Are gold stocks the real barbarous relic?

In 1924 John Maynard Keynes referred to the gold standard as a “barbarous relic”, but we...

In 1924 John Maynard Keynes referred to the gold standard as a “barbarous relic”, but we think the new barbarous relic is using gold stocks as a trading or investment vehicle in an attempt to benefit from rising gold prices. This isn’t the 1970s. One can buy GLD call options from a laptop in bed or take a long position in gold futures with a few taps on a smart phone whilst in line at a coffee shop. The days of having to call a broker and hopefully buy some gold shares that will hopefully go up if the gold price goes up are over. There is no longer any need to take the risk that your gold stocks will not go up with gold.First off let us say that the aim of this article is not to discredit any gold mining or exploration company, or the efforts of the industry. We are not saying there isn’t money to be made in the gold mining industry, we are simply saying that gold stocks are unsuitable for trading gold and unsuitable for investing in rising gold prices. Many companies may be worth a buy on their own merits, but we do not think they should be bought to gain exposure to rising gold prices. There may be many undervalued gold companies out there, but then the reason for buying them is more on a valuation basis and not as a ploy to profit from rising gold prices. A gold stock may be a good investment, but using it as a vehicle to benefit from rising gold prices is a poor trading strategy. We are not saying that there isn’t money to be made from investing and trading gold stocks, but that is a separate issue from using gold stocks to play upwards moves in gold prices.Why do many people continue to think gold mining/exploration stocks are a good investment to play rising gold prices? Even investors with stellar reputations such as John Paulson have large holdings in gold equities as a way to play rising gold prices, which is puzzling to us. One may be able to defend holding gold stocks if one is managing a mutual fund where by the mandate may prevent you from investing in physical gold or trading derivatives, but with ETFs even this is a very weak argument. This makes Paulson’s choice all the more bewildering since he runs a hedge fund and so can trade futures, options or whatever he likes (and in fact he came to fame by trading credit default swaps).Investing in gold exploration stocks built purely on the premise that gold prices are going higher is a poor reason to place a trade. The price of the exploration stocks depends far more on whether or not they have the gold, much more than the gold price. If a junior exploration stocks successfully finds a great gold deposit then their stock price will rise, whether the gold price is $1000, $1500 or $2000. In addition to this it might be 10 years before they actually get the gold out the ground to sell it and who knows what the gold price will be then. It may be the case that the gold bull market has come and gone long before the explorer gets to sell just one ounce of gold.Picking undervalued stocks is a separate process and area of expertise from that of trading commodities such as gold. If one thinks one can pick gold exploration plays that are going to do well, then one can apply the same reasoning to silver, copper and other metal explorers. If one is good at this it doesn’t matter so much if the underlying metal price is going to rise in the next year, as if a company makes a great find it will usually do well regardless.An argument often cited by those investing or trading gold stocks is that they could outperform the gold price. The argument goes something like if it costs the company $500/ounce to mine gold and the gold price rises from $1000 to $1500 then the company is making twice as much, whereas the gold price has only increased 50%. It sounds fairly logical. However in reality the costs of mining are most often rising too.What most is important about this is that many of the costs of mining gold are actually often positively related with the gold price. For example oil prices and gold prices are somewhat positively related so if the gold price is going higher in coming years, chances are that oil prices may well be higher too, leading to increased fuel costs involved with gold production. Plus if you are holding gold investments as an inflation hedge, then holding gold stocks isn’t as good a deal as it first may appear as the gold miner’s costs base will be inflating too.