Claude B. Erb, managing director at First Chicago NBD, published a research report titled “A Golden Bet: Gold Mining Equities versus Gold” earlier this week. Erb takes an in-depth look at the factors behind the price of gold and the relationship between gold prices and the prices of gold mining equities. His conclusion is that if you believe in the relationship between gold and inflation, then gold is overvalued and gold mining stocks are generally undervalued.

Poor performance of gold mining stocks

The first leg of Erb’s analysis focuses on the “horrible performance” of gold equities relative to spot gold prices or equities in general. As a quasi-explanation, Erb highlights the fact that it is extremely difficult to make a case for a fundamental relationship between gold and gold prices.

Gold Mining Stocks equities

Equilibrium between gold and gold mining stocks

Erb takes a zen-like approach to his analysis, posing a series of open-ended questions and suggesting some possible answers. In terms of the relationship between gold and gold mining stocks, he says:

“If there is a “long-run equilibrium” between gold and gold mining equities

– Then the price of gold suggests gold mining equities could rise 100%, and

– The price of gold mining equities suggests gold could fall 50%

  • A seeming equilibrium relationship may be “fundamental” or “behavioral”

– A fundamental relationship may exist over many different time periods

– A behavioral relationship may hold over one period or many time periods

  • A seeming long-run equilibrium may be more apparent than real”

Historical Gold Mining Stocks indices

The golden constant

The report also elaborates on the theme of the “golden constant”. The “golden constant” is the “rule” that the price of gold keeps up with inflation over the long haul. Erb argues that this also means that the expected real price of gold is constant and the expected return of gold is just simply the expected rate of inflation.

Gold constant

Erb’s conclusion

Erb ends his analysis with the conclusion that gold prices may be “expensive” and that gold mining stocks may be “cheap”.

“It is possible to entertain the idea that inflation drives the price of gold

  • It is possible there is an equilibrium gold and gold mining equities relationship

– It is possible to believe in the idea but there is no way to prove the belief

  • However, given a willingness to assume such a relationship exists then

–The price of gold may be “expensive”

–The price of “gold mining equities” may be “cheap”.”