METALS OUTLOOK: Gold, Silver Strength Could Continue, But Watch For Potential Correction

By Debbie Carlson,

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(Kitco News) - Share prices of gold-mining companies have lagged gold itself during the metal's recent run to record highs.

Analysts and fund managers attribute the stocks' collective underperformance to a simple preference among many investors to hold the metal itself at the moment, as well as rising operating costs for mining companies that limits profits even when they are also fetching high prices for the gold they sell.

Gold has surged in 2011 due to inflation worries, civil unrest in the Middle East and North Africa, sovereign-debt issues in Europe and the U.S., plus a weak U.S. dollar. June gold hit a most-active-contract record of $1,509.60 an ounce Thursday on the Comex division of the New York Mercantile Exchange. This represented a 5.9% gain for the year.

However, the Philadelphia Gold/Silver Index ( XAU ) of mining stocks was nearly flat for the year to date. The Gold Bugs Index (HUI) of unhedged gold stocks was up 4%.

There also has been an underperformance by silver stocks as silver rocketed to 31-year highs, said Daniel Brebner, head of metals research at Deutsche Bank.

Shares of gold producers have outperformed gold itself for much of the bull run that began around a decade ago, said Jeff Clark, precious-metals analyst with Casey Research. Up through 2007, this often occurred at a rate of three or four to one, he said.

Depending on the index, gold stocks outperformed gold by roughly four percentage points last year, Clark said. "And now year to date, they are not outperforming gold as a group."

Some analysts cited a desire among many investors in the current environment to hold the metal itself as a hedge against geopolitical and economic concerns. This especially the case due to the "immediacy" of owning gold via investments such as coins or exchange-traded funds, Brebner said.

"When you buy an equity, you're buying future gold-future production or ounces," Brebner said. "When you buy gold through an ETF or direct, it's not future. It's now. A lot of investors are looking at risks much more immediate than five or 10 years away."

Rising Mining Costs Cited As Factor Limiting Advances For Gold Stocks

As commodity prices soar, so do the expenses for mining companies. Labor costs are also increasing in many nations.

"The exposure that you get to the gold price is diluted through the equities because they are seeing that kind of cost inflation," Brebner said. "The earnings performance of many of the senior gold-mining companies, or the earnings growth, is lower than what you're getting from the performance of the gold price."

Energy is one of the most significant costs for mining companies, said Mark Johnson, portfolio co-manager for the USAA Precious Metals and Minerals Fund. June crude oil on the New York Mercantile Exchange earlier this month hit $114 a barrel for the first time since August 2008. The market has been factoring in an expectation that the impact of various rising costs will be reflected in first-quarter earnings reports from producers, Johnson said.

These costs are also occurring in other types of mining, such as copper and coal, said Kimberly DuBord, director of research for Briefing Research. "It's not just gold miners," she said. Coal prices have been supported by tight market, with U.S. coal being exported. Yet, she continued, share prices of some coal producers took a "huge hit" in the last month.

Strong currencies in key mining nations such as Australia and Canada also cut some into the profitability of mining companies, Johnson explained. Companies receive payment in U.S. dollars, which is how gold is priced on the global market. But when a currency such as Canada's strengthens, the company's expenses rise when translated into U.S. dollar terms, even if those costs held steady in terms of the Canadian dollar.

Brebner also said it is becoming increasingly challenging for many companies to keep boosting mining output.

Meanwhile, mining companies face political risk in certain parts of the world, analysts said. There are worries about some nations basically taking away a majority stake in mines after companies spent huge sums of money developing them. Further, there have been attempts by governments to hike taxes or royalties on mines, even in some nations normally perceived to have a low political risk for miners.

Analyst: Mining Stock Underperformance Suggests No 'Mania' Forming Yet

Clark sees the underformance of mining equities versus gold as a sign that a "mania" some fear has not occurred yet. This would be a condition in which so many investors suddenly pile into a market that a bubble forms, such as the Nasdaq and real-estate market crashes since the turn of the century.

"That is probably the most important point that can be made," Clark said. "If the mania was really here-and one might think that is the case the way gold and especially silver are running to the upside--you would think gold stocks would not only be outperforming the metals but demonstrating three to four times the leverage that they have in the past. And they're certainly not doing that. So that's a clue we're not there yet."

Nevertheless, he said, the current situation could portend some type of consolidation or correction. This likely will "wash out" some newcomers to the market. "And of course, that will be the best time to buy," Clark said.

Analysts offered mixed views on whether mining stocks will continue to underperform the metal itself.

"I don't see any convincing reason at this stage why that trend will reverse," Brebner said. "I think it's likely to continue over the next couple of years and actually it may worsen, if there is a growing desire for investors to get their hands on metal. That may exacerbate the underperformance of mining companies versus the commodity."

However, DuBord looks for the mining shares to close any gap with the metal. "I think they will catch up over time," she said, suggesting there might be a move toward diversified miners who produce more than one metal.

Clark looks for gold stocks to eventually regain the upper hand, particularly when "non-gold types" enter the market on a larger scale. These new investors tend to turn to the metal first, he explained.

"People outside of our industry are starting to look at gold and silver," Clark said. "That's the first place they're going to go. They haven't gone to the stocks yet. And once they do, that is going to be the catalyst, I think, that will push gold and silver stocks up much higher.

By Allen Sykora of Kitco News;

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing Commodities
Referenced Stocks: XAU

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