Gold Shares Poised to Rally?

The past two weeks have been dominated by deliberations regarding Iraq at the United Nations.  Gold traded to $390 before US Secretary of State spoke on February 5^th, and then slid to a low of $341 after the latest round of discussions on February 14^th.  What seems clear is that the short-term speculative positions that were anticipating an

invasion of Iraq immediately have been cleared out.  We believe that the market is now reflecting the broader economic and political issues: increasing geopolitical instability, the return of the twin deficits – trade and budget – in the U.S., and the movement of capital out of the dollar.

While there has been some good economic news in the headlines, the underlying numbers remain worrisome.  Increased industrial production went almost entirely into inventories; Fed Chairman Greenspan’s positive comments about growth in the technology sector were based on data that reflects improvements in technology, not gains in sales, let alone employment; and retail sales were buoyed by increased spending on fuel reflecting the frigid weather in the northeast and rising gasoline prices at the pump.

The international value of gold, adjusting for the trade-weighted value of the dollar against major currencies, is just 4% above its twelve-month average, and 11% above the average of the past decade.  Certainly the price is rising for international investors, but the strength of the price rise is largely the result of the accelerating decline in the value of the dollar.  There is enormous potential for gold to benefit from asset diversification away from the biggest investment block – dollar-based assets.

Despite the gyrations in the price of bullion, precious metals stocks remain generally quite stable – the benchmark Amex Gold Bugs index of un-hedged producers traded in a narrow range of 132 to 151 – only slightly more volatile than bullion.  The XAU index, which includes larger companies that do hedge, declined to 72 at which level it is discounting gold at less than $300 per ounce.  Looked at the other way around, the Proteus Capital Fair Value Indicator points to the XAU at 91 with gold at $352 – 26% above the current level.

We believe that this disparity reflects several phenomena, including:

Ø       Many institutional investors expect the gold price to decline significantly and think that is the time to buy the stocks.  However, we repeat that, based on historic relationships, the stocks are discounting a gold price of $300 already.

Gold stocks rarely go up while the price of the metal they produce is going down, but the reaction in the stocks to the first sign of a turn in the gold price could be dramatic.  Put simply, waiting for the same pullback that everyone else is waiting for is not generally a recipe for successful investing.

Ø       Traditional buyers of gold stocks are already invested – newcomers haven’t generally come into the market yet.

Ø       International investors seeking security and liquidity outside the U.S. financial system are buying bullion – registered shares may not meet their requirements for anonymity or liquidity.