One of the things I have been thinking about a lot lately is how gold mining stocks are going to perform in the coming global economic collapse. There is no doubt that the price of gold will continue to rise as the world realizes that fiat currencies and government debt levels are unsustainable, but rising gold prices don’t necessarily translate into rising stock prices for gold miners.

Graham Summers wrote a nice piece on gold-eagle.com titled Will Gold Miners Act Like Stocks or Gold During the Crash? Summers writes that “Since 2000, the HUI Index has rallied more than 500% compared to 340% for Gold bullion over the same time period.” During this same period the S&P 500 has fallen 27%. Looking at this 10 year period it makes sense that gold stocks would outperform the price of gold as the cost to get an ounce of gold out of the ground did not rise as fast as the price of gold.

The story is a little different when you look at the crash of 2008. Summers writes, “In 2008, stocks fell 37%, Gold miners fell 30%, and Gold actually ROSE 5% (despite an extremely volatile year).” It is this type of crash that worries me as an investor in gold miners. In 2008, gold stocks did not perform well because investors on margin were being forced to sell everything to raise capital. Typically when this happens you tend to sell your most profitable investments first, which for these investors were their gold holdings.

Flash Crash vs Slow Gradual Decline

I think that if we experience a quick, sharp decline like we did in 2008 then gold mining stocks will get killed. While they will probably still outperform the S&P 500, they will still get killed nonetheless. However, if we have a slow, gradual decline then it is very likely that gold miners will perform extremely well. Personally, I hate to be right about an economic trend, but fail to properly play my cards correctly. Here is how I would play this going forward.

How to hedge gold mining stocks for the coming collapse

The best way to hedge this is going to be to short the stock market. Personally, I think the best way to do this is to take a position in FAZ. FAZ is a financial bear ETF that is leveraged 3 times, so if financial stocks drop 2% in a day, FAZ will theoretically be up 6% on the day. The reason I think that shorting the financials is the right way to play this is because I think financials are currently the most overvalued industry and will be the sector hit the hardest in the event of another economic collapse.

Here is my strategy with different scenarios…

Scenario: Stock market slowly climbs higher

If this happens, the price of gold will continue to do well and gold mining stocks will outperform. FAZ will fall, but your losses in your small hedge position in FAZ will be offset by outstanding performance in the gold miners.

Scenario: Stock market moves sideways with volatile swings

In this case, gold miners will likely still outperform the S&P 500. You will want to be trading FAZ as it will have the ability to move 5-10% in a single day. Anytime FAZ drops more than 5% in a day, you should buy a small position. If it goes up more than 5%, take your profit and wait for the next 5% drop. The idea here is to not hold FAZ long term in a sideways market, but to use the volatile swings to trade. You also should only start to take small positions, don’t go “all in” on a single 5% drop as this is a way to get burned very quickly. If FAZ continues to drop, it means the stock market is going up, so hopefully your gold miners are also doing well. In a large stock market rally, you should consider taking some of your gold profits and add to FAZ at depressed prices.

Scenario: Stock market crashes in a sharp decline

If the stock markets crashes, you will profit handsomely with your FAZ position. However, in a sharp decline in the stock market it is likely that your gold mining stocks will probably drop as well. DO NOT SELL THESE STOCKS AT A LOSS. Instead you will want to slowly sell your FAZ position at a 50-100% profit and buy more of your gold miners at depressed prices. In 2008, gold stocks rebounded extremely fast after the initial collapse.

Scenario: Stock market slowly declines overtime

A slow, steady stock market decline is probably unlikely in this economic environment, but if this were to occur it is my opinion that gold mining stocks will still perform well an increase in price and FAZ will also do well.

I would love to hear your thoughts on this strategy - comments welcome…

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Gold, Stock Market by Andrew Nadeau