GDX is the Market Vectors Gold Miners ETF.  It is composed of the big gold mining stocks, like Barrick, GoldCorp, Newmont and AngloGoldAshanti.  It has a small 0.27% dividend yield.

GLD is the SPDR Gold Shares which holds physical gold. GLD shares can be exchanged into gold and vice versa. Thus, it tracks the gold price very well. It has an annual expense ratio of  0.40%.

The valuations of the big gold miners have steadily declined in the past couple years. This can be seen in the spread between the GDX and GLD.  Using a 3:1 ratio, the spread traded as high as $52 over. (GDX over GLD, 3:1). Currently, it is trading for negative $7.

There has been a lot of speculation as to why this has occurred. Some think that the introduction of the GLD type instruments have siphoned off a lot of money that would have gone into the miners. The thinking is that in the past people bought the miners because the transaction costs and storage/insurance costs of the physical were prohibitively high.  Certainly this is a plausible explanation.

I think another dynamic is that when gold is low-priced the miners act like out of the money options on the gold price. Their valuations are rich, just as out of the money calls on gold usually trade fat in that environment.  When gold then rallies, the stocks become deeply in-the-money options and their premiums get crushed.  I think too, that as the price of gold rises, these companies start to get valued more on earnings etc rather than as speculative calls on gold.

Various “stakeholders” (labor, governments, enviros, etc.)  have all risen up to take an extra bite of the value the gold companies accrued due to the gold price rise.

So, why I am advocating buying the big miners here, versus gold?

1)      All stocks were recently very cheap versus their “underlyings”. Energy stocks vs oil. S&P500 vs earnings. This has changed to a large extent with the rally off the Fall lows. Gold stocks have not participated much in this revaluation.

2)      Sentiment is simply horrible. Gold miners are just universally unloved. Even the Gold Bugs are disgusted and gone. Totally washed out. When no one loves a company or sector, the bottom is often in.

3)      The companies are generating good cash flow. They are aware of their diminished valuations. I think the companies will use this cash flow to try to close this valuation gap, through things like dividend increases or stock buybacks. They may spin assets out into income-producing royalty type vehicles.

4)      Lastly, this spread will act like a “put” on gold. A lot of something is priced into gold here. Gold is not exactly an undiscovered asset class and the financial travails, present and future, of the Sovereigns of the world is likewise also not an un-discussed fear. Gold could easily collapse from here if it turns out that the widely-anticipated world financial Armageddon is successfully postponed. In this case, the gold stocks, while suffering along with gold, will suffer much less and eventually “tail out” and retain premium valuations due to their “call option” on gold feature.