Gold at the Bottom of the S&P 500

 | Dec 31, 2013 | 12:00 PM EST
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The "Dogs of the Dow" strategy is pretty simple to understand. You want to buy the worst-performing stocks in the Dow Jones Industrial Average over the course of a year, on the thesis that mean reversion will take hold and that the same stocks that underperformed in year n will outperform in year n + 1.

I'm sure someone has done an academic study on whether the strategy works, but I haven't read it. Personally, I'm more of a trend follower, so I never had any interest in it.

Well, if it works for the Dow, it should certainly work for the S&P 500. And do you want to know what the numero uno worst stock in the SPX was this year? Newmont Mining (NEM), of course. It is down more than 50%. It also happens to be the only gold miner in the S&P 500.

2013 has been a tough year for gold miners. Back in January of 2012, I went out to breakfast with one of my clients, and he asked for my thoughts on gold. I told him that 2012 was going to be a tough year for gold. That turned out to be a huge understatement, and it ended up being two tough years, not one. But I think that the worst excesses of the gold bull market have been worked off. For starters, many of the CEOs are gone.

I'm not sure why, but gold mining is a notoriously shady business. I suppose it's because the geology of it is so imprecise -- you really don't know how much in reserves a given gold mine has until you start digging. As with biotech, there are a lot of gamblers and a lot of pretenders. And as with biotech, the safe investment strategy is usually to invest with proven producers, not speculative moonshots. (Van Eck Global offers a systematic way to invest in a portfolio of moonshots, the Market Vectors Junior Gold Miners ETF (GDXJ), but I don't own it.)

So the shady gold mining business had a few good years and completely lost the cost discipline it was forced to maintain during the lean 1990s. Coincidentally, most gold mines are in out-of-the-way, politically unstable places, and in 2011 and 2012, the miners were faced with skyrocketing costs, flabby expense discipline and a plummeting gold price. For some miners, the cost to produce an ounce of gold now exceeds the spot price. It doesn't take a degree in finance to know that that situation is untenable.

So a bet on gold miners is implicitly a bet on the gold price. The miners, at this point in time, have very call-option-like returns. Many of them are operating under assumptions of a very low gold price, and market expectations have followed suit. A modest rise in gold would turn many unprofitable miners into profitable ones. For the time being, I'll spare you the monetary policy discussion and the investment case for gold and simply talk about the fundamentals of gold mining.

When I started in this business, in 1999, on the options exchange floor, one of the stocks we had at the post was Placer Dome, a gold miner. I noticed that when stocks were up, Placer Dome was down, and vice versa. Simultaneously, I was in business school, taking a portfolio theory class, and I told the professor about Placer Dome's moves. He explained that a stock that was negatively correlated to the overall market improved the risk characteristics of the portfolio.

Over the last two years, many people have forgotten this. I'm bullish on gold miners on a standalone basis (I'm long the Market Vectors Gold Miners ETF (GDX)), but even if I weren't, at this stage I would be forced to consider an allocation to gold miners to reduce my exposure to market risk. Novice investors often fail to take correlation into account -- they buy stocks idiosyncratically, then they are surprised to learn that their stocks all go down at the same time.



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