The Big Picture: Gold Stocks

March 28, 2009

I believe that the fundamentals for gold stocks are widely misunderstood. The current environment we are in is wildly bullish for gold stocks. This is not because of inflation, but because of deflation. The strongest fundamentals for gold stocks are during a deflationary period. Because we have entered a secular credit contraction (i.e. Kondratieff Winter, depression, etc.), understanding how gold stocks do during such periods is crucial.

Though this seems counterintuitive to many gold bugs, who are always looking for the next great inflation, such gold bugs invested in gold stocks will be right but for the wrong reasons. Gold stocks outperform the metal during deflationary periods (and gold can actually do rather well during deflation), especially when compared to other asset classes such as general stocks, bonds and real estate.

I am a proponent of both fundamental and technical analysis and following is a "big picture" summary of where I think we are and where I think we're headed in the gold mining sector.

Gold miners make more money when the price of mining gold is declining relative to the price of gold itself. Not to belabor a basic point, but it doesn't matter if the gold price is rising, falling or flat. If costs decrease faster than the gold price, profit margins rise. Though short-term swings in the markets are far from rational, most investors would agree that expanding profit margins will almost always eventually translate into a higher stock price (and often higher dividends and dividend yield).

In an inflationary period, costs can rise faster than the gold price itself, as happened last spring. Gold was rising in price but less than the price of oil, for example, and thus profit margins for many gold miners were flat to declining despite a big price rise in gold. So the miners did go up, but did not "leverage" the price of gold and in fact most underperformed the gold price itself.

In a deflationary period, the gold price is often in the range of flat, though it can decline or rise as well. However, costs drop rather rapidly as other commodities such as oil get killed and labor costs fall. This is best exemplified using ratio charts comparing the price of gold to the price of a basket of commodities. Below is a 10 year weekly ratio chart (log scale) of the gold price divided by the Continuous Commodity Index (CCI):

Because labor costs are also falling, profit margins are now in a position to expand rapidly for miners and this will continue as the credit contraction we are now in continues. The current rise in this ratio chart is the biggest move upward move this ratio has seen in decades. This will cause gold stocks to increase in value, their stock prices to rise and the gold stock sector to outperform the gold price.

The chart below exemplifies this concept and is a log-scale 10 year weekly ratio chart of the AMEX Gold Bugs Index ($HUI) divided by the price of gold:

These concepts are simple yet powerful and fundamental to understanding gold stock behavior. This also explains why gold stocks can go up during a bear market. Let's take a look at the last bear market in general equities in the United States from 2000-2003 to demonstrate a recent historical example. The chart below is a weekly log-scale chart from early 2000 to early 2003 and contains two different price graphs: the S&P 500 a candlestick chart with the scale on the right and the $HUI a black line chart with the scale on the left.

History is in the process of repeating itself again. The weekly log-scale ratio chart of the $HUI to the $SPX over the past 10 years shown below demonstrates what happened in the last bear market and what has already started to happen again:

In terms of where we are in this leg of out-performance by gold stocks relative to gold and general stocks, I think we are 2 years away from topping out in this ratio and I believe, using Friday's closing price, that senior unhedged gold stocks (using the $HUI as a proxy) will gain at least 200% within the next 2-3 years. This is a tremendous pending gain considering the general stock market will continue to do poorly over the next 2 years.

I believe all investors should allocate at least 5-15% of their investment funds to physical gold. I am talking about actual physical gold coins and bars, not paper proxies. I also believe that a currency crisis and heavy inflationary period are coming for the United States and that gold could go to astronomical levels once this occurs. However, the bottom line for investors in the gold sector looking to profit from the ongoing secular bull market in gold is clear: new money is better put to use in the gold mining sector right now rather than in the physical metal and this will be true for at least the next 1-2 years.

 

Please visit my blog for additional information on gold and the general markets.

 

http://goldversuspaper.blogspot.com

10 karat gold is 41.7% pure gold.