It looks like we're finally nearing "put up or shut up" time for gold
stocks. Any consumer of the financial media knows the case in favor of the
sector: The price of gold has risen sharply this year, meaning that miners'
profit margins will rise and the stocks should move sharply higher. The story
seems like a no-brainer on paper, yet the Market Vectors Gold Miners ETF (NYSE:
GDX ) is just barely in positive territory year-to-date, a time in which the
SPDR Gold Trust (NYSE: GLD ) has surged over 25%. It's true that part of this
shortfall comes from the presence of silver miners in GDX. Still, only a handful
of the largest gold stocks most notably Yamana Gold (NYSE: AUY ) and Randgold
Resources (NASDAQ: GOLD ) have provided a better return than simply owning
physical gold through GLD. The gap between the gold price and performance of
mining stocks has made the call for mean reversion a popular one but this trade
may not be as easy as it looks. As Simon Maierhofer pointed out in his article
last week , it's equally likely that the gap could close because of a
correction in gold rather than a rally in mining stocks. Wells Fargo sounded a
similar alarm Tuesday when it issued a report stating gold is in a "bubble
that is poised to burst." Despite the near-universal positive sentiment toward
gold stocks, a lot still has to happen for the sector to stage the rally that
the pundits have been predicting throughout 2011. Since there is an extremely
low likelihood of gold stocks moving higher as the price of the metal falls, a
prediction for mean reversion also is a bet that gold prices will keep climbing.
This might prove a tall order given the nearly universal positive investor
sentiment, the recent stabilization of the U.S. dollar and the prospect of
further increases in margin requirements. A breakout in mining stocks also will
require stable energy costs and a steady performance for the broader equity
market. A loss of any of these pillars of support will make the long-anticipated
mean reversion trade a much more difficult prospect. Further, the trend of
underperformance for gold stocks is fairly recent compared with their
substantial performance advantage over the metal since both touched bottom in
November 2008. In other words, it's all how you draw the chart: For
argument's sake, let's assume the rally in gold does in fact continue. Even
in this scenario, the onus is on the gold-stock bulls to answer the question,
"Why now?" as it relates to outperformance for mining shares. The current
environment couldn't be better, with the gold price rocketing, energy costs
declining and hedging policies long abandoned by the major producers. With the
positive story so well known, it seems as though gold stocks should have taken
off already yet most are well below their year-to-date highs. The
underperformance of gold stocks might therefore represent a warning rather than
a buy signal for those considering a long position in GDX or of one the larger
producers, such as Newmont Mining (NYSE: NEM ) or Barrick Gold (NYSE: ABX ). The
clue as to the future direction of gold stocks probably lies in the charts. GDX
has traded in a range of $52 to $64 for almost 10 months now. At $60.74, the ETF
is 5.4% away from a breakout and 14.4% from breaking down. Although GDX is
closer to its upside boundary, the chart also has some bearish elements to it
most notably, a series of lower highs and a 50-day moving average currently
below the 200-day. Although the breakout scenario is the popular prediction, the
chart presents a more neutral picture. To be clear: This discussion isn't a
recommendation to establish short positions in the gold miners. The proximity of
the $64 breakout point for GDX makes betting against this sector a dangerous
proposition right now. Instead, consider this a warning to take the bullish
predictions with a substantial grain of salt. And watch the 200-day moving
average for GDX, currently at $58.02, very closely. Another breach of this level
particularly one that is accompanied by weakness in bullion could indicate
that the gold-stock story has run out of steam.
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