Gold, producers' stocks march to different drummers

While the price of gold has been marching upward in recent years, gold producers' stocks have simply been dragging their feet. For example, the NYSE Arca Gold Bugs Index of major producers has risen 60 per cent over the previous five years, while gold's price has gone up 135 per cent. This creates a disconnect that, at first, seems difficult to explain.

Are gold stocks cheap and underpriced? Should we invest in them? Are they the best way to play gold?

More than three years ago, I wrote about the conflicting signals from the bond market and gold prices. At the time, I sided with gold. Not many things have really changed, except that gold has almost doubled since then.

Just as they were in 2008, the markets for real assets, normally a good hedge against inflation, are now booming. Gold prices have appreciated at a rate not seen since the last big runup of inflation in the late 1970s and early 1980s. So have the prices of other commodities, such as energy and food.

The primary force behind gold's meteoric rise is investors' conviction that gold will act as a haven against a long-run increase in inflation and the related debasement in the value of the U.S. dollar. While much has been done to fix imbalances over the past few years, indicating that we have learned from past mistakes, markets are afraid that we will most likely make different mistakes. Buying gold affords one protection against a myriad of unknowns.

So what is wrong with the stock prices of companies that make money from mining and exploring for gold?

In the long run, gold has not been a good investment. It has been a good short-term investment: To make money in gold, investors must be good market timers. But that's not easy for most - it is hard to identify the peaks and the troughs as they occur. Investors are buying gold on the expectation that the price will keep rising and they will be able to sell at a higher price. Yet, commodities and gold are cyclical. They go up and down in price; they do not go only up.

If you had invested $1 in gold in 1802, it would have grown to only $1.95 in real terms by the end of 2006. A study by Merrill Lynch looked at the performance of 10 different asset classes over different rolling periods between 1970 and 2007 - the worst-performing asset class was gold. History shows that the longer you hold gold, the worse it is. True, you can make a killing if the momentum continues, but what happens when it stops? And it will stop.

Contrast this with investing in the stock of gold producers. That provides an investor with a share in the present value of future cash flows from their operations. The better the future cash flows look, the higher the stock price, and vice versa.

What the price of gold stocks is showing us is that investors doubt the ability of gold to continue its upward trend in the long run. It is reflecting reservations over what gold investors bet on, namely the inability of world economies to resolve their problems in the long run.

Investors in gold stocks are not willing to make the bets against the economic system in the long run that gold bulls are making. They heed the advice of Warren Buffett, namely, "be fearful when others are greedy, and be greedy when others are fearful."

And so, although the shares of gold stocks may look cheap in relation to the metal, this may not be the case. Gold stocks price the long term, while the metal only reflects the short-term outlook. If you plan to buy gold producers because they have not kept pace with bullion, you may be making a mistake.