Hedging With Gold Miners (AEM, GFI, NGD, DGL)

In the last period of sharply rising prices (the late 1970s), Gold shot from $100 to $850. This gold bull began at $250 9 years ago, and Gold bug such as hedge funds manager John Paulson believes it may peak well above $2,125 an ounce before this one's over.

Last Thursday Gold price plummeted $50 as mounting debt worries out of Portugal, Ireland, Greece and Spain (PIGS countries) and boosted the dollar to a multi-month high.
Is it still a good time to jump on the bandwagon?

4 Reasons to Hold Gold
1. Even though we're still in a deflationary environment, there will be a time when we have to worry about inflation as government spending continues to grow.

2. Central banks like India and China hold much more of their reserves in the U.S. dollar than in gold for economic and political reasons, but there's a clear, long-term diversification away from the greenback and Gold is benefit from this trend.

3. Gold’s price is highly correlated with political instability and has negative correlation with stock market (http://seekingalpha.com/article/149636-portfolio-diversification-is-key-...).

4. In September 2009, Barrick Gold (ABX), the 2nd largest gold-mining company in North American, lifted its hedge against gold prices falling, an admission it expects gold prices to continue to rise.

18 Major Gold-Mining Companies
# Name (Symbol) Mkt cap P/E Forward P/E (1yr)
1 Barrick Gold (NYSE: ABX) 35.23B - 13
2 GoldcorP (GG) 26.02B 23 28
3 Newmont Mining (NYSE: NEM) 22.66B 30 15
4 AngloGold Ashanti (AU) 13.92B - 16
5 Kinross Gold Corp (NYSE: KGC) 11.95B - 26
6 Agnico-Eagle Mines (NYSE: AEM) 8.48B 140 28
7 Gold Fields Limited (NYSE: GFI) 8.19B 27 9
8 Compania de Minas (NYSE: BVN) 7.85B 24 11
9 Yamana Gold (NYSE: AUY) 7.67B 22 14
10 Randgold Resources (NASDAQ: GOLD) 6.27B 118 -
11 Lihir Gold Limited (NASDAQ: LIHR) 6.24B - -
12 IAMGOLD Corp (NYSE: IAG) 5.15B 104 18
13 Eldorado Gold (NYSE: EGO) 4.94B 27 31
14 Harmony Gold Mining (NYSE: HMY) 4.03B 23 14
15 Royal Gold (NASDAQ: RGLD) 1.81B 41 30
16 New Gold Inc (AMEX: NGD) 1.64B - 18
17 Gammon Gold (NYSE: GRS) 1.27B 217 11
18 NovaGold Resources (AMEX: NG) 1.03B - -

Gold mining companies have their own business risks influenced by many factors, such as the grade and depth of the deposit, financial as well as operation issues.

Production cost varies among these companies, from Eldorado Gold (EGO)’s $300 an ounce to Gold Fields (GFI)’s $600 an ounce. Also, profits can swing wildly for companies lacking of price hedges.

10 Gold ETFs
# Fund Name (Ticker)
1 SPDR Gold Shares (NYSE: GLD)
2 Market Vectors Gold Miners ETF (NYSE: GDX)
3 iShares COMEX Gold Trust (NYSE: IAU)
4 PowerShares DB Gold Double Long ETN (NYSE: DGP)
5 Ultra Gold ProShares (NYSE: UGL)
6 PowerShares DB Gold (NYSE: DGL)
7 PowerShares DB Gold Double Short ETN (NYSE: DZZ)
8 UltraShort Gold ProShares (NYSE: GLL)
9 PowerShares Global Gold & Prec Metals (NASDAQ: PSAU)
10 PowerShares DB Gold Short ETN (NYSE: DGZ)

SPDR Gold Trust (GLD) is now the second-largest ETF, after SPDRs (SPY) which tracks the S&P 500. Market Vectors Gold Miners ETF (GDX) consists of companies involved in the gold mining industry.

Conclusion
According to Douglas Breeden, professor of Duke University, historical statistics are insufficient for accurately assessing risk. Since 1975, housing prices have never declined in the U.S. for a full 5 to 10 year period. Yet, price declines have occurred in 2008 and 2009 that have never been seen, or even imagined, since the Great Depression of the 1930s. One of the worst misuses of models is to look at history to determine the worst that has been seen and concluded that it is the worst that can be. The problem is that the historical scenario may not be bad enough. We need to think about circumstances that have not occurred but are possible.

Besides its use in jewelry, gold serves very few functions. For protection against inflation, you can always use iShares Barclays TIPS Bond (TIP), or as Warren Buffett does: investing in companies that have the ability to pass on price increases. With average forward P/E of 19 for major gold mining stocks, it might indicate Gold is overvalued.

However, no one knows when and where the next shoe will drop. Even without a potential new round of stimuli, current level of U.S. borrowing indicates that the U.S. dollar may depreciate over the long term. Sooner or later inflation might come. If the world really does falls into the cliff, gold might prove a nice insurance. I allocate a few pentane of my portfolio in gold mining stocks, just for a peace of mind.

Disclose: I have long position on ABX, NEM, and TIP. Data are from iShares (http://us.ishares.com), Google and Yahoo Finance as of February 5, 2010.

Stocks: ABX, AEM, AU, AUY, BVN, DGL, DGP, DGZ, DZZ, EGO, GDX, GFI, GG, GLD, GLL, GOLD, GRS, HMY, IAG, IAU, KGC, LIHR, NEM, NG, NGD, PSAU, RGLD, TIP, UGL