Another Good Year for Gold and Gold Stocks?

A new year, yes. But a well-aged story: Generalized fear and loathing about Europe is fueling the safety trade.

The longest, most-boring financial crisis in history continues.

For laughs, let’s tote up the damage:

  • The Dow is down nearly 1%. Other US indexes are down more, others less
  • Banks dragged down European stock indexes. Spain closed down nearly 3%, Italy 3.5%
  • The euro is down to $1.279 — a level last seen in September 2010
  • The dollar index is approaching 81 for the first time in a year
  • The yield on a 10-year Treasury note is back below 2%
  • Oil is down about 1%, to $102.21

No single euro-story is driving the action:

The Italian bank UniCredit plans to offer new shares at a steep discount to raise capital. Spain’s government said that nation’s banks need to raise 50 billion euros in new capital. A French bond auction generated less demand than you’d expect considering the rating agencies insist on rating France AAA.

In other words, there’s nothing especially new or alarming… just scattered reminders that the dust bunnies of Europe can’t be swept under the proverbial rug.

Gold isn’t escaping the fallout. It dipped below $1,600 just after Comex trading opened… At last check, it’s recovered a bit to $1,607. Silver clings to $29 by a few slender pennies.

“What we learned in 2011,” wrote Bill Bonner on Tuesday, “was that when a Great Correction pinches, the dollar is the salve of choice — not gold.

“When investors fear losses, they turn to the dollar for protection.” They will continue to do so a while longer, Bill surmises: “We’ll probably see a further correction in the gold price…perhaps down to $1,200. Or perhaps it will stop at $1,400.”

“2012 should see more trouble from Europe, and therefore potentially more dollar buying,” adds Peter Schiff — who now sells bullion in addition to running a brokerage.

“But,” he cautions, “what is important to understand about these circumstances is not the scale of the moves but the direction of the trend.”

Even with the dollar riding high, “it’s still down over 30% over the last decade as measured by the generous US dollar index,” says Mr. Schiff. “Gold, by contrast, is up over 350% in that period.

“Of course, past performance does not guarantee future results, but the fundamentals have not changed.” Indeed, one day, it will dawn on nearly everyone that no fiat currency is safe, including the dollar.

But we’re not there yet. Not by a long shot. It goes back to our friend Doug Casey’s crack about how something that’s inevitable might not be imminent.

For all of today’s “risk-off” weakness, gold stocks are holding up remarkably well. The HUI index is off a quarter percent, a hair below 520.

“In this environment, to make the big money,” says our old friend Rick Rule, “you need to enter [gold] stocks that aren’t institutional momentum favorites. Those stocks aren’t going to work.”

Instead, you need to look for “the kinds of stocks that are going to be sold to the Rio Tintos and the BHPs and the Newmonts and the Barricks of the world. The buyer this year is going to be the industry.”

Thus, “the impetus for the market in exploration stocks this year will be takeovers. The companies that have done a good job, although they may not find traction among institutional or retail investors, will be taken over by larger mining companies.

“These larger companies have both the need to replace production and the financial strength to complete the takeovers and to build out the discoveries that have been made by the juniors.”

As a result, Rick sees the majors paying substantial premiums for the juniors — more than you’d normally see.

“If the industry sees $2 billion in discounted free cash flows and they see a market cap of $600 or $700 million, they are willing to pay $1.3 billion to secure net-present value. So it’s possible that you will see 70%, 80% or even 100% premiums in bad markets, for good assets, in select names.”

Options traders are already sniffing this out: Early signs of a rally in small-cap gold stocks are showing up. According to figures from Trade Alert, open interest in call options on GDXJ — the gold junior ETF — reached a record 222,300 contracts as of Tuesday.

Starting a week earlier, “Options traders have demonstrated conviction in a turnaround, setting up multiple new positions that profit from gain over the coming months,” reports the Dow Jones Newswire.

What’s more, the put-versus-call ratio is the lowest since mid-September.

Interesting activity for an ETF that, as we noted yesterday, dropped 38% during 2011.

Another catalyst Mr. Rule sees: New gold discoveries.

“It’s my belief that we are going to re-enter a discovery cycle and I would be surprised, frankly, if we didn’t have four or five names that made 50- or 100-fold returns on pre-discovery market capitalization.”

In fact, Rick finds the coming period analogous to the mid-1990s… when names like Diamond Fields shot up from $4 to $160… and Arequipa Resources catapulted from 30 cents to $30.

Addison Wiggin
for The Daily Reckoning

The Daily Reckoning