Where's The Leverage?

The AMEX Gold Bugs Index [HUI] is designed to track the performance of the fifteen largest unhedged gold producers. One of the standard talking points in the goldbug world, particularly among boosters of mining shares, is that gold stocks provide leverage to the gold price itself. That's because, assuming that costs don't go up, an increase in the gold price disproprtionately benefits a mining company's bottom line. If gold goes for $1,000, and a mine company's cost is $500, then the gross profit for the mine is $500. If gold moves up to $1,100, and the mining company's costs stay at $500, then gold's gone up 10%. However, the mining company's gross profit has moved from $500 to $600 - a gain of 20%. The higher the costs, the greater the leverage - or so the story goes.

This tendency should show on a graph that divides the HUI by the gold price. In a gold bull market, the line should be rising: the HUI's own rise should outpace gold's. And yet, a StockCharts.com weekly chart of that relationship - going back three years - shows a different picture. During those three years, gold itself has been in a bull market...




...but the leverage supposedly given by gold stocks doesn't appear to be there.

Or, it wasn't until the financial crisis. In late '07, when gold went on an upwards tear, there clearly was no leverage. There was, on the other hand, a lot of downwards leverage in June to November of '08. However, as '08 turned into '09, the leverage that kicked in on the positive side began to dissipate. Like in the last half of '07, there hasn't been any during the run-up that started last September. Since that date, gold and the HUI have merely kept pace with each other.

There are different interpretations of this phenomenon; in the goldbug world, it's claimed that the lack of HUI magnification right now means that gold stocks are undervalued. This "Number Cruncher" piece courtesy of the Globe and Mail has a different explanation: the amount of economic value added by gold companies in a similar index product, the iShares CDN Gold Sector Index ETF, has been zero:

Bundle the stocks in [the index] together and you've got a big zero from an EVA point of view. Stockpointer explains this as being a result of the trouble gold producers have had in converting high prices for gold bullion into strong profits. XGD was up about 26 per cent in the past 12 months, so let's not get too carried away in dissing the S&P/TSX global gold index tracked by this fund.

So, what's the story? Are the goldbugs who keep to the leverage line merely kidding everyone, including themselves?

Not quite. Back in the old days - by that term, I mean pre-1980s - gold was actually counter-cyclical. Before the late-1970s bubble, the best bull run gold had was in 1974. Yes, 1974: the dreadful year epitomizing postwar stock-market carnage until 2008 replaced it. Gold mining companies found the price of their product ratcheting upwards in the middle of a recession...at a time when hard times in general held down their input costs, except for the oil spike in '73. In such an economic environment, the codicil "if costs remain constant" could be treated as little more then boilerplate.

Needless to say, things have changed. In the 1980s, gold was mildly procyclical. That procyclicality led to the mining sector being gutted in the 1990 recession. Gold went back to being somewhat countercyclical in the 1990s, but that was because a gold bear market was superimposed over a roaring economy. In the '00s, gold went back to being procyclical - as was most evident in '08. There actually was positive leverage in the gold-mining sector from 2001 to 2005; at least one producers (Yamana Gold) came onstream in that period. However, the leverage disspiated as the Bush boom continued. That's because cost increases caught up with the profit boosts. One of the costs that squeezed the producers was, unsurprisingly, energy. The soar-up of oil was far more than a one-shot jump in the late '00s.

With respect to the economy, gold has become countercyclical again. With respect to the stock market - and the energy market - gold is still procyclical. A cost squeeze is the most likely reason why the leverage is dissipating again. Upside leverage may return, but the odds make for far less than a guarantee of it doing so. Speculating that it will is, in essence, speculating that mining companies will be able to contain their costs. In other words, the kind of analysis required is a lot like the kind used for regular companies. The period of specialness for gold miners, where cost trends didn't matter all that much, has passed.

Once day, the leverage trope might appear in an economics class - not as a lesson, but as a trick question.