Gold Stock Time Is Here

Why gold stocks?

If you are bullish on gold, then first of all you need to own gold. Gold is, after all, real money in finite supply and is the best performing asset of the last 8 years. In addition, it looks like it will only perform better in the near future until the DJIA/gold ratio (see our latest educational article for more information) approaches 3:1 or so. After you have a base in gold (which, arguably, should come after a base in food, water, and means to protect them), you may want to consider looking at gold stocks. After all, if you think gold at $1000 an ounce or so is good, what would you think about gold at $300 an ounce?]

Gold stocks provide leverage to the price of gold. Of course, it also increases the risk since you are dealing with companies that must explore, mine, and cost effectively produce gold. Often, these mines are located in politically unstable areas, the companies themselves can be corrupt, and incidents may simply happen that can wreck a mining company that would leave gold itself unaffected (like an earthquake, a dictator nationalizing the mine, or eco-terrorists shutting it down.)

Nonetheless, with risk comes reward, and for the prudent investor that does his homework, we may be about to enter the optimal time for gold stock investment.

There are three primary technical factors, in our opinion, to consider when shopping for gold. First, you need a generally bullish stock market. Since 70% of stocks are correlated (ie, 70% all tend to go up or down together), a panic sell-off in the general stock market (say, due to a credit crisis) will likely take down gold stocks as victims (and present good buying opportunities after the carnage).

Second, you need a rising gold price. Easy enough. Based on our technical analysis (which is often updated here), we believe that gold is just going to, at worst, retest the triangle from which it broke out. That means that within a few days to a week and half, gold will probably turn and move back up, piercing the 1000 level with ease. Currently, as we've been discussing, gold is overbought and appears that it will need a short consolidation. However, once the price moves up and the gold stocks are generally set to go up, we believe they will outperform the metal significantly.

Finally, you need a rising REAL price of gold. That is, gold miners can only make money when the gold they produce is rising in profitability. As the costs of production rise (notably energy), the profit margins become thinner, putting downward pressure on the stocks. There are a few ways to look at the real price of gold, but a reasonable one is to compare the gold:copper ratio, gold:commodities ratio (preferably the Continuous Commodity Index, or CCI), and the gold:oil ratio. If these are all generally rising (meaning gold is move up in price faster than the other measures), then you can have some confidence that the miners will have more profitability.

A few other notes. For one, consider purchasing gold miners in non-dollar currencies on non-US exchanges. You will get both currency appreciation and stock appreciation. Also, if you believe that gold is going higher (as we do), then consider looking into unhedged miners. When a mining company hedges, it is protecting itself with futures contracts against a falling price in gold. That works if gold is going lower, but hurts profitability badly when gold is going higher. Understanding this point, you can see why Barrick is working to remove its hedged position, and why this should be taken as a bullish sign for gold:

Barrick to sell $3 billion in stock to buy back hedges

MATHEW MURPHY

September 10, 2009

BARRICK GOLD, the world's largest gold producer, is raising $US3 billion ($3.5 billion) through a share offering to close its gold hedges, a move widely seen as delivering credibility to the bullish outlook for the metal.

Against the backdrop of a falling US dollar and rising fears of inflation, the gold price has pierced the technically critical $US1000 an ounce mark to hit as high of $1009.70 - 3 per cent shy of the $1033.90 record it reached in March.

Some analysts predict it will maintain its momentum and climb as high as $US1200 as investors protect themselves against a greenback ravaged by the ballooning US deficit.

Barrick is one of the last gold producers to eliminate its hedges - derivative instruments that protect it against a fall in the gold price - and its move has resulted in a mark-to-market loss of $US5.6 billion thanks to gold sales contracts for 9.5 million ounces.

Further to the momentum for the burgeoning ranks of the gold bulls, Barrick said it now held an ''increasingly positive outlook on the gold price''.

Its chief executive, Aaron Regent, said its hedge book had been a concern among shareholders and across the broader market and had ''obscured the many positive developments within the company''.

The Toronto miner paid $US24 million in March to settle a lawsuit with investors who claimed they had been misled by Barrick's suggestion that its hedge book would not affect profits.

''With the industry's largest production and reserves, Barrick provides exceptional leverage to the gold price, which we expect will be further enhanced as we build our new generation of low-cost mines,'' Mr Regent said.

Countervailing the bullish view is the prospect of lower physical demand for gold this year, most significantly in India, and the likelihood that at a higher price a good deal more production will come on stream.

A higher bullion price is a big fillip for Australian producers, particularly high-cost players.

Gold producers use hedges to lock in cash flow, usually at a lower price to the spot market. With the price on the rise Barrick has decided to cut its losses rather than wear any more pain to its share price.

A senior investment adviser at Patersons Securities, Mark Goulopoulos, said the consensus for gold was that it would hit $US1200 an ounce. ''Gold has been dead in the water until late last week, when everyone jumped on board, and that has coincided with the devaluation of the US currency. Most are saying $US1200.

''It seems that pretty much all of the major gold producers are now unhedged and I can't think of a time in the past when they have all been unhedged. Barrick has been quite late to the party.''

Goldman Sachs JBWere said it expected a run on gold to extend for a few more weeks.

''But I'd be very wary of being long gold in a month,'' a Goldmans analyst said in a note.

''I keep hearing many say they are buying gold as a hedge against inflation. Due to the massive stimulus, future inflation is coming. Well, maybe it is, but the more relevant point is that it isn't coming this year or even next year … inflation is a 2011-12 story.''

Source: The Sydney Morning Herald