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Prospecting with Gold Mutual Funds

by Jay Kaeppel CTA and Essex Director of Research (published in the July, 1993 issue of 'Technical Analysis of Stocks and Commodites' magazine) Gold mutual funds have been disappointing performers in recent years as most precious metals have declined steadily in price. The further bad news for investors is the lack of opportunity to make money in gold funds while mining shares are experiencing a prolonged downtrend. The good news though, is that no bear market lasts forever. It now appears that gold mining stocks may be in the late stages of a bear market and that they may be presenting gold mutual fund investors with a buying opportunity. By analyzing the relationship between stock prices of gold mining companies and the price of gold bullion, investors can identify those occasions when gold mining shares are either overvalued 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. Since the mid-70's, extreme readings in the relationship between BARRON'S Gold Mining Index and the price of gold bullion have exhibited a near-perfect record in foreshadowing major price movements - both bullish and bearish - for gold and gold mining shares. To measure whether mining shares are undervalued or overvalued, look at the following ratio: Each week divide the latest Barron's "Gold Mining Index" (or GMI) value by the latest price of gold bullion (or GB) quoted under Barron's "Gold & Silver Prices" heading. We will refer to this as the Gold Share Index/Gold Bullion ratio (or GMI/GB ratio for short). By examining the GMI/GB ratio each week, investors can often predict with a high degree of certainty whether gold mining shares are likely to rise or fall over the following 52 week period. To interpret the significance of a given GMI/GB ratio, compare the current reading to the following parameters:

BULLISH SIGNALS

A GMI/GB Ratio of 1.45 or less signals that gold mining shares are slightly undervalued and are likely to rise in the following 12 months (See Chart 1). A GMI/GB Ratio of 1.20 or less signals that gold mining shares are extremely undervalued and that a major buying opportunity is at hand (See Chart 2).

BEARISH SIGNALS

A GMI/GB Ratio of 1.91 or higher signals that gold mining shares are slightly overvalued and are likely to decline in the following 12 months (See Chart 1). A GMI/GB Ratio of 2.15 or higher signals that gold mining shares are extremely overvalued and that gold mutual funds should be sold immediately (See Chart 3).

As an example, on June 18, 1982, the GMI fell to 344.46 while gold bullion was selling at $308.75 an ounce. The result was a GMI/GB ratio of 1.12 (344.46/308.75 = 1.12). Since this reading was less than 1.20, a "screaming" buy signal for gold mutual funds was flashed. Prices of gold bullion, gold mining shares and gold mutual funds subsequently soared. By January 14, 1983 the GMI had risen 205% to stand at 1050.78. During the same period, gold bullion rose 57%, to stand at $483 an ounce. At that point the GMI/GB ratio stood at 2.17 (1050.78/483 = 2.17). Since this reading of 2.17 was greater than 2.15, a signal was flashed that mining shares were extremely overvalued and that gold mutual funds should be sold immediately. Over the following 52 weeks, the Barron's Gold Mining Index fell 31%. As this example illustrates, following the simple Buy and Sell Signal rules detailed earlier, can allow investors to put themselves in a position to earn substantial profits in gold mutual funds, while avoiding the sharp down swings that gold funds can suffer from time to time. Chart 1 details a summary of average price performance by Barron's Gold Mining Index in the 52 weeks following a given weekly reading for the GMI/GB ratio, since 1975. As you can see, low readings are much more likely to be followed by higher mining share prices and high readings are much more likely to be followed by lower mining share prices.

Chart 1
Total # of GMI/GB Ratio Weekly Readings 1.00 or less 1.01-1.05 1.06-1.10 1.11-1.15 1.16-1.20 1.21-1.25 1.26-1.30 1.31-1.35 1.36-1.40 1.41-1.45 1.46-1.50 1.51-1.55 1.56-1.60 1.61-1.65 1.66-1.70 1.71-1.75 1.76-1.80 1 5 10 18 12 16 10 23 21 30 41 23 32 33 26 15 8 # Times GMI Higher 52 Weeks Later 1 5 10 17 10 13 10 19 18 25 25 11 15 23 13 8 1 % of Time GMI Higher 52 Weeks Later 100 100 100 94.4 83.3 81.3 100 82.6 85.7 83.3 61 47.8 46.9 69.7 50 53.3 12.5 Average 52 Week % Gain/Loss

46.5 92.4 99.7 108.4 67.2 82.8 72.1 61 52.6 46.1 30.5 7.4 -3.5 10 -2.5 -11.3 -14.7

1.81-1.85 1.86-1.90 1.91-1.95 1.96-2.00 2.01-2.05 2.06-2.10 2.11-2.15 2.16-2.20 2.21-2.25 2.26-2.30 2.31-2.35 2.36-2.40

30 43 23 26 32 36 21 11 8 11 6 2

10 9 1 2 2 2 0 0 0 0 0 0

33.3 20.9 4.3 7.7 6.3 5.6 0 0 0 0 0 0

-10.5 -12.7 -20.4 -19 -16.3 -20.4 -24.4 -21.4 -23.8 -26.8 -27.6 -17.2

2.41-2.45 1 0 0 -15.6 Since 1975 there have been three periods during which the GMI/GB ratio fell to 1.20 or less. The starting dates for each of these periods and the subsequent action of the GMI and gold bullion are depicted in Chart 2.

Chart 2
Date GMI/GB GMI 3 mos. GMI 6 mos. GMI 12 first falls later later mos. later below 1.20 09/12/79 06/18/82 24% 72% 49% 137% 148% 185% Gold Bullion Gold Bullion Gold Bullion 12 3 mos. later 6 mos. later mos. later

32% 43%

51% 42%

83% 45%

07/18/86 23% 36% 109% 23% 20% 30% In all three cases depicted in Chart 2 the prices of gold mining shares moved sharply higher after the ratio between gold mining shares and gold bullion fell to 1.20 or below. In fact, in each case, Barron's Gold Mining Index stood over 100% higher 12 months later. This represents the kind of rare buying opportunity that gold mutual fund investors should be looking for. On the flip side, Chart 3 depicts the performance of Barron's Gold Mining Index and gold bullion following those occasions when the GMI/GB ratio first rose to 2.15 or higher. In each case the Gold Mining Index declined sharply in the ensuing months.

Chart 3
Date GMI/GB GMI 3 mos. GMI 6 mos. GMI 12 mos. Gold Bullion Gold Bullion Gold Bullion later later later 3 mos. later 6 mos. later 12 mos. later

first rises to 2.15 or above 01/04/83 08/28/87 -7% -24% -10% -34% -31% -41% -10% 5% -12% -5% -23% -4%

01/12/90 -15% -24% -23% -10% -13% -6% In more recent history, the GMI/GB ratio rose to 2.25 in January of 1990. This signaled that a bear market for precious metals and related assets was soon to begin. At that time, Barron's Gold Mining Index stood at 938.61. Early in February of 1990 the Index peaked at 1021.87. By June of 1992, that index had plunged 38%, to 660.33, and a number of analysts were beginning to speculate that a bullish move in precious metals was imminent. However, the GMI/GB ratio still stood at a relatively high reading of 1.86, indicating that any talk of a bull market in precious metals was premature. The Gold Mining Index subsequently plummeted another 25%. Following this most recent plunge, the GMI/GB ratio has finally slipped into sowewhat favorable territory, at 1.42. As depicted in Chart 1, over 80% of the readings below 1.45 have been followed by higher mining share prices one year later. Investors should remain alert to the fact that gold mining shares could suffer still further declines before a "screaming buy" reading of 1.20 or less is generated. On the other hand, there is no guarantee the GMI/GB ratio will decline to that low of a level before a rally in mining shares begins. Also, from a contrarian point of view, it is interesting to note that the GMI/GB ratio is entering favorable territory at the same time that the outlook for precious metals is being portrayed as extremely negative, with newspaper headlines heralding the "2nd lowest inflation in 25 years". If history proves an accurate guide, there is now a strong possibility that mining share prices will move higher in the year ahead. In light of these developments, it may be time for investors to start taking another look at gold mutual funds.