Invest in Gold, or Gold Stocks? Consult the K-Ratio.

Posted March 1, 2011

People buy gold for many reasons such as a store of value during inflationary times and to provide a hedge during troubled times caused by geopolitical events (both may be good reasons to buy gold now). But whatever the reason it was purchased for there’s no doubt that gold has been a great investment for the last nine years appreciating from about $250/oz to over $1,300.
Many gold experts believe that a better way to profit from higher gold prices right now is by owing stock in the companies that mine it vs. buying the metal itself. I know from experience that gold mining stocks have a history of being one of the most volatile investments you can own. This fact makes owning gold stocks very exciting when they go up and terrifying when they go down. According to Jay Kaeppel a good barometer to look at when evaluating whether to buy the metal itself or the stocks that mine it is the “K-Ratio”.
Figure 1: The K-Ratio (Barron’s Gold Mining Index divided by Gold Bullion)

Source: Jay Kaeppel
The K-Ratio is calculated by dividing the price of the Barrons Gold Mining Index ((BGMI) as the proxy for gold stocks) by the price of 1oz of gold. Kaeppel says that there are no precise bullish or bearish “cutoff” levels; however the following observations have been made:
     Bullish K-Ratio Readings:
          -Readings under 1.45 tend to be bullish.
          -Readings under 1.20 are almost always followed by higher gold stock prices 12 months hence.
          -Readings under 1.00 present a screaming buying opportunity for gold stocks.
     Bearish K-Ratio Readings:
          -Readings above 1.80 tend to be bearish.
          -Readings above 2.00 are almost invariably followed by lower gold stock prices 12 month hence.
Click here to read Kaeppel’s full article on this subject.
Current K-Ratio Reading: Figure 1 shows how the K-Ratio has varied since 1975. You can see that after the 2008 stock market meltdown that this ratio hit an all-time low of 0.60. Since that time gold bullion has rallied +70% and gold stocks have soared +228% according to Kaeppel. Despite the massive rally in the price of gold since 2009 the K-Ratio remains at a relatively low – and presumably bullish – level of 1.10. According to Kaeppel K-Ratio readings of under 1.13 fall into the lowest decile and that 94% of the time such readings were followed by higher gold mining stock prices 12 months later, with an average 12-month gain of over +43%. Past performance is not a guarantee of future performance comes to mind!
We’ve found that exchange traded funds (ETFs) can provide an effective way to invest in specialty market sectors such as precious metals mining companies. One interesting ETF in this area is the Market Vectors Junior Gold Miner ETF ticker GDXJ. Disclosure: Our Dynamic Investing Group’s Growth Model portfolio owns GDXJ so my family and clients own it as well. It should go without saying but do your own homework especially prior to investing in a high risk/reward area such as gold and gold mining stocks.