Saturday, January 31, 2009

Gold mining fundamentals revisited - deflation

Gold stocks are not well understood and not well studied by most investors. Everyone thinks gold stocks are an inflationary play just like all commodity stocks. Gold miners behave differently than other commodity stocks such as oil or agricultural stocks, however. Gold stock fundamentals are actually paradoxically strongest during a deflation.

The reason, it turns out, is basic economics/finance 101 type stuff: gold falls in price less than the costs of mining during a deflation. If the product you are selling decreases in price by 10% (as in gold from the March 2008 peak to now) but your costs decrease even more than 10% (as in oil falling in price by 70% in price), you just increased your profit margins despite a falling price of gold!

Here is a ratio chart of the gold price divided by a basket of commodities to show the relative outperformance of gold since the deflationary storm began:

In the end, gold miner stock prices will reflect the increased earnings deflation brings them. Paradoxically, the greater the deflationary forces, the greater the profit margins for gold mining companies will rise. If the deflationary shit storm we are in spirals out of control and gold goes down to $500/ounce, that means oil will be $3/barrel and unemployment will be 30-35%. Labor costs will drop precipitously for gold miners as every base metal mining company in the world will go out of business and/or cut 90% of its work force in that setting and there will be all kinds of experienced mining talent available for pennies on the dollar.

Once one understands that gold miners are a better deflationary play than an inflationary one, the paradox of investing in gold miners in a deflationary crash makes sense. It's not that gold miners won't get whacked when the general stock market takes a dive, but they will outperform and create net gains while general stocks and other commodities generate steep net losses.

Think about that for a minute. Where can you invest your money in a deflationary shit storm and actually make money? Government bonds pay maybe 0-3% yield, cash in the bank and CDs pays the same, and everything else loses money. Look at how gold stocks did during the last Depression in the 1930s here and take a look at the historical countercyclical nature of gold stocks here.

The non-believers in gold stocks for the period we are in are those steeped in conventional "wisdom" who listen to mainstream media sources and fail to look at history. Did you know that gold is a better protector of wealth during deflationary periods than inflationary ones? Again, it's about relative price not absolute price. If gold drops 20% and real estate and stocks drop 80%, a gold investor can buy a hell of a lot more real estate and stocks once the dust settles.

A new cyclical leg up in this gold stock bull market has begun. The secular gold stock bull market began in 2000, the same year the secular bear market in stocks began. A fast and furious cyclical bear market in gold stocks from March 2008 to October 2008 took only 7 months to wipe out two-thirds of the gains from the first cyclical leg of the gold stock bull market from 2000- March 2008. This is a pretty typical correction after the first cyclical leg up in a bull market.

The current cyclical (i.e. measured in years, not decades) leg up in gold stocks that has started is considered a "wave 3" in Elliott terms and it promises to be a wild, profitable ride. Since the first leg up in the $HUI (a basket of blue chip, non-hedged producing gold miners - aka the gold bugs index) produced gains of 1470% in 7.5 years, the third leg up may provide a similar or even greater relative gain. A gold stock "mania" is sure to evolve since profits for gold miners are about to shoot to the moon and profits for 95% of other publicly traded companies are evaporating.

Wikinvest Wire