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The Coming Bull Market in Gold Stocks?
by Professor von Braun
May 14th, 2001
There is these days much comment around about the traditional role of gold and gold stocks during periods of economic downturns. Personally I am opposed to the word traditional when I see it used both in relation to gold and as an attempt to explain today's gold market.
What we do know is that gold has a tradition of being at a price fixed by a central bank and traditionally one could redeem ones paper "whatevers" for gold. Traditionally this redemption process has proven problematic, especially when the issuing of paper became a tad overdone. During a period of crisis the Bank of England suspended redemption of the pound for gold in 1797. President Nixon closed the gold window in 1971 and the US dollar was no longer redeemable in gold. Governments and central banks traditionally tend to monopolize the gold market and change the rules to suit themselves.
The value of an ounce of gold does not of itself change. It is what it is. The price it commands is dependant upon how it, in relation to its alternative, the local coin of the realm, is perceived. For many years (from 1834 to 1933) that price was set at $20.67 per ounce. That's what gold miners received for every ounce they mined and sold. It was a simple equation.
On January 31st, 1934 President Roosevelt "proclaimed" the official price of gold to be $35.00 per ounce, a fixed price that lasted through to 1970, when unofficially gold was trading on the London market closer to $40 per ounce. This proclamation devalued the US dollar by 59.06 per cent. It was not the content of an ounce of gold that changed, it was the value of the local currency that changed. Quite a large change actually.
This devaluation of the US dollar proved a boom for some mining companies, Homestake in particular saw its cash flow improve dramatically and its share price responded accordingly. However it needs to be noted that it was an official act that was intended to devalue a currency that created the increase in the gold price. To say that gold stocks traditionally do well in a contracting economic environment using the actual act of a planned devaluation of the US dollar is putting the cart before the horse. While it is true that stocks peaked in 1929, the real damage was done with the failure of the secondary peak in 1930 and after that it was down hill all the way. Roosevelt increased the price of gold gradually from 1931 through to his "proclamation" in 1934. Homestake's share price was flat in 1930, rose nicely in 1931, again in 1932 and went ballistic in 1933.
That's three years after the market failed and immediately after the local currency was offically debased. Here we are in 2001, with similar conditions to the late 1920's and we do not yet have confirmation of a final top in either the S&P or the Dow. True, the Nasdaq is unlikely to return to its previous highs, but the Nasdaq is NOT the market. It is a component of the overall market which includes the US dollar which is as of today as strong as ever.
If we look at the period that culminated with gold peaking at $850 per ounce in 1980 we see that 75% of this gain occurred in a short period of time. Gold began a rally in 1972 but the final blow off top, a top not too dissimilar to the Nasdaq or the Nikkei lasted less than a year. Gold has by any definition been in a "bear" market ever since, even though the top in the gold stock indices was several years later. Now it's true that an increase from $35 to $200 is a healthy (nearly 6 fold) rise, but by mid 1976 gold was back at $100 per ounce. It had retraced 50% of its initial gains. Those who had been buying physical metal at $40 per ounce were still ahead, with the best yet to come.
It is interesting to note that the development of most of the larger mines in Northern Nevada and in Australia did not really begin until after 1983, which is three years after the top was in and eleven years after the bull market had begun. I saw a comment recently about declining production through to 2007. What the author was saying was that existing gold production would decline some 38% between now and then and that new production would take at least five years to happen. He also said that most mining companies would need to see at least two years of rising prices before committing to development, which would then take five years. That's seven years from the end of the current bear market, an event which has not happened yet.
Getting permission to mine in the US takes on average four years, but this is increasing and the five-year time frame is not unreasonable. The agencies, both State and Federal that handle these applications are currently handling an increased work load as a result of a rapid increase in the number of applications for new power stations while applications for new gold mines have dropped off dramatically. Employees familiar with the processing of mining applications have now been assigned power station applications. In effect a slow process has gotten slower.
It is worth remembering that the gold price increase that began in 1972 followed a period during which the Bank of England completed the sale (over five years) of 2/3rds of its gold holdings, from 2100 tonnes to 656 tonnes. Now they are close to completing the sale of 2/3rds of the remaining third of their pre-1965 cache. Sound familiar?
The ongoing willingness displayed in today's markets for the US dollar works against the gold price. The dollar is the currency of choice and until this perception begins to be replaced by one that favors gold the yellow metal may well, with some help, languish at the current levels.
We believe that there is still enough metal around (the IMF for one, the Swiss National Bank for another) that is accessible to the powers that be (and their respective bankers) to keep the gold price in this range for a few more months. They are running low on supplies but there is still the odd hoard out there. A collapsing dollar and a rising gold price will be the first clue that the cupboards are nearly bare but not an indication that the war against gold has been lost. At that point however this event won't be far away.
Now back to the bull market in gold stocks brigade with some questions.
If you have a collapsed stock market as in 1929, then where is the interest in gold stocks going to come from and what sort of gold stocks are we talking about?
If the mutual fund industry gets decimated, what will that do to their respective gold mutual funds? Could they be redeemed because of a desperate need for cash?
What will the effect of a rising gold price have on heavily hedged gold mining companies?
If you are looking at unhedged producers do you know what their ability to maintain production actually is, given that most miners are not replacing reserves at these price levels and new production will take time?
Where will the value in junior exploration stocks actually be? Owning a gold resource may be great but what good is it if it cannot be turned into cash flow or if it is in some exotic location?
Will the stock brokering community, especially the more speculative side of it, be able to absorb a serious stock market crash and be able to promote gold stocks at the same time?
A rising gold price may increase the risk of nationalization of mines in poorer countries, especially if there is a backlash against the US dollar and American economics. Do you understand sovereign risk?
Will gold stocks return to their more traditional role of being a source of reliable dividends and end up with relatively low P/E ratios?
Yes, an interesting market in gold stocks will arise once the gold price bottoms, and this 21-year bear market ends, but to assume that it will take the same shape as the run up in gold stocks from 1979 through to 1986 may be a mistake. We believe that the key will be in gold mining companies that have unencumbered production, coupled with good existing producible reserves and/or projects that can be brought into production relatively quickly. From a speculative standpoint one would look for "juniors" that have projects that have completed the permit process and are currently on hold.
We firmly believe that owning physical metal is the key to taking advantage of the coming bull market in gold. No question. At these price levels gold is a gift. Our next choice is in owning companies that have unencumbered production, followed by companies that own a permitted mine that has strong cash flow potential.
The Prof can be contacted by email at email@example.com
Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.
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