V.11:7 (310-313): Prospecting With Gold Mutual Funds by Jay Kaeppel

Prospecting With Gold Mutual Funds by Jay Kaeppel

Gold. In the past, it inspired rushes and revolutions, passion and poetry, but in recent times gold mutual funds have been distinctly lackluster. The emotion that the precious metal inspired may have dwindled, but gold mutual fund investors can still make money.

Gold mutual funds can provide huge profits to investors when things are going well — but unfortunately, these funds can also expose investors to the risk of devastating losses when a precious metals bear market is in force. As a result, many investors simply shy away from gold funds altogether — which, given the profit potential of a well-timed gold fund investment, is unfortunate. But it appears that there may be a simple way for investors to assess the probability of making money in gold funds over any ensuing 12-month period. The key is to determine whether gold mining stocks are overvalued or undervalued in relation to gold bullion.

By analyzing the relationship between stock prices of gold mining companies and the price of gold bullion (Figure 1), investors can identify occasions when gold mining shares are either over- or undervalued. Identifying these situations can be particularly rewarding for gold fund investors because gold funds generally hold the bulk of their assets in shares of gold mining companies rather than in gold bullion itself. Thus, if an investor can recognize when mining shares are selling at deeply undervalued levels, he or she can buy gold funds when they have tremendous upside potential and minimal downside risk. Likewise, by selling when gold mining stocks reach overvalued levels, investors can avoid the serious downside damage that occurs during a severe decline in precious metals prices.