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Why Aren't Gold Stocks Rising with the Price of Gold?

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During the first nine month of the year gold rose 14.8% yet gold stocks ,measured by the Gold Miners Index ($XAU) or the Market Vectors Gold Miners ETF (GDX - Free Report) , fell more than 18% during the same time period. That is a 32% difference between two highly correlated investments, which is historically quite unusual.

Also this disconnect between the spot price of Gold and gold stocks frustrated many investors as gold stock based ETFs and mutual funds did not perform as many investors expected, who put money in these instruments thinking they would perform well during bear markets periods of turbulent markets.

So why have Gold stocks not returned anywhere close to the price of Gold this Year?

The first reason, all stocks regardless of what they are based on become highly correlated with the broder stock market indices when there is a major market correction, like what happened over the last two months as the S&P fell almost 20%.The reason for this is during severe market corrections institutions are forced to sell any and all stocks to raise cash, and at the same time individual investors panic and want to sell everything involved with the stock market.

Secondly many analysts believe that gold mining companies are facing a growing number of headwinds which could affect their future profitabilty, these include, rising labor and power costs, and mines that have already been farmed out , leaving only the gold which is tougher and therefore more expensive to get out. All of this could lead to higher costs thereby cutting into these gold companies future profit margins.

On the other hand because of the huge disconnect between gold stocks and gold, many people believe that the above two fundamental factors are already priced in, remember Gold is up nearly 15% YTD, Gold Stocks (measures by the Gold Miners Index) are down almost 18% YTD, while the S&P is down only 7%.

Therefore since there is a high probability that gold mining stocks are undervalued, and gold stocks have been highly correlated with the price of Gold, one could argue that this is a good time to go out and buy a basket of gold mining stocks, through ETFs such as Market Vectors Gold Miners ETF (GDX - Free Report) . GDX  is currenlty selling at a historical low P/E of 14 times earnings.  Furthermore the Market Vectors Gold Miners Index has a historical correlation to the Price of Gold of nearly .80 or 80%, meaning that 8 out of 10 times the price of Gold and GDX move in the same direction and of the same price magnitude.

More risk averse types you hedge thier purchase of GDX, buy selling short the equal dollar amount of SPDR Gold Shares (GLD),  thus betting on the spread between these two highly correlated investments reverting back to its mean.

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