It is often said that you can tell a bull market has run its course when your taxi driver starts recommending stocks.

Gold mining stocks look undervalued relative to physical gold. (Newmont Mining's Carlin-Nevada Complex)

Not many cabbies are recommended stocks these days – their fingers are still smouldering from the bursting of the dot-com bubble in 2000 and the financial crash of 2008 – but they are recommending gold bullion.

This could be saying two things. First, that now is not the time to buy physical gold and, second, that now is the time to buy equities.

At first glance, gold’s stellar rise from just over $600/oz five years ago to well over $1600 today does look a little heady. Taking some profit now may be wise, but this does not mean it is overvalued. Far from it, the case for gold remains strong and underpinned by a number of factors.

These factors include exceptionally low interest rates, which reduce the opportunity cost of owning gold; a weakening dollar, which by definition leads to higher gold prices; long-term inflation fears, which lends itself to gold’s status as an inflation hedge; rising demand in emerging markets as more and more Indians and Chinese buy gold jewellery; and increased central bank purchases following a waning of the euro’s reserve-currency status. None of these factors looks likely to diminish any time soon.

So, if physical gold looks safe, could taxi drivers inadvertently be telling us something else – that, if now is the right time to buy equities, gold mining stocks is where the smart money should be? Indeed, the valuations of gold mining giants such as Barrick Gold, Goldcorp and Newmont do not look stretched, especially when compared to the current price gold.

Gold mining stocks versus physical gold (performance, rebased at 100 in 2005).

As the chart to the right shows, gold mining stocks (as represented by the S&P Commodity Producers Gold Mining Index) have trailed the price of gold for much of the past five years. This divergence in performance has accentuated over the past 18 months.

Many analysts now think that the gap has become unjustifiably wide and that gold mining stocks are set for a period of outperformance relative to physical gold.

Sector fundamentals support this view. The valuations of gold mining stocks do not reflect gold at $1600+/oz, and many gold miners themselves are still basing feasibility models on a $1000/oz gold price. This suggests that, despite gold’s meteoric rise, there’s still a lot of value within the gold sector that has not been realised.

Moreover, profits and revenues are stronger than ever. The difference between current extraction costs for miners and the price of gold is significant (approximately $900-1000 an ounce for extraction vs. spot of circa $1600/oz) creating the opportunity for miners to enjoy higher profit margins and the potential for favourable risk adjusted returns.

This is backed up by analysis from BlackRock which showed that while the gold price year to date has averaged $300/oz higher than in 2010, the average costs in H1 2011 rose by only $75/oz.

All this suggests that gold mining stocks offer significant upside potential.

Of course, there are other issues to consider. For example, dividends paid out by gold miners currently average an anaemic 16% of net income, plus there are concerns that legislation related to cleaner emissions and the environment may hit profit margins.

Another factor to consider – though not necessarily negative – is that gold miners aren’t always 100% focused on gold. Many have exposure to copper and some even have exposure to platinum or palladium.

For investors looking to invest in gold mining stocks there are a number of exchange-traded funds (ETFs) to choose from:

iShares S&P Commodity Producers Gold ETF (UK)
The iShares S&P Commodity Producers Gold ETF aims to track the performance of the S&P Commodity Producers Gold Index. This index provides exposure to the largest publicly-traded companies involved in the exploration and production of gold and related products from around the world.

ETFX DAXglobal Gold Mining Fund (UK)
The DAXglobal Gold Mining Fund aims to track the performance of the DAXglobal Gold Miners Index. This index gives investors the opportunity to participate in and track the performance of companies operating around the world primarily in the areas of gold mining. The constituents are exclusively companies that generate at least 50% of their income from this sector.

RBS Market Access NYSE Arca Gold BUGS Index ETF (UK)
The RBS Market Access NYSE Arca Gold BUGS Index ETF aims to track the performance of the NYSE Arca Gold BUGS Index. The Gold BUGS (Basket of Un-hedged Gold Stocks) Index is a modified equal weighted index of companies involved in gold mining. The index provides significant exposure to near-term movements in gold prices by including companies that do not hedge their gold production beyond 1.5 years.

ComStage ETF NYSE Arca Gold BUGS (De)
The ComStage ETF NYSE Arca Gold BUGS also tracks the NYSE Arca Gold BUGS Index (see above).

Market Vectors Gold Miners ETF (US)
The Market Vectors Gold Miners ETF seeks to track the performance of NYSE Arca Gold Miners Index, a modified market capitalization-weighted index which provides exposure to companies worldwide involved primarily in gold mining, representing a diversified blend of small-, mid- and large- capitalisation stocks.

Higher risk

Global X Gold Explorers ETF (US)
The Global X Gold Explorers ETF seeks to track the performance of the Solactive Gold Explorers Index. This index offers exposure to the largest and most active companies involved in the search, or exploration, for gold.

Market Vectors Junior Gold Miners ETF (US)
The Market Vectors Gold Miners ETF seeks to track the performance of the Market Vectors Junior Gold Miners Index. This index is more speculative as it offers exposure to smaller -and medium-sized companies operating in the global gold mining industry, so-called ‘junior miners’.

Horizons BetaPro S&P/TSX Global Gold Bull+ ETF (Can)
The Horizons BetaPro S&P/TSX Global Gold Bull+ ETF seeks daily investment performance equal to 200% the daily performance of the S&P/TSX Global Gold Index. This index consists of securities of global gold sector companies listed on the TSX, NYSE, NASDAQ and AMEX.

Direxion Daily Gold Miners Bull 3x Shares ETF (US)
The Daily Gold Miners Bull 3x Shares seeks daily investment results of 300% of the performance of the NYSE Arca GoldMiners Index.

(all returns are before fees and expenses)