Jefferies Gets Negative on Gold Miners, with an Interesting Pairs Trade Idea

The one thing that is appealing to the team at Jefferies is the volatility in gold. They believe higher interest rates will be the key to force gold prices modestly lower. Regardless of whether the Federal Reserve tapers its efforts or the market raises interest rates by itself, they analysts believe interest rates will go modestly higher. Therefore, they are sticking with a long-term forecast of $1,250 an ounce. They do have an interesting avenue for investors, should they want to put a gold trade on.

The trade is called a pair trade, and it is a common strategy used by portfolio managers on Wall Street. It involves being long and short stocks that are in the same category or sector. In this case, the Jefferies team has put together a trade that involves being long the actual physical gold, while being short the gold miners. Here is how the trade is constructed.

SPDR Gold Trust ETF (NYSEMKT: GLD) is bought as a long position. This is the exchange traded fund that serves as a vehicle for holding the physical gold itself. Typically in a pair trade, the portfolio manager will match the dollar amount of the long and short positions. So investors seeking to put the pair trade on buy the GLD in their account.

Barrick Gold Corp. (NYSE: ABX), Goldcorp Inc. (NYSE: GG), Kinross Gold Corp. (NYSE: KGC) and Newmont Mining Corp. (NYSE: NEM) are all sold short in the account, in equal lots of 25% each. This provides the investor with the basket of stocks that make up the other part of the trade.

The main idea behind the trade is that while physical gold prices often can spike on inflation threats, geopolitical risk and headlines, the actual gold miners are in far bigger trouble from a profit standpoint. Gold mining is an extremely capital intensive and expensive business. Given the short reserve lives, rising costs, rising political risks and a stagnant commodity price, the Jefferies analysts believe an argument could be made that gold equities should trade at valuation discounts to other resource equities. Instead, they continue to garner valuation premiums. So, that continues to make the risk/reward for the North American gold group very unattractive.

For investors wanting just to be either long or short the gold trade, Jefferies does have specific recommendations in its report.

Freeport-McMoran Copper & Gold Inc. (NYSE: FCX) is the favorite name in the space. The company announced Friday that its Indonesian union workers are expected to sign a new contract within two weeks after reaching an agreement over wages. Freeport Indonesia employs about 24,000 workers, including contractors and staff. About three-quarters are union members. This puts one of its top copper mines back in production. The Thomson/First Call price target for the stock is $37.50. Investors are paid a very solid 3.7% dividend. Freeport closed Thursday at $33.01.

Newmont Mining Corp. (NYSE: NEM) is the stock to focus on if investors are looking for a specific gold mining stock to sell short. The stock was hit hard this week on speculation the company would bid for a large copper mine in Peru. The Jefferies target for the stock is $18, and it has an Underperform or Sell rating on the stock. The consensus price target is $32. Investors are paid a 3.6% dividend. Remember, in a short sale the seller is responsible to pay the dividend. Newmont closed Thursday at $26.96.

Gold stocks remain very expensive in Jefferies’ opinion. The analysts believe the only way they make sense is if gold prices rise materially. They also expect the gold equity multiple to continue to compress. The analysts are very in the pair trade that is long gold and short gold equities. This may be a smart way for investors to play what has become a very tricky sector, after a long upward move.