purchasing the SPDR Gold Shares ETF (NYSE: GLD). This ETF represents ownership shares in gold bullion. As of September 30^th, it was hedge fund superstar John Paulson’s largest position. I was concerned that GLD’s status as a stock exchange traded security might cause it to deviate from bullion’s price action, but it matched bullion very closely during the 2007-2009 bear market:

Source: Bloomberg

The main disadvantage to the ETF is that you pay for management fees. As you can see in the above chart, GLD trailed bullion by 1.57% over the 17-month bear market.

Gold stocks can also be purchased via an ETF. Example: Market Vectors Gold Miners ETF (NYSE: GDX).

Advantage: Toss-up.

Conclusion

In conclusion, bullion and gold mining stocks are quite different asset classes. In my opinion, bullion is the better bet for hedging and asset allocation purposes, but gold stocks offer an aggressive leveraged play for more risk-seeking investors.

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I may be late to the gold party, but KCI’s Yiannis Mostrous, editor of Silk Road Investor, has known the secret of gold’s hedging benefits since . . . forever.  His recommended portfolio includes gold hedges. No-risk guarantee: For the first three full months if you’re not completely satisfied simply call us for a 100% refund – no questions asked.