The performance of Gold mining shares relative to Gold is most often measured in terms of ratios between Gold and various mining shares’ indexes. One of the most popular ones is the Gold/XAU ratio presented in Chart 1. The Chart clearly illustrates the marked under performance of the XAU index since the beginning of Gold’s up trend in 2001 as compared with earlier periods. Moreover, it is evident that this situation has worsened in recent months as the ratio has fluctuated very narrowly between just under 20 and just shy of 24 even in the face of one of the best bull moves of Gold. The reasons for such under performance are not well understood. Among the most frequently mentioned are rising energy and other costs, dilution of share values by excessive share offerings, and difficulties in finding new Gold deposits to replenish reserves,

While these reasons intuitively seem to have a great deal of validity, it is believed that perhaps a better explanation could be envisaged by asking another question: why mining shares outperformed so starkly Gold during several earlier periods when the metal moved up only slightly or moved side way. As shown in the Chart, the period 1990-97 is quite representative in this regard as the out performance of mining shares pushed the Gold/XAU ratio up to a peak of nearly 39.

A reasonable explanation which we like to offer here would run as follows. After the blow off in 1980 the collapse of Gold prices combined with a regime of tight monetary policies and sustained disinflation to discourage investments in Gold and prompt forward selling by producers. These conditions depressed the price of Gold to significantly undervalued levels. Investors, however, were willing periodically to bid up the prices of mining shares to what could be surmised to represent more realistic Gold prices. Then, beginning in 1996, increasing real interest rates in what was then defined as "passive monetary tightening" by the Fed (real Fed interest rates reached 4.0% in early 1998 as the Fed "passively" kept rates unchanged in the face of declining inflation rates) and a consequent strong appreciation of the US dollar, caused a second collapse of Gold and mining shares. Thus, by the year 2000 for the first time since 1976, Gold prices declined to or below cost of production. Shortly thereafter, from 2001 onward, conditions dramatically changed as the Fed cut interest rates to record low levels and the US dollar slid into a sustained slide. Gold prices started to rise and mining shares followed suit with a bang. However, as Gold prices rose to more reasonable levels of valuation, the rate of appreciation of mining shares began to contract. With expectations for Gold appreciation became at least partly, investors, particularly institutional ones, became less willing to bid up mining shares and more willing to take profits for capital gains distributions to shareholders.

This sort of evolution is and should be regarded as normal since it occurs not only in the PM sector but also in all other stock sectors and, further down, in the micro-environment of individual stocks. Thus, it is a matter of common observation that the price earning multiples (PEs) of stocks contract as corporate earnings increase and fulfil investors’ expectations. In the particular case of Gold mining shares, the Gold/XAU ratio is in effect the equivalent of the Index’s PE ratio. These ratios represent important measures of fundamental valuation which in turn affect the prices investors are willing to pay for any given level of earnings. As a corollary, it should be expected that, just as greater and greater increases of earnings are necessary to produce given amounts of common stocks appreciation, so greater and faster increases of Gold prices are essential for mining shares to go higher. Otherwise the shares’ movement will eventually lag that of the metal and the Gold/XAU ratio will continue to contract to the point where the normal leverage of the shares will fall to a minimum or disappear and the returns from ownership of shares will equal that of the metal itself.

From the above arguments it follows that the prospect for a better performance of Gold mining shares will depend crucially on one’s view

as to whether or not sufficiently favorable conditions are now at hand for an accelerated rise of Gold. Notwithstanding the high probability of a Gold price correction in the very near future, the answer is believed to be in the affirmative.