Friday, October 10, 2008

Gold miner fundamentals ripe for investing

A few charts to show how good fundamentals are for gold miners. We are within 15-20% of the final low for this gold miner stock correction, which has been wicked in terms of percentage and how fast it has been. The gold mining sector is nothing if not volatile. However, the next leg up will be just as if not more powerful than this current leg down.

First, a gold to $XAU ratio chart, which divides the price of an ounce of gold by the price of a blue chip gold mining index ($XAU). When the ratio is high, gold is favored over mining stocks.

This ratio chart shows a current "blow-off" top with an exhaustion gap that should be quickly reversed. Notice the last time this happened in mid-1986. This means we are within a few weeks of the low for gold stocks.

This long-term chart of the $XAU shows what happened in the year after mid-1986, the last time there was a blow-off top in the ratio - a gain of roughly 265% in one year. Not only that, but I am looking at buying stocks that will make more in percentage terms than the $XAU for this next leg up and I am going to buy options (translation: 300-600% gains are possible). If you look at other peaks in the ratio chart through the past two decades, you can see evidence of 100-150% gains following these peaks routinely.

What supports this happening again? Many things. First, people are scared of financial things and are moving toward tangible things that can't evaporate (like 401k plans invested in equity mutual funds). Second, the "real" price of gold is skyrocketing. The concept of the real price of gold is critical to understanding the profitability of mining companies.

Remember that gold miners dig both a commodity and money out of the ground. In a deflationary bear market environment, the commodity function of gold is less important than its monetary role. Cash is king during deflation, because the price of everything else you would want to invest in is going down (real estate, stocks, corporate bonds, unstable government's bonds and all other commodities). In other words, the true price of what the gold miners are digging out of the ground is increasing relative to what it costs to dig it out of the ground. Profitability for miners expands rapidly in such an environment. The best way to display the real price of gold is to compare it to other tangible goods, such as energy (which is a major mining expense).

The gold to general commodities ($CCI as a proxy) ratio chart shows the increased profitability that gold miners are now experiencing.

Bottom line: we are near the psychological (i.e. technical) bottom of this leg and the underpinning profitability environment (i.e. fundamentals) is strong. Within 2-3 weeks gold stocks should bottom and I will start to make some serious money in the gold stocks. I nibbled on a small amount of RGLD and GG today and will starting buying much more on significant price dips over the next 2-3 weeks.

Wikinvest Wire