Time to Buy Gold Stocks...Again

It’s time to buy gold stocks. Top-down “macro” analysis indicates that the bull market in gold stocks still has a long way to go. And bottom-up analysis tells me that gold stocks are cheap.

Buying opportunities in this asset class will be rare, simply because so many institutional investor portfolios remain hugely underweight gold. These investors will keep looking to add exposure to gold because of the dismal state of the private credit markets, government debts and central banks. Western central banks are trashing their own currencies at unprecedented rates, while Eastern central banks are slowly tightening policy and accumulating gold bullion.

If current trends in government spending and central banking continue, gold could soar to multiples of its current price. If, under these conditions, central banks continue to inflate, then a hyperinflationary destruction of the monetary system is almost certain. But rather than a total wipeout of the system, I expect we’ll eventually see the end (not a reversal) of quantitative easing programs and a re-pegging of the dollar to gold at much higher gold prices.

But that won’t happen in a day. Inflationary forces need to gather some momentum first.

What might that process look like? Well, let’s say that the Fed doubles the size of its balance sheet yet again, all while the market’s expectation of future inflation steadily rises. The selling pressure on Treasuries would steadily grow, undermining the value of the Treasuries already sitting on the Fed’s balance sheet. On a mark-to-market basis, the equity on the Fed’s balance sheet would become negative – by several hundreds of billions of dollars.

Are we to expect, at that point, that the Fed would start to unwind its Treasury portfolio, selling it back into the hands of the public at much lower prices? If so, such selling of Treasuries (a reversal of QE) would lock in hundreds of billions of losses, requiring taxpayers to recapitalize the Fed (although not if Congressman Ron Paul has enough political influence).

Plus, from a technical perspective, the act of dumping Treasuries into an already panicked market would at least temporarily drive prices down (and yields up) even further. Finally, in such an environment a few years out, the $16-18 trillion in US national debt (at that point), which has a short duration, would have to be refinanced at much higher rates. That would put the US government budget in a position similar to that facing the Greek government in 2010: it would have to choose between:

1)    Defaulting/restructuring;
2)    Totally inflating the value of the debt away or;
3)    Crushing the private sector economy by sucking incredible amounts of taxes and fees out of it, simply to pay interest on the national debt.

Now can you imagine how, in the coming years, gold and gold stocks could launch into hyperbolic rallies? Inflation – as long as the bond market tolerates it – remains the most politically popular way of dealing with unaffordable government debts.

The market’s reaction to radical central bank policies is something we don’t see discussed very often. Yet this single factor – the reaction to QE – will be the key driver of financial markets in coming years.

Paper currencies rely on confidence, and central bankers only maintain confidence by offering to pay a real rate of interest on deposits. With interest rates currently near zero, the only reason to expect confidence to remain high would be if holders of that currency expected future prices to remain tame.

Only after a widespread repudiation of government paper would central banks re-peg their currencies to gold. They wouldn’t do this because they want to. Rather, they would re-peg currencies to gold simply to restore confidence in paper money. Most central bankers like to inflate as much as they deem necessary to fill the “output gaps” in their ivory tower models. The notion that monetizing the federal deficit (QE) can lower the US unemployment rate is so ridiculous that only an academic could dream it up; it demonstrates ignorance about how the US economy functions.

This is a constantly evolving process. But for right now, I see the most likely macro scenario as follows: a steady rally in gold, a sideways stock market (some sectors up, some down) and falling Treasury bonds (rising yields), as more bond investors look ahead to a future of endless US budget deficits and decide to hit the Fed’s “QE2” bid.

The Fed’s balance sheet will probably double in size again over the next few years, filling up with even more Treasuries. The central banks in China, India and elsewhere are woefully short of gold – and stuffed to the brim with less desirable US dollar assets – so they should continue to trade paper for gold and other real assets at a steady pace.

The current ten-year bull market in gold is very rational; it’s a reaction to the explosion in the US money supply plus the explosion in US dollar assets overseas (which are a result of seemingly endless US trade deficits). More than an inflation hedge, gold is a hedge against chaos in the monetary system; people flee to gold when confidence in paper money crashes.

Today’s global monetary system remains chaotic, so demand for gold stocks will remain strong…

Twice in the recent past I advised the subscribers of the Strategic Short Report to buy calls on the Market Vectors Gold Miners ETF (GDX)…and I did not neglect to issue profitable “sell” recommendations. Based on the published recommendations the first GDX option trade – from Nov. 2008 to Feb. 2009 – gained about 330%. The second option trade – from April 2009 to Nov. 2009 – gained about 65%. I think it’s time to attempt a “hat trick.” I suggest buying long-dated call options on GDX.

Gold stocks may not be dirt-cheap like they were in late 2008, but they remain relatively cheap. The nearby chart shows the ratio of the HUI index (a basket of 16 un-hedged gold stocks) to the price of gold. Other than the exceptional low of late 2008, the HUI/gold ratio is as low as it’s been since 2003. Furthermore, Gold stocks are as cheap (relative to cash profit margins) as they have been since they bottomed in 2001.

HUI-to-Gold Ratio

Given these factors, along with the continuing chaos in the sovereign debt markets around the world, I would not be surprised to see the gold price rise into new record. Accordingly, I would not be surprised to see the HUI Index double during the next couple of years.

Regards,

Dan Amoss
for The Daily Reckoning