I’ve found many people are particularly energized about predicting a hard landing for China’s economy, but I believe the country is no sinking ship. China isn’t fast-approaching an iceberg in the dark of the night like the Titanic. Beijing has long been anticipating the ice chunks and subtly adjusting the rudder around inflation without steering the economic ship too far off course.

China’s government angled its vessel away from inflation by increasing the required reserve ratio (RRR) every month for the first six months of 2011 and raising interest rates three times. Once inflation was sufficiently under control, the country began to steer in a direction of growth again.

Recent results show how positive this easing has been. In its latest research this week, BCA Research reported that despite the policy tightening of 2011, the “most recent economic data out of China has all but confirmed that the economy remained incredibly resilient.”

One significant data point is the sharp increase in money supply. After the country hit a low level of monthly money supply growth, the three-month change in M-2 money supply climbed to record levels during the final month of the year, says Greg Weldon of Weldon Financial. He says that money supply “pegged at +6.419 trillion, easily exceeding the previous record 3-month increase, seen at the peak of the global crisis, in March of 2009.

Easing in China is expected to continue through 2012, with ISI Group anticipating a potential RRR cut after Chinese New Year celebrations in February, then possibly again in April, June and August. Also, loans “have become more readily available in recent weeks,” says ISI. This should all be bullish for commodities, such as copper, oil and gold, and also trickle down to boost share prices of natural resources equities.

Chinese Copper Inventories Increase

Base metals were the laggards among commodities last year, with copper one of the worst performers, losing 21 percent.

Global consumption of copper increased only 4 percent in 2011, which is lower than the 10 percent growth in 2010, but higher than the decade-average of around 3 percent, says Macquarie Research. China’s consumption of copper—which makes up 40 percent of the global demand—was a primary reason for decreased consumption, as the country was drawing down on its own supply throughout the year.

This can’t continue forever, Macquarie says, adding that “demand made on new supply direct from producers would need to rise, with positive implications for prices.” Europe’s largest copper fabricator agrees with that sentiment, indicating that it anticipated China’s copper demand would be strong in 2012, according to Barclays.

A recent rise in copper imports is likely the result of restocking China’s depleted copper inventories. As is typical for China, after the metal fell in price last fall, the world’s largest buyer of the metal advantageously scooped up copper to replenish its cupboard, says Barclays Capital. As shown below, copper inventories into China reached a record low in 2011, but have sharply reversed recently.

An increase in copper demand places pressure on the supply side, which continues to experience shortfalls in mine output versus forecasts. These are caused by a variety of factors, such as weather, labor strikes, or simply a poor grade deposit. While Macquarie says there’s a possibility the world’s two largest copper mines, the Los Bronces mine in Indonesia and Peru’s Escondida mine, could deliver year-over-year increases in production, it concludes “it is highly unlikely that miners will succeed in delivering this level of additional output in total.”

While Chinese demand growth for commodities is not expected to be as robust as it has been historically, demand is expected to pick up throughout 2012. As confidence returns, Macquarie says there should be “a slow gradient of recovery in the near term before gathering pace into the mid-year.”

Increasing Reliance on Energy Imports

China’s rapid growth and increasing reliance on other countries for key resources has made a powerful case for commodities over the past several years. These three charts from BCA Research illustrate that once the country shifted from exporting to importing a commodity, there was no looking back.

You can see in all three how dramatically the energy balance has shifted to an ever-increasing dependence on imports. In each major commodity, after China began importing, growth took off.

China became a net importer of crude oil in 1994, and today, is the second-largest oil importer in the world. BCA forecasts the country is expected to surpass the U.S. as the largest oil importer in only a few years.

To obtain more natural gas, China spent years building massive pipelines to transport the commodity from Russia and other western Asian counties, and since 2006, natural gas imports have “gone vertical,” says BCA.

Coal, which accounts for the majority of total energy consumption in China has also been imported since 2008, and since that time, imports rose substantially.

Even with these imports, energy consumption is only a fraction of developed countries. The China story is just getting started: Urbanization just surpassed the 50-percent mark, hitting what I believe to be the pivotal moment that dramatically shifts buying patterns, driving an enormous demand for housing, consumer staples and durable goods. You ain’t seen nothing yet!

Happy Chinese New Year!

This weekend, the world’s largest annual migration takes place. Millions of people in China head home to celebrate Chinese New Year and welcome in the Year of the Dragon. U.S. Global Investors’ research analyst and Shanghai native Xian Liang recently talked about the significance of the dragon in Chinese culture:

“Unlike its western counterpart portrayed as evil, the Chinese dragon is an imaginary, mythical creature. Its body parts are from nine animals, including the horns of a deer, mouth of an ox, nose of a dog, trunk of a snake, and claws of an eagle. It has auspicious power because it can make itself invisible or visible at any time. It can both fly and swim. It makes clouds and rain. Because of these magnificent things, the dragon is associated with royal powers as well.”

After bounding through a tough Year of the Rabbit, we anticipate the Year of the Dragon will breathe fire back into Chinese markets in 2012. Kung hei fat choy!

Regards,

Frank Holmes,
for The Daily Reckoning

P.S. For more updates on global investing from me and the U.S. Global Investors team, visit my investment blog, Frank Talk.

It May Take a Dragon to Breathe Fire Into Markets originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Despite this volatility, our research shows that investors can use gold stocks to enhance returns without adding risk to the portfolio.

In 1989, Wharton School finance professor Jeffrey Jaffe completed an academic study that illustrated the effects of portfolio diversification into gold stocks. Jaffe’s original study covered the period from September 1971, just after President Nixon ended convertibility between gold and the dollar, to June 1987.

During Jaffe’s study period, the average monthly return for the S&P 500 Index was 0.89 percent. Gold stocks, as measured by the Toronto Stock Exchange Gold and Precious Minerals Total Return Index, converted to U.S. dollars, performed considerably better, returning an average monthly return of 1.42 percent.

On the risk side, gold stocks had greater volatility (measured by standard deviation) than the S&P 500. But Jaffe found that, because of their low correlation to U.S. stocks, adding a small percentage of gold-related assets to a diversified portfolio slightly reduced overall risk.

Here is an updated version of Jaffe’s results.

To find an optimal portfolio allocation between gold stocks and the S&P 500, the efficient frontier plots different portfolios, ranging from a 100 percent allocation to U.S. stocks (the S&P 500) and no allocation to gold stocks, and gradually increases the share of gold stocks while decreasing the allocation to U.S. equities.

Assuming an investor rebalanced annually, our research found that a portfolio holding an 85 percent allocation to the S&P 500 and a 15 percent allocation to gold equities* had essentially the same volatility as the S&P 500 (horizontal axis) but delivered a higher return (vertical axis). In other words, the addition of a small allocation to gold stocks increased portfolio returns with no increase in the portfolio’s volatility.

Between September 1971 and November 2011, the S&P 500 averaged a 9.69 percent annual return. A 15 percent allocation to gold equities and an 85 percent allocation to U.S. stocks, with annual rebalancing to maintain the allocations, would have yielded, on average, an additional 0.82 percent per year.

How much is 0.82 percent per year?

Let’s use a hypothetical $100 investment as an illustration. A $100 investment in gold stocks in 1971 would have grown to nearly $5,100 at the end of November 2011, while the same amount in the S&P 500 would be worth about $4,800.

But look what happens when you combine the two. Assuming the same average annual returns since 1971 and annual rebalancing over 40 years, a hypothetical $100 investment in a portfolio with 15 percent gold stocks would be worth about $6,600. That is 37 percent greater than the $4,800 for the portfolio solely invested in the S&P 500, while adding virtually zero risk.

U.S. Global Investors consistently suggests allocating up to 10 percent gold in a portfolio, so we also looked at returns for investors at that level. In dollar terms, a hypothetical $100 investment in the 90-10 portfolio would grow to $6,022 over the ensuing 40 years (assuming annual rebalancing), compared to $4,820 for the portfolio solely invested in the S&P 500.

And when you look at the efficient frontier in the chart, a portfolio with a 10 percent weighting of gold stocks and a 90 percent allocation to the S&P 500 has also historically increased return with no additional volatility.

More than two decades and many ups and downs have passed since Jaffe published his study, but our follow-up research shows that the relationship among gold, outsized returns and volatility has remained consistent through the past four decades.

If you haven’t already completed your annual portfolio rebalancing, this may be an opportune time recalibrate your portfolio with gold stocks.

Regards,

Frank Holmes,
for The Daily Reckoning

P.S. For more updates on global investing from me and the U.S. Global Investors team, visit my investment blog, Frank Talk.

*The time series for the Toronto Gold & Precious Minerals Index discussed above is a composite of this index’s returns from 1970 to 2000.  Thereafter, the S&P/TSX Gold Index is used.  Both series are analyzed based on their returns achieved in US dollar terms.

Striking Portfolio Balance with Gold Stocks originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Among the E7 and G7 countries, only two markets increased for the week—Pakistan (up 2.2 percent) and Japan (up 0.5 percent). Russia (down 12.2 percent) and Indonesia (down 10.7 percent) were the leaders in the opposite direction. The average return for the 14 countries was a 5.7 percent decline.

Many investors have used gold and other commodities as a haven from recent volatility, buoying prices while equities sunk, but even those investments weren’t immune to the wave of selling. Silver was hit the hardest, falling nearly 24 percent, with copper (down 16.5 percent) and platinum (down 11.2 percent) not far behind. Gold and oil were down roughly 9 percent and the yellow metal was down more than $100 during intraday trading on Friday.

The U.S. dollar, in contrast, was up 2.2 percent. Much of the dollar’s rally came after the Federal Reserve announced the creatively named “Operation Twist” on Wednesday. The Fed will sell $400 billion of short-term securities and buy an equal amount of long-term debt. The goal is to push down long-term interest rates, which would spur economic activity.

As a result of last week’s actions, the S&P 500 Index is just slightly below two standard deviations from its mean over the past 60 trading days. The MSCI Emerging Markets Index is at a similar position, just greater than two standard deviations from its mean over the same time period.

The two charts above illustrate how rare two standard deviation events are for these markets. Over the past ten years, 60-day percentage changes to the downside of this magnitude have only occurred just over 5.4 percent of the time for the S&P 500 and 4.8 percent of the time for MSCI Emerging Markets.

This rare territory is often called “oversold” by traders and portfolio managers. That simply means too many investors have sold their holdings in a condensed timeframe, driving the price down more than its historical average.

Take a look at the gold/U.S. dollar relationship, for example. Over the past 20 trading days, gold has dropped 8.7 percent while the U.S. dollar appreciated by 6 percent.

This week’s moves are even rarer for gold and the U.S. dollar. The U.S. dollar has experienced similar upward moves only 3.5 percent of the time over the past decade, while similar declines in the price of gold have happened roughly 4 percent of the time.

I point this out because markets have historically reverted back to their mean after crossing into extreme territory, creating a “buy” or “sell” signal for the asset. This gauge has proven a reliable indicator for our investment team as it seeks to limit downside risk and take profits when assets have experienced a big run.

Since mid summer, our investment team has sought to limit exposure to downside risks by raising cash levels, selling mid-caps to buy large-cap companies and downsizing positions in cyclical areas such as industrials while increasing those in more stable areas such as consumer staples. Last week’s market volatility provides an opportunity to selectively invest cash and redeploy capital.

The market’s reaction to the Fed announcement is indicative of how little confidence investors have in policymakers in controlling what appears to be an escalating situation. More than half of investors and analysts surveyed believe a global recession is imminent.

While we certainly recognize the current downside risks for the global economy, we think it’s worth noting that investor sentiment and emotions can be significant market drivers, but the math of the market indicates we are probably at an extreme and a price reversal is likely.

One of these is the Conference Board Index of Leading Economic Indicators (LEI), which our director of research John Derrick highlighted for you in the previous week’s alert. The LEI, has historically been a good predictor of economic growth as it measures peaks and troughs in the business cycle. Despite it being one of the most volatile months for equity markets in recent memory, the LEI increased more than expected during August. In addition, initial July figures were revised upward. ISI Group said in a report on Thursday that “the LEI is not flashing any sign of an impending recession.” In addition, the firm also expects a modest gain for the September jobs report. ISI calls America’s jobs outlook “capital market’s most important economic statistic.”

These are positive developments, but we’re not out of the woods yet. The U.S. economy will continue to inch its way forward over the next one to two years and U.S. companies and consumers must adjust to this low-growth environment. It’s critical investors identify the companies that will successfully compete in this environment. We believe America is up to the challenge.

Regards,

Frank Holmes,
for The Daily Reckoning

P.S. John Derrick, director of research, contributed to this commentary. For more updates on global investing from me and the U.S. Global Investors team, visit my investment blog, Frank Talk.

Extreme Moves Leave Markets in Rare Territory originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Increases in demand from China and India have driven a 7.5 percent increase in demand for gold jewelry during the first half of the year despite a 25 percent increase in the price, according to a report released this week from GFMS. However, much of India’s potential gold demand remains untapped.

Toussaint highlighted an interesting fact: Of the roughly 800 tons of gold imported to India each year, only the top 40 percent of Indian households purchase all of the country’s gold, says Toussaint. The other 60 percent of Indians, who may have the same adoration for gold and celebrate Ramadan and Diwali, historically may not have had access to purchase gold. This large population represents a huge untapped market. To fulfill demand, the WGC has created a program with Indian post offices to distribute coins and small pieces of gold. Toussaint says right now there are 700 post offices in the rural areas servicing 90,000 customers and he expects that number to grow. This market is worth pursuing based on McKinsey’s research that a “huge wealth creation wave” is developing in India. As Toussaint puts it, “if purchase patterns continue, we will see from 2005 to 2025, a four times larger gold market in India.”

This is a fascinating idea because very few entities other than the post office have the network and infrastructure necessary to reach beneath the surface of the world’s largest gold market.

India may be the world’s largest gold market, but in China, gold buying has become so significant that the country has become the fastest-growing market for gold jewelry in the world. Not only are Chinese purchasing increasing amounts of gold, they prefer pure 24-carat gold. This high-quality gold is given to celebrate special occasions, such as birthdays, and purchased for a bride at her wedding. In 2010, 6.6 million brides will make gold a part of their ritual as the yellow metal signifies the importance of a long-term relationship, says the WGC website.

While jewelry represents a large percentage of gold purchases in the country, Chinese can also purchase gold at their local bank. WGC formed a partnership with the Industrial and Commercial Bank of China (ICBC Bank), the largest bank by deposits in the world. They began offering a “Gold Accumulation Plan” that lets investors buy and accumulate small portions of gold over time. Similar to a bank account, people participating have access to the underlying gold or the cash value at any point. Since it was launched in December 2010 through this summer, the ICBC has an estimated 1.7 million accounts, with an accumulation of more than 12,000 kilograms of gold.

After India and China led the global demand for gold, accounting for 52 percent of 2010 tonnage, the GFMS says the two Asian countries have “continued impressive growth” this year. Gold buying in India jumped 38 percent during the second quarter alone. GFMS reported China’s gold purchases jumped 90 percent on a year-over-year basis through June. This is a follow up to the 75 percent increase in gold demand the country experienced last year.

This share tops all of North America, which accounts for 8 percent, Europe and Russia, which account for 13 percent, and even the Middle East and Turkey, which together account for 12 percent. North American gold demand fell 12 percent during the first half of 2011 due to the slumping U.S. economy and rising prices.

David Lamb, the WGC’s managing director for jewelry, recently told Reuters there is a “significant tidal shift to the Asian markets, to India and China in particular, and gold rising upwards and disappearing from the mass merchandising in the West.”

Central Banks Load Up on Gold

Demand for gold isn’t only coming from the residents of China and India. There’s been a huge sentiment shift among central banks as well. Toussaint noted how, after many years of selling, central banks have become net buyers of gold. He says, “Western Central banks have essentially shut the tap off, and the vast majority of the buying is coming from Eastern central banks.”

In just the first half of this year, official sector purchases are up three-fold over the 2010 total to 216 tons, accord to the GFMS report. GFMS says the rise is largely due to low sales levels from Central Bank Gold Agreement (CBGA) signatories and the International Monetary Fund (IMF) completing its sales program at the end of 2010. In addition, other countries have gobbled up gold in an effort to diversify reserves away from the U.S. dollar. Scotia Capital estimates central banks’ total purchases of gold will reach 248 tons by year-end.

Some of the big buyers have been Mexico (whose central bank purchased roughly 100 tons of gold earlier this year), Korea (purchased 25 tons in June), Thailand (purchased nearly 19 tons in June) and Russia (which has purchased over 50 tons of gold from its domestic market year-to-date).

Toussaint says Eastern central banks are “catching up with the rest of the world” because their current allocation is tiny right now. However, whenever the WGC discusses these buying habits with the central banks of Korea, Taiwan and other Asian countries, they consistently say that they are interested in gold, and looking to hold it over the long-term. In other words, he says, this is not a “knee-jerk reaction to the direction of the dollar.”

GFMS also believes that this could be just the beginning. In a release announcing the report, Philip Klapwijk, Global Head of Metals Analytics at GFMS, said, “we are in essence in chapter three of the central bank story—we’ve left behind a period of heavy net sales, then a short period of neutrality and we’re now in a new environment of heavy buying.”

Regards,

Frank  Holmes,
for The  Daily Reckoning

P.S. This only scratches the surface of what was covered during the webcast. We discussed much more than China, India and central bank gold demand. If you missed it the first time, you can listen to the entire presentation at your leisure here. Find out the reasons we don’t believe gold is in a bubble, the economic factors affecting how gold is valued, and how our culture and emotions shape the gold-investing landscape. It’s great insight for the serious gold investor.

Perfect Storm Creates Tidal Wave of Gold Demand originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

With gold miners, in general, so attractively valued relative to the gold bullion price, the question becomes: Which stocks are the most compelling and have the best leverage to robust precious metals prices?

First, an investor could begin the process through elimination. FINRA highlighted some of the key warning signs when analyzing gold stocks, such as claims of being a “buyout target,” or speculative claims about reserve growth, and grandiose predictions of exponential growth, to name a few. FINRA says investors should be wary of “free lunch” programs that claim profits in gold are “easy,” and we agree.

Research from geologist Robert Sibthorpe shows that only one in 2,000 (0.05 percent) companies would ever find 1 million ounces of gold, and that only a third of those would be able to turn that find into production. In addition, research from Barry Cooper at CIBC shows that these discoveries are becoming even more difficult. There were 51 gold/copper porphyry discoveries of +3 million ounces during the 1990s, but only 24 of such discoveries occurred during the 2000s.

In order to find the diamonds in the rough, I use what I call “The Five M’s” for mining stocks. I discussed this process thoroughly in The Goldwatcher: Demystifying Gold Investing, an investor’s guidebook to gold investing I co-authored with John Katz a couple of years ago.

The Five M’s are: Market cap, Management, Money, Minerals and Mine life cycle.

1) Market Cap
Market cap is simply the number of shares outstanding multiplied by the stock price. The gold sector is broken down into three sectors by market cap: Seniors (market caps >$10 billion), intermediates (between $2 and $10 billion) and juniors (<$2 billion).

If a gold company has 10 million shares outstanding at $1 per share, the company is valued at $10 million. The question any investor should ask is, “Is this company really worth $10 million?” If the market pays $25 per ounce of gold in the ground, the company should be valued at $25 million (1 million ounces in reserves X $25 an ounce). If the company’s market cap is only $10 million, it may look undervalued. Accordingly, if the company’s market cap is $50 million, it may appear to be overvalued.

For larger gold companies, an investor can measure a company’s market cap against its production level, reserve assets, geographic location and/or other metrics to establish relative valuation. For junior mining companies—an area of focus for our World Precious Minerals Fund (UNWPX)—we look for balance sheets with ample cash for exploration and development of prospective reserves, but we resist paying more than two times cash per share.

2) Management
Essentially, management of mining companies must have both explicit and tacit knowledge to be successful. Explicit knowledge is academic. How many PhDs or masters in geology/engineering does company management have?

Tacit knowledge is more personal in nature and much more difficult to obtain. It is acquired over time through first-hand observation, experience and practice. How many years have they worked in the industry? Has management ever successfully completed a project with similar geopolitical/environmental constraints?

Success in the mining sector, especially the juniors, relies on the ability to raise capital and communicate with investors. Often the heads of junior companies are geologists or engineers who have no relationships in the brokerage business. This lack of relationships impedes their ability to generate market support. Historically, companies with the highest number of retail shareholders have the highest price-to-book ratios and carry higher valuations than peers.

Some of the most successful company builders in the gold-mining industry are what I call the “financial engineers” – people who have the relationships and understand the capital markets and who know how to hire the best geological and engineering teams. We tend to have more confidence investing in them.

3) Money
Mining is an expensive business. Often, companies burn through substantial amounts of capital before generating their first $1 in cash flow. A gold exploration company has to deliver reserves per share to have a chance at another round of financing. It has to convince the capital markets that it is an attractive investment on a per-share basis.

We call this the “burn rate”—how long will the company’s current cash levels last before it has to return for additional financing. If a junior exploration company has $15 million in cash reserves and is spending $3 million a month, it has five months to deliver enough reserves per share to convince capital markets it is worth the risk.

This calculation can be done quickly. Exploration reserves are generally valued at one-third the reserve values of a producing mine—if producing reserves are valued at $150 an ounce, exploration reserves would be $50 per ounce.

The gold-equities market is generally efficient at judging reserves per share, so if the exploration company doesn’t come up with the results necessary to get an evaluation—find gold for less than $50 an ounce—investors quickly lose confidence. There is an old rule when it comes to exploration companies: don’t pay more than two times cash per share if there are no proven assets in the ground.

4) Minerals
Compared to the rest of the mining sector, gold companies have the highest industry valuations based on price to earnings, price to cash flow, price to enterprise value and price to reserves per share.

Companies operating mines that produce gold as well as industrial metals tend to have lower valuation multiples.  For example, the current price-to-earnings ratio for Freeport-McMoRan (FCX), is 8x-times forward earnings. This is considerably lower than Yamana (20x), Goldcorp (21x) and Agnico-Eagle (36x). Investors can use the low relative valuations of copper/gold producers to increase their margin of safety in anticipation of an upward move in gold prices.

5) Mine Lifecycle
There are many delays and disappointments during the development and operation of a gold mine. Input costs can rise out of control (such as what happened in 2008 when oil hit $140 per barrel), labor workers can strike, and political/environmental policy shifts such as higher taxes or stricter environmental regulations can shrink margins.

During the exploration and development phase, the price of a gold stock often follows a course that ends up looking like a double-humped camel (see graphic). First there’s euphoria over exploration results that are better than expected. The stock price rises as investors race to buy shares. Then reality sets in – this gold discovery is still years away from being an actual producing mine. At this point, there’s a huge correction in the stock price.

Assuming the company continues down the path to development, its share price drifts sideways until around six months before the first ounce of gold is expected to be produced. At this point, the stock begins a strong new leg up when a more sophisticated set of shareholders come into the market. Eventually the price drops off and then levels as the speculative money moves on to the next hot opportunity and the company transitions from explorer to producer.

Clearly, the task of picking which gold miners to invest in isn’t easy. We actively travel to mining projects in places such as Colombia, Panama and West Africa to “kick the tires” and ask tough questions of management. This is the value that our investment team at U.S. Global Investors provides for our shareholders and how we seek to generate alpha.

Regards,

Frank  Holmes,
for The  Daily Reckoning

P.S. Don’t forget to sign up for A Case for Investing in Gold, a special webcast with Frank Holmes and special guest Jason Toussaint, managing director of the U.S. and Investment for the World Gold Council. Time: September 6, 2011 at 4:15pm ET. Sign up here.

How to Pick Gold Miners originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

One market trend that seems to be attracting more and more attention is the large performance gap between gold bullion and gold stocks. The price of gold bullion has increased roughly 28 percent in 2011, while the S&P/TSX Gold Index was down 1 percent as of Monday. This shouldn’t come as news for subscribers to these weekly alerts; we first discussed this opportunity back in June.

A report this week from BMO Capital Markets offered one reason behind the performance gap, “The rate of change in the gold price has been high over the past decade, perhaps too high for investors to gain confidence in that price as sustainable for an equity investment decision.” BMO says it was hard to imagine gold prices could sustain a $1,000 an ounce levels five years ago, but “now it’s hard to see the gold price falling to that level.”

Using the implied value of a defined group of global gold stocks, it calculated the internal rate of return to measure how gold stocks have underperformed compared to the yellow metal. Over a period of nearly 20 years, BMO’s group of global gold stocks has never been this inexpensive. Only twice—during the Tech bubble in 2000 and the financial crisis of 2008—has the internal rate of return compared so closely with the price of gold bullion.

RBC Capital Markets also sees potential in unpopular, undervalued gold equities and urged readers to take “a fresh look” at gold companies in a report this week. RBC says gold companies currently have margins that are at record highs and it believes margins could be approximately $1,200 an ounce for the next 12 to 24 months. This is substantially higher than the 10-year average of $320 an ounce. Comparatively, many current projects were economically sound at $700-$1,000 per ounce gold prices, creating $300-500 an ounce margins.

Right now, BMO calculates the total cost to produce an ounce of gold at roughly $900 an ounce, while the company can turn around and sell that ounce for upwards of $1,400. This puts margins near 40 percent, roughly twice what they were in 2007 and four times higher than in 2000.

Increased profit margins put more money in gold company coffers and this is reflected in the unprecedented amount of free cash flow (FCF), RBC says. The firm says the industry has reached an inflection point with a “substantial wave of free cash flow” coming over the next 1 to 2 years.

You can see this incredible increase in Tier 1 producers, such as Barrick, Goldcorp, Kinross and Newmont Mining. Looking at their trailing 12 months of free cash flow over 10 years, FCF never rose above $2 billion. However, following the trend in gold prices, FCF among these Tier 1 companies stair-stepped up to $4 billion.

Looking forward over the next few years, RBC estimates that if the price of gold remains at $1,850, FCF should stair-step even further, reaching nearly $12,000 by the end of December 2013. BMO estimates the global gold companies will accumulate net cash of $120 billion by 2015 if gold prices remain elevated.

Rising FCF is especially relevant to shareholders, as it allows the gold company to use that money to invest in projects that should enhance shareholder value. This could include pursuing new projects, making acquisitions, reducing debt or paying dividends. Many gold companies are opting for the latter and increasing dividends but these increases haven’t kept up with the pace of rising earnings. The average payout ratio was roughly 20 percent in 2008 but currently sits around 10 percent in 2011.

BMO says, “A dividend policy linked to the financial performance of the company offers investors additional leverage to the gold price. The provision of a meaningful and sustained dividend has the potential to broaden investor appeal and to instill fiscal responsibility for management.” I’ve often echoed similar sentiments.

BMO says gold stocks are currently trading at historically cheap levels, which the company sees as an opportunity investors can take advantage of. RBC attempts to quantify that opportunity by saying “if gold prices remain elevated and/or investors accept a higher long-term gold price, we could see 25-50 percent upside in equities.”

To be continued in How to Pick Gold Miners later this week.

Regards,

Frank Holmes,
for The Daily Reckoning

P.S. Don’t forget to sign up for A Case for Investing in Gold, a special webcast with Frank Holmes and special guest Jason Toussaint, managing director of the U.S. and Investment for the World Gold Council. Time: September 6, 2011 at 4:15pm ET. Sign up here.

Valuation Gap Makes Gold Miners Attractive But All Miners Aren’t Created Equal originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Long-term gold bulls have been forced to listen to these naysayers since gold reached $500 an ounce. If you would have joined their groupthink then, you would’ve missed gold’s roughly 270 percent rise since.

That said, gold is due for a correction. It would be a non-event to see a 10 percent drop in gold. This would actually be a healthy development for markets by shaking out the short-term speculators while the long-term story remains on solid ground.

Forty years ago this week, President Richard Nixon “closed the gold window,” ending the gold-backed global monetary system established at the Bretton Woods Conference in 1944 and kicking off a decade of stagflation for the U.S. economy.

At the time, $1 would buy 1/35th an ounce of gold. Today, $1 will net you about 1/1,178th an ounce of gold. Put differently, “One U.S. dollar now buys only 2 cents worth of the gold it could buy in 1971,” says Gold Stock Analyst. This means that consumers have lost roughly 98 percent of their purchasing power compared to gold over the past 40 years.

The U.S. dollar isn’t the only asset gold has outperformed during recent decades. The yellow metal has also seen periods of relative strength against the S&P 500.

This chart from Gold Stock Analyst pits the performance of gold bullion against the S&P 500 since 1971—you can see that gold immediately rallied following Nixon’s announcement before peaking at $850 an ounce in 1980. At that price, one ounce of gold was 7.6 times greater than the S&P 500, according to Gold Stock Analyst. Gold’s relative performance then declined for the next 20 years, with the S&P 500 taking the lead in 1992 and peaking at 5.3 times the value of gold in 1999. Currently, gold’s value is roughly 1.6 times greater than the S&P 500.

What drove gold’s relative underperformance from 1980 to 1999? It was a shift in government policies, which have historically been precursors to change—a key tenet of our investment process here at U.S. Global Investors.

Gold Stock Analyst points out that Federal Reserve Chairman Paul Volcker began steering the U.S. economy toward positive real interest rates in 1980 and Volcker’s goal was met in 1992—the same year the S&P 500 overtook gold.

In order for gold’s relative value to return to 1979-1980 peak levels of 7.6 times the S&P 500, Gold Stock Analyst’s John Doody says gold prices would have to hit the $10,000 mark. Obviously that scenario is unlikely, but it does put all this “gold bubble” nonsense into perspective.

One point to pop the “gold bubble” talk is that negative real interest rates are poised to stick around for a while. We’ve previously discussed that negative real interest rates—one of the main drivers of the Fear Trade—have historically been a miracle elixir for higher gold prices. The magic number for real interest rates is 2 percent. That’s when you can earn more than 2 percent on a U.S. Treasury bill after discounting for inflation. Our research has shown that commodities tend to perform well when rates fall below 2 percent.

Take gold and silver, for example, which have historically appreciated when the real interest rate dips below 2 percent. Additionally, the lower real interest rates drop, the stronger the returns tend to be for gold. On the other hand, once real interest rates rise above the 2 percent mark, you start to see negative year-over-year returns for both gold and silver.

It’s important to point out that it’s the political policies not political parties that drive this phenomenon. During the 1990s, when President Clinton was in office, there was a budget surplus and investors could earn more on Treasury bills (about 3 percent) than the inflationary rate (about 2). This gave investors little incentive to embrace commodities such as gold, and prices hovered around $250 an ounce.

Since 2001, increased regulation in all aspects of life, negative real interest rates, welfare and entitlement expansion funded with increased deficit spending have created an imbalance in America’s economic system. It’s this disequilibrium between fiscal and monetary policies that drives gold to outperform in a country’s currency.

Today, the Fed capped interest rates near zero back in 2008 and the federal budget deficit has ballooned to $1.4 trillion. In fact, both the deficit as a percentage of GDP (negative 11 percent) and federal government debt as a percentage of GDP (nearly 65 percent) are at the highest levels since 1950, Citigroup research shows. This has helped fuel gold’s rise through $1,000, $1,500 and now $1,800 an ounce.

This is only one side of gold’s long-term story. Another point to pop the “gold bubble” talk is that we’re entering what has historically been gold’s strongest period of the year in terms of demand. In the past, gold prices have bottomed in August but recently gold’s strong seasonal period has extended into the dog days of summer as the holy Muslim holiday of Ramadan moves forward on the calendar by 10 days each year. This year Ramadan began August 1.

In its latest Gold Demand Trends report, the World Gold Council (WGC) confirmed that the Love Trade is burning bright in Asia. The WGC council said Chinese and Indian buyers continue to be the “predominant drivers” of gold demand, accounting for “52 percent of bars and coins and 55 percent of jewelry demand.” China’s demand grew 25 percent, while India saw an increase of 38 percent. WGC attributes this growth to “increasing levels of economic prosperity, high levels of inflation and forthcoming key gold purchasing festivals.”

But China and India aren’t the only emerging markets feeling the love for gold. Vietnam, Indonesia, South Korea and Thailand – labeled by the WGC as the “VIST” countries – are additional key gold-consuming countries.

The WGC’s chart below shows a potential opportunity in increased demand for gold, especially in jewelry, in the VIST countries. In 2010, demand rose to 253 tons after a sharp drop in 2009. Jewelry demand, however, was historically low while investment demand grew considerably.

Similar to China and India, the VIST countries have had a 2,000-year long relationship with gold which is intertwined in their culture, religion and economy. Jewelry and investment demand are one and the same, says the WGC: “The demand for gold as a store or accumulator of wealth, as an auspicious gift or as insurance against unforeseen risks, is to a large extent independent of the form it takes.”

This strong tie to gold means that, as wealth among residents of Vietnam, Indonesia, South Korea and Thailand increases, price is less of a consideration, and gold will continue to be at the top of their shopping lists.

At some point in the future gold prices will fall, that’s for certain. However, don’t expect it to happen soon. We believe the one-two punch of the Fear Trade and Love Trade will keep gold prices at elevated levels for another few years.

Regards,

Frank  Holmes,
for The  Daily Reckoning

P.S. For more updates on global investing from me and the U.S. Global Investors team, visit my investment blog, Frank Talk.

The Neverending Story of a “Gold Bubble” originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

There was more “blood in the streets” Monday as the world continued to digest S&P’s downgrade of U.S. debt, the two-week market selloff, and the likelihood the U.S. economy could possibly slide back into recession. These concerns, combined with continued political/economic struggles in the eurozone from socialist policies, have created a potent concoction of fear across global markets and sent volatility skyrocketing Monday to its highest level since the May 2010 “Flash Crash.” While many investors are running for the exits, others have chosen to ride the wave of volatility or buy depressed shares.

The S&P 500 Index has fallen 11 percent over the past three trading sessions. This has only happened fives times since 1960: The 1987 Crash, the Asian financial crisis in 1998 and twice in 2008, according to research from Desjardins. In each of these instances, markets gained an average 9 percent the following month.

The CBOE Volatility Index (VIX) rose more than 46 percent to break the key 40 level, signaling an extreme event, and is up over 164 percent for the year. In general, any time the VIX reads above 30 means conditions are volatile. Above 40, it’s clear the only thing at a premium in this market is fear.

The S&P 500 isn’t the only investment that’s been experiencing extremes. A flood of safe-haven buying sent gold prices up more than $50 an ounce (more than 3 percent) to $1,715.40 at market close Monday. Gold continued its climb early Tuesday morning, rising another $34 an ounce. Gold prices are up over 46 percent for the past year and roughly 13 percent the past 30 days. The increase over the past month is roughly equal to gold’s normal volatility over an entire year and is a short-term risk for a minor correction in a secular bull market.

Meanwhile, oil (along with oil-related equities) has been bludgeoned down to price levels not seen in a year—off almost 30 percent from April 2011 highs. Other commodities such as copper, wheat and cotton have also taken sizable haircuts over the past two weeks.

Such market turmoil creates a real challenge for investors who are in it for the long haul. Investors must control their emotional response and remain on the lookout for opportunities. Equity performance and fear-driven volatility carry a strong inverse correlation. This chart shows sharp spikes in the VIX trigger an autonomic selloff in the S&P 500. However, these selloffs have historically resulted in strong rebounds, thus providing an opportunity for clever investors who like to buy their summer clothes during a winter sale and their winter clothes during the summer.

Before Monday, the VIX closed above the 40 level five times since 1995, and in all but one occurrence the market was at higher levels just three months later. The exception is 2008, when the VIX passed 40 on its way to 90 and remained elevated for months during the worst financial crisis since the Great Depression.

You can see from the table that the market has rebounded roughly 6 percent on average over the three-month period after hitting the 40 mark. Short-term reactions are more mixed. The market has swung 11 percent in either direction during the next month of trading and the average gain is only 80 basis points.

For the purposes of this exercise, the analysis is based on weekly data from August 8, 1995 through August 8, 2011. There were stretches of time, such as in 2008, when the VIX remained above 40, but we’re only counting the initial breach.

Market selloffs are actually common this time of year. According to the Stock Trader’s Almanac, August has been the second-worst month of the year for the Dow Jones and S&P 500 since the 1987 crash. The 7.2 percent decline for the S&P 500 last week was the worst week ever recorded during the month of August, beating out another dismal week for performance in 1974.

With this in mind, investors must remember there are some good opportunities out there and we’re working relentlessly to find them. Some of the best are in great American companies, whose balance sheets are the envy of Washington, with many carrying dividend yields above the 10-year Treasury bill. Currently, the 2.28 percent yield for the S&P 500 is the highest level since July 2009, Desjardins says.

A similar phenomenon took place following banking crises in France, Sweden and the U.S. during the 1990s. Without the ability to tap banks for additional capital, companies moved to large positive cash-flow positions and self-financed their growth, GaveKal research said in a note this morning. These strong capital structures provided the foundation for the market’s bull run during the back half of the decade.

This opportunity has largely been ignored as investors have fled like lemmings to the “safety” of cash, government bonds and money market funds. These investments “afford zero prospects for capital gains and only microscopic income,” says Murray Pollitt from Pollitt & Co.

This mad dash for cash is driven by fear and investor desperation to preserve their money rather than make any. Naysayers have been flippantly labeling gold a bubble since it reached $500 an ounce, but have turned a blind eye to the unprecedented amount of “money pouring into government bits of paper” that is the “biggest bubble of all time,” says Pollitt.

History is filled with cycles and each asset class carries its own DNA of volatility. Those who are highly leveraged or those forced to sell in order to raise capital are experiencing the most pain right now. Investors not in those two camps must remember that the markets are cyclical, just like the tide, which comes in and out each day, and the moon, which cycles every 29 days.

One area with potential is gold equities, which have lagged bullion significantly this year, pushing the gold-to-XAU ratio to the second-lowest level in nearly 30 years in June. Gold stocks also have a history of performing well when the U.S. economy hits a bump in the road. Depression-era babies might remember gold stocks’ strong performance during the 1930s.

This lag sets the stage for a possible strong rally in gold equities relative to bullion once mean reversion to historical levels kicks in, just like it has done time and time again. Desjardins notes that one current catalyst for a rebound in gold stocks is increased profitability from rising gold prices and decreased input costs due to oil’s 28 percent decline off of 2011 highs.

In addition, many quality gold companies are “paying investors to wait” by increasing dividend yield rates above those of money funds. This creates a cash incentive to hold shares of the company and allows investors to participate in rising earnings.

A key question for the global economy is: Who will lead a recovery in global markets? Where will growth come from?

With trillions of dollars in debt acting as a ball-and-chain for much of Europe, the U.S. and the rest of the developed world, must detoxify their balance sheets before hitting the ground running. On the other hand, emerging market economies carry low levels of debt and operate like a cash business, making them the final frontier for strong economic growth.

A key reason is emerging market governments have the long-term policies in place to facilitate growth of their economies. GaveKal points out it’s unlikely we’ll get a second dose of large stimulus like we did in 2008-2009 because of inflationary pressures, but that magnitude of assistance isn’t needed. Because China and other emerging market governments focused their stimulus on job creation and infrastructure development, their roads to economic growth have already been paved.

This will allow them to flex their economic muscles during short-term instability and insulate them from the turmoil. This is why we think emerging markets will continue to shine for many years to come.

Take China’s $300+ billion commitment to construct a nationwide high speed rail network, for example. The project is already paid for and will invigorate consumption across all sectors of the economy by connecting 700 million people across 250 cities. The recent accident was a terrible tragedy but the country is not going to abandon its plans. Rather, China will learn from the setback and push forward with better safety standards.

While the investment herd rushes into CDs and other “zero” yielding investments, nimble-minded investors can use these cycles to seize current opportunities and position portfolios for when the bull market tide returns.

Regards,

Frank  Holmes,
for The  Daily Reckoning

P.S. For more updates on global investing from me and the U.S. Global Investors team, visit my investment blog, Frank Talk.

Run, Ride or Buy? What Should Investors Do? Don’t Sell on Mondays! originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Since pulling back to $1,487 an ounce on July 1, gold has surged nearly 12 percent. Over the past 10 years, gold’s normal volatility has been about 15 percent, so we’ve seen nearly a year’s worth of price movement in just 34 days!

Does this mean we’re due for a correction? Possibly. Gold could easily correct 5-10 percent, but given today’s current environment, I don’t think that’s what the crystal ball reflects.

Gold markets are clearly being affected by the Fear Trade. CNBC host Carl Quintanilla told me this morning that this run is “obvious to anyone who’s watched markets over the past few months.”

First, we were subjected to the antics on Capitol Hill surrounding the debt limit. Though the resolution wasn’t enough to knock America’s debt rating from its AAA pedestal, the market didn’t digest the news very well. Bloomberg screens are red with uncertainty.

Second, a slew of poor economic data is signaling the U.S. is weaker than many, including our team, originally thought. Our Ralph Aldis said yesterday, “We can’t grow our way out of this because there’s no growth.”

On CNBC and Mineweb, I provided my insight on recent gold developments today that I think you’ll find useful. The first is a podcast discussion on gold and the current opportunity in gold stocks with MineWeb’s Geoff Candy. You can listen here. We discuss gold’s key drivers and calculating value among gold miners.

I also appeared on CNBC’s “Squawk on the Street” to discuss what’s driving gold. You can watch below.

Regards,

Frank  Holmes,
for The  Daily Reckoning

P.S. For more updates on global investing from me and the U.S. Global Investors team, visit my investment blog, Frank Talk.

Gold Bugs Rejoice originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Gold has now increased for 124 months straight, says Deutsche Bank. The rally is in its 11th year, lasting nearly three times as long as other historical rallies going back to 1971. If the metal rose to $2,100 an ounce, it would represent the most powerful percentage increase in history, according to Deutsche Bank.

I believe what’s happening in the market today is a short-term driver of gold prices spurred by ETF investments. While Deutsche Bank believes a “market friendly resolution to the U.S. debt ceiling may trigger a short-term correction in the gold price,” fundamentals seem to be in place to keep gold prices elevated over the long run. Even in many economic scenarios today, Deutsche Bank believes gold prices “appear irreversible.”

A more important driver that will keep gold prices elevated over a longer time period is the Love Trade. Marcus Grubb, managing director of investment at the World Gold Council (WGC), highlighted the significant aspects of this trend in his interview with Andrew Bell on the Business News Network (BNN). He says investors need to consider the issues outside of the euro zone, the debt-ridden countries and fiscal deficits.

More important to him is what he calls the “transfer of wealth from west to east” and the accumulation of wealth, particularly in China and India. This is what is driving the longer term strength in the gold price.

He states that the demand for gold is particularly strong in China: The country has a $3 trillion surplus, with some of it in gold, and he estimates that household wealth will most likely rise by five times. China and India also share a strong cultural affinity for gold as an investment and jewelry. For these reasons, Grubb believes this will drive gold demand.

Merrill Lynch has found that there is a positive correlation between gold jewelry demand and rising with increasing wealth. The chart below shows that as the GDP per capital rises so does demand for gold.

September has traditionally been the beginning of the gift-giving season for gold. This is the time of year when gold jewelers are the busiest. The Muslim holy month of Ramadan begins in August and concludes with generous gift-giving in early September. Then it’s Diwali, known as “the festival of lights” in India, Christmas in the U.S., and Chinese New Year. The key to this seasonal strength over the past few years has been demand from China and India.

The spending spree has already begun in East Asia. In the WGC’s second quarter report, physical gold delivered at the Shanghai Gold Exchange was 14.65 percent higher than the previous year. Gold purchases also remained strong across East Asia, with tourists from mainland China buying gold in Hong Kong. In India, coin stocks, symbols of good fortune, were running low during the Akshaya Tritiya annual holiday in May.

Immediately following Marcus Grubb’s interview, I spoke with BNN’s Andrew Bell and expanded on the Love Trade season. We also discussed how today’s financial worries in the market place have caused a selloff in many equities and gold stocks. I talked about how many of these gold stocks are becoming extremely undervalued relative to the price of gold.

With approximately fifty percent of the world’s population controlling the Love Trade, we’re in for an exciting period.

Regards,

Frank Holmes,
for The Daily Reckoning

P.S. For more updates on global investing from me and the U.S. Global Investors team, visit my investment blog, Frank Talk.

The 2011 Gold Season is Just Around the Corner originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.