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Why Hold Gold Stocks At All?

Below is an extract from a commentary posted at www.speculative-investor.com on 5th August 2004.

Our view that the US$ will trend higher over the next several months and, as a consequence, that gold stocks are likely to trade at lower levels at some point between now and November, has prompted questions from subscribers along the lines of: Why do we suggest maintaining a sizeable position in gold stocks in the current environment? Wouldn't it be better to just get out of all gold stocks and re-enter later this year once the corrective activity comes to an end and the next major advance gets underway?

Well, getting out of all gold stocks would be a reasonable thing to do if we could be absolutely CERTAIN that the stocks we own were going to trade significantly lower in the future, but that isn't the case. Rather, there's a good CHANCE that the stocks will be available at lower levels before year-end, but this is a reason to be cautious and to maintain higher-than-usual cash reserves (something we've been strongly advocating since January); it is not a reason to be completely out of the market.

Being completely out of gold stocks would be akin to betting everything on a single short- or intermediate-term call and would, in our opinion, fly in the face of sensible risk management practice. The reason is that while most gold stocks will PROBABLY be available at lower levels the magnitude of the upside risk is generally many times greater than the magnitude of the downside risk. We can show what we mean by this by doing a 'back of the envelope' valuation of NovaGold (TSX, AMEX: NG).

If things go roughly to plan then NG will have annual gold production of around 700,000 ounces by 2008. Currently, the average market cap per ounce of gold production across the entire gold sector is around US$2000, so the aforementioned production would be valued at around US$1.4B if the gold price were near current levels (a higher gold price would increase the value of gold production). Now, assuming that NG has to issue another 10M shares over the next 4 years in order to finance project development -- a reasonable assumption given the company's current cash reserves and the likelihood that earlier projects will provide the cash to finance later projects -- then a US$1.4B market cap in four years time would be equivalent to a stock price of US$19 (C$25).

The above-calculated price of C$25/share for NG is 280% higher than yesterday's closing price of C$6.44 and, as mentioned, assumes ZERO increase in the gold price. However, we expect that the gold price will be trading well north of US$1,000 by 2008 so the actual stock price could be MUCH higher than our calculated value.

So, that's the potential upside over the next few years for one of our stocks and against this we must balance the risk of a drop back to around C$5.00 at some point over the next few months.

Most gold stocks don't have NovaGold's growth prospects so the above example is not representative of the sector as a whole. As far as the overall gold sector is concerned, though, a similar argument can be made in that the upside potential over the next few years can be shown to dwarf any short- or intermediate-term downside risk. In particular, with current sentiment towards the gold sector ranging from disinterest to pessimism (refer to the below discussion on gold market sentiment) the probability of another large down-swing in the prices of gold shares is low. What would, instead, be more likely is a drop back to near the May lows or, perhaps, to a few percent below the May lows; and against this downside risk we must balance the potential for another multi-year advance of similar magnitude to the one that unfolded during 2001-2003.

When it comes to gold stocks something else that unfortunately needs to be taken into account at this time is the very real potential for another large-scale terrorist attack. As discussed in our 26th July commentary, gold stocks would probably get hit hard if the broad stock market tanked UNLESS the reason for the plunge in the stock market was terrorism, in which case gold stocks would move sharply higher if the September-2001 experience was anything to go by. In other words, at this time it might be appropriate to hold some gold stocks as a hedge against a financial crisis brought on by the destructive acts of barbaric terrorists.

Further to the above, we think it's important to be aware of the downside risks in the gold sector as far as the next several months are concerned, but not to allow the potential for additional counter-trend moves in gold and the US$ to completely override our longer-term views and all other considerations.

Gold Market Sentiment

TSI is not a "gold newsletter", but as mentioned in a previous commentary the level of interest in the TSI web site tends to ebb and flow with the level of interest in gold-related investments. Specifically, when rising prices cause the public to become more enthusiastic about gold and gold shares we see an increase in subscriptions (trial subscriptions and paid subscriptions) whereas the level of interest in the TSI service invariably drops off during corrections in the gold market. In this respect this year's gold market correction has had a similar effect as the corrections that occurred during 2002 and 2003, and even though the prices of gold and gold stocks have made a moderate recovery over the past 2.5 months it appears as if sentiment has remained quite depressed.

Other sentiment indicators paint a similar picture to our experience at TSI. For example, the commitments of traders (COT) data show that small traders were only marginally more bullish on gold with the gold price trading above $400 in July as they were when gold was trading in the 370s during the first half of May. Also, the below chart shows that the total assets in the Rydex Precious Metals Fund are now less than they were when gold and gold stocks were near their lows in May. In other words, since the May bottom the public has continued to lose interest in gold-related investments. This is, of course, bullish from a contrarian perspective and should help to limit the downside from here because it means that a lot of the weak hands are out of the market.

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