Gold is for the risk averse, gold shares for the risk loving

The gold price in US dollars and in rands has moved ever higher while JSE listed gold shares have moved mostly sideways over recent years. The explanation seems obvious enough. The cost of mining gold in SA has risen every bit as rapidly as the price of gold while the volume of gold mined in SA has declined consistently with these higher costs and the lower grade of ore being crushed. In 1970, before the price of gold escaped the constraints of the gold standard that set the price at $35 or approximately R27 per troy ounce, SA mines produced over 600 metric tonnes of gold a year.

SA gold mines now produce fewer than 200 tonnes of gold a year and this output is falling. The only consolation in this sad tale of events is that presumably the US dollar and rand price of gold would be a lot lower had SA continued to produce as much as it did before.

But the hope that the gold mines will be able to take advantage of the higher gold price in the form of profits and dividends seems to rest eternal. Investors have consistently paid up more for the dividends actually paid by the gold mines. Currently the mines are selling at 122 times their trailing dividends or at a dividend yield of less than a third of one per cent. Gold mining accounting earnings follow no consistent pattern and have often been negative in recent years. For the record , the JSE Gold index reported earnings per share have been positive over the past 12 months and the share prices are on average 315 times their trailing earnings.

The hope clearly implicit in these extraordinary market ratings is that gold mining companies will some day, maybe soon, be able to get more valuable gold out of the ground at greatly improved margins. This makes gold shares the ones with the longest odds in the equity markets. This taste for risk may well continue to provide support for gold shares for some time to come. Presumably the risk lovers assign only a small proportion of their portfolios to this gamble.

Accordingly the relationship between the gold price (much higher) and gold shares (sideways) is therefore a very weak one and may remain so until the mines actually deliver much improved dividends. Since January 2008, for every one per cent daily move in the rand gold price, the JSE Gold Mining Index has moved on average by only 0.42% (the so called gold price beta). However the gold price explains only about 7% of the daily move in gold shares over this period. There is clearly much more than the influence of the gold price at work on gold shares. The gold price expressed in US dollars does only a marginally better job explaining the JSE Gold index (in rands) with a beta close to 0.75 but still with very low R squared or explanatory power of 0.16%.

Gold shares are clearly only for the risk lovers. Gold itself however would have served the risk averse very well over this period. This is because, on average, when the market was down the gold price was up and vice versa. The correlation between daily moves in the JSE All share and the rand gold price was a negative (-0.16). Negative correlations of this order of magnitude provide outstandingly good risk reducing diversification benefits for portfolio managers. The correlation between daily changes in the rand gold price and the S&P 500 in US dollars has been even more negative (-0.44). Thus for South Africans with exposure to developed equity markets, gold would have provided especially good insurance. For the offshore investor the correlation of daily changes in the dollar price of gold and the S&P 500 was close to zero (0.04) over the period indicating that gold would also have provided very good insurance for the US dollar investor.

Past performance may not be a guide to future performance. But if the past is anything to go by the case for investing in gold, especially for South Africans, has been greatly strengthened while the case for investing in gold shares remains at best unproven.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View:

Daily View 20 July

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