Wednesday, December 10, 2008

Gold versus gold stocks - back the other way

Ratio charts can be helpful to compare asset classes and can help define turning points in markets. The fundamentals for gold stocks in a deflationary/contractionary economy are superb, because the gold price declines less than costs and expands profit margins. If this concept seems odd, think of Walmart in the 1990s. They kept dropping prices but were dropping costs even faster, thus they made money hand over fist. Gold stocks are wild, volatile creatures but can provide phenomenal gains in the type of environment we are in now. While general stocks crash, burn and dwindle over the next few years, gold stocks will provide extraordinary gains.

The $HUI or gold bugs index is an index comprised of unhedged miners, meaning those that don't sell forward future gold at a fixed price, so they are subject to the whims of gold price fluctuation. This can be of benefit when costs are declining and the gold price is stable to rising, thus these stocks provide higher leverage going up. However, this is a two-edged sword and rising costs and a flat to declining gold price crushes these stocks on the way down more than hedged companies (i.e. unhedged gold miners are more volatile). The ratio of gold to gold stocks is a long-term chart of beauty, though I never expected the ratio to get as low as it did last month:

An historical chart of the $HUI gold stock index (which you can't buy, but you can buy the individual stocks or the slightly less impressive GDX ETF) shows the potential gains using the last time gold stocks outperformed the metal (the ratio of the $HUI to gold price is plotted at the bottom for comparison):

The current mini-leg up in gold stocks should be over before December is and there will then be a 4-8 week correction. Gold stock corrections can be brutal (i.e. 20-50% of the previous mini-leg advance) but will provide an outstanding buying opportunity in mid January-early February of 2009. Anyone not positioned in this sector currently who wants to be should plan on buying then. From the bottom in January-February, a 50% gain in this sector in 3-4 months is a reasonable expectation.

Wikinvest Wire