All That Glitters Are Gold-Mining Stocks

Last week's unbearable heat in Chicago didn't deter me from strolling in the park, past assorted mad dogs, Englishmen and laid-off chip designers from Motorola and network engineers from Lucent and Tellabs.

When a bright yellow bus full of singing day-campers drove by, the proverbial light bulb over my head appeared. Was this a Sign From Above telling me to pay attention to gold? At best, the school bus-colored metal hasn't helped or hurt very many portfolios lately. But with the violent crosscurrents emerging in global financial markets, how long can that last?

For a while longer, it appears. That doesn't mean inquiring minds can't come up with decent gold trades.

Gold, as you might remember, reached $800 an ounce two decades ago. Back in 1980, the notion of it rallying to $275 an ounce on a good day would've seemed preposterous. Of course, we could say the same thing for the once-mighty Nikkei, now struggling below 12,000, or the Nasdaq, now struggling below 2000. But, hey, these things happen.

Amid the crosscurrents, gold will be hurt by falling measures of inflation, such as last Friday's 0.9% drop in the producer price index . On the positive side, the central bank's ongoing attempts to reflate the global economy should boost inflationary expectations, and the apparent crack in the dollar's strength should raise the dollar price of gold. Finally, we're witnessing what's shaping up to be the most misguided set of economic policies since the respective heydays of Richard Nixon and Jimmy Carter. Still, gold's going to do what it does best: just sit there.

When in Doubt, Stay Out

The price of gold should rally only when the expected rate of inflation exceeds short-term interest rates, the cost of holding the metal. This hasn't been the case lately. If we take the spread between standard 10-year Treasuries and inflation-indexed bonds that I discussed two weeks ago, the present reading of inflationary expectations is 1.72%. Three-month Treasury bills are yielding 3.41%, a gap of 1.69%.

This means a dollar-denominated holder of gold either is willing to pay a penalty of 1.69% for the privilege of converting cash into metal or perceives an impending change toward scarcity in gold's supply-demand balance. At the risk of infuriating gold bugs, let's dismiss the latter possibility. Nothing in the gold lease-rate market, which is the difference between gold swap rates and short-term interest rates, suggests any impending surge in demand for gold. In fact, present lease rates indicate a real lack of interest in the metal.

Gold Prices and Lease Rates Nothing here shows much interest in the metal

Source: Bloomberg.

The first point, a willingness to pay a penalty for owning gold, is more important. We don't live in a dollar-only world, and any dollar-holders who fear a loss in their exchange value greater than the 1.69% penalty may be willing to buy gold as a hedge. The dollar, as measured by the trade-weighted dollar index (DXY), and gold have long had an inverse relationship. The DXY is approaching a major trend line of support going back to the Russian default crisis of 1998.

Gold and the Dollar: An Inverse Relationship The trade-weighted dollar index approaches a major trend line

Source: Bloomberg.

Rumors of the dollar's demise over the past two years have been greatly exaggerated, and the question of which currency would benefit from any dollar weakness is an open one. Has the European Central Bank or the Bank of Japan done anything recently to suggest it's ready to assume the mantle of world monetary leadership? The lack of confidence in others' economic management likely will place a floor under the greenback for the foreseeable future.

Gold Stocks

Nothing in these three indicators -- inflationary expectations, lease rates or the dollar's exchange value -- suggests the time is right to enter the gold market. If gold bullion is a waste of time, do gold-mining stocks offer a better alternative? The nine-member Philadelphia Stock Exchange Gold and Silver Index, or XAU, has risen 4% so far in 2001 and has outperformed the S&P 500 by 24.9% since August 2000. Barrick Gold (ABX Quote - Cramer on ABX - Stock Picks) is acquiring Homestake Mining (HM Quote - Cramer on HM - Stock Picks), a member of this index, in a consolidation-style merger that suggests the cheapest place to mine gold is on Wall Street, not in them there hills.

Gold stocks and gold bullion have a well-defined relationship: The stocks lead bullion higher and rise faster in price.

Gold Stocks as a Function of Gold The stocks are the clear leader

Source: Bloomberg.

If the yellow trend line looks like the profit profile of a call option , it should. If the price of gold falls, the damage to the XAU is gradual. If the price of gold rises, the gains on the XAU accelerate. An obvious hedge trade is suggested: Buy gold stocks and either sell gold futures forward or buy put options on gold.

It's a little more complex than finding the next hot tech stock, but it may do you some good and won't do you much harm.