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January 23, 2008

Are Gold Stocks Dangerous?
by Alex Wallenwein

I have thought hard for a long time about writing this article. There is a danger that it might spook a lot of investors out of gold stocks and gold mutual funds altogether, and therefore bring unnecessary loss to many people. On the other hand, this one article will probably not be that influential.

I cannot shake the feeling that, during the first part of 2008 at least, gold stocks will have a whale of a bad time. Yet, nobody wants to address the subject because most so-called gold bugs are really gold stock bugs. Nobody wants to scare their own customers away, but there is a time when a warning is due, and I think hat time is now.

The problem is not that regular stocks are diving right now, and that gold stocks will necessarily follow regular stocks. That is simply not the case. As long as gold holds up and continues to rise, gold stocks will have a floor under them, but it's extremely risky (and foolish to assume that the floor lies right where the two gold stock indexes currently are.

What's the Problem?

On the one hand, several main trends are converging that negatively impact the profitability of gold miners in the near future. On the other, there are only two "plus" factors that will support gold miners - and then there is the wild card.

The negative trends are:

Decreasing ore grades across the world's gold mining industry;
Depletion of known deposits; (3) Difficulty in discovering new deposits to replace depleting ones;
Rising production costs (fuel, transportation, inflation, etc.);
Rapidly tightening environmental restrictions on gold mining and a deteriorating public image of mining companies as "nasty polluters", etc.

The plus factors are (1) gold is in a secular uptrend that is in the process of establishing a new phase of steeper price increases than those prevailing in the previous phase, and (2) the building US and world economic slump that will have mainstream stock and bond investors looking for safe and profitable places to seek refuge for their money.

The Question

The question is: To what degree will the two positive factors outweigh the five negative ones so as to prevent the gold mining industry from going downhill, even as the metal itself becomes more and more expensive in fiat currency terms, world wide?

Before we get into the subject matter, let's establish what exactly we are talking about here. We're addressing the two major gold stock indexes, the XAU and the HUI as well as gold mutual funds - not individual mining companies not yet listed on any of the indexes. In other words, we are looking at macro trends in gold mining.

First, the charts:

The HUI is below its November 2007 High but above its 2006 High

... while the XAU is below BOTH its November 2007 and 2006 highs.

Gold, on the other hand, is well above both highs and very near its most recent closing-high of $905 per ounce.

Both the HUI and XAU are showing similar megaphone patterns emerging (only the HUI's chart is shown here because of the close similarity).

The days of the really steep HUI rises appear to be over for now.

For any starting point after 2004-2005, the comparison charts show the HUI to be no better than gold, sometimes worse, in its percentage performance. The XAU has traditionally been gyrating around the price of gold, although with a much wider amplitude on both sides.

However, more recently gold has had the upper hand, and in view of the five negative factors pushing its stocks down, that is not surprising.

Guess it all depends on how quickly the crash comes. If people have time to prepare and think, and if it happens in stages and in a somewhat controlled fashion, gold stocks will do well as long as people have time to shift their assets around as the Dow and its associated plunge downward. If the crash is sudden and catastrophic, having loaded up on gold stocks will do little to ameliorate the disaster.

The problem is, none of us know which way it's going to be, so the most sensible way would be to get out and either buy gold for the proceeds or stay in cash and wait for the bottom.

Naturally, the smart thing for all gold stock investors (as a group) to do would be to sell stocks and buy gold. That way, the gold price is supported and with that one going up, the stocks will do okay as well. Alas, gold stock investors only act as a group when they are either scared or greedy.

If you want to be "super-clever", you will sell your stocks and wait for gold to consolidate after its drop and then buy back in. That can be a gut-wrenching game, however. As we all most recently saw, a gold consolidation period can last for a year and a half. Few will have the inner fortitude to keep their cash dry during all of that time. Their return-dependent investment fingers will be itching to put the money into something else in the meantime so it can "work" for them.

The Wild Card - India

Indians are selling gold. From a fiat-oriented perspective, it makes sense for them. India isn't nearly as debt-laden as the US economy. People who had their money in gold watched their neighbors brag about general stock market gains many times those who held gold for years now. The gold they once bought at much lower prices now fetches far more - so hey, why not?

The problem is that even the kicking Indian economy is still a fiat economy with all the attendant ills. It has a very export dependent economy, with 17 percent of all exports going to the US, with the next largest numbers going to the UAE at 8.3 and China at 7.8 percent (CIA World Fact Book, 2006 numbers). Betting on continued stock market gains of that magnitude while the US is going through a serious economic "readjustment" would be rather foolish. Cash-strapped, debt-laden, and unemployed Americans just won't have that much of a need for outsourcing their services to India - or to anywhere for that matter.

In any case, Americans had better wise up quick and buy "physical." Gold and silver stocks (with the exception of stock of individual companies with the occasional "big find") are just not going to fare that well - not until everybody and their brother decides that gold stocks are the only place left to invest in.

The point is: It doesn't make sense to stay in gold stocks and wait for that time.

Gold stocks and gold mutual funds have their time and their place, but now appears to be neither. It will make more sense to redeploy money into them after the annual mid-year correction bottoms out. Monitor subscribers will know when the time comes. Although there is still a chance they may go higher again before then, at least to some extent, the downside risks right now are just too great to justify.

As always, stocking up on physical gold is a far better choice for long-term investment. No matter how far the illusory dollar "price" of gold may sink, owning physical means you never lose your entire investment.

Got gold?

Alex Wallenwein
Editor, Publisher
The Euro vs Dollar Monitor

Just like driving your car, investing only makes sense if you can see where you are going. The Euro vs Dollar Monitor is your golden windshield wiper that removes the media's greasy film of financial misinformation from your investment outlook. Don't drive your investment vehicle without it!