Gold Stocks and Burning Matches

With all the movement in the gold market lately, a lot of investors can’t help but wonder about gold stocks. What moves them? What keeps them on the rise? International Speculator’s Doug Casey has the answers to these questions – and more.

Gold stocks move with the price of gold, but their price swings are more emphatic. In other words, gold stocks have leverage with respect to gold.

That’s the broad-brush picture, and it’s the starting point for thinking about gold stocks. But of course, it doesn’t answer all the questions. For example, in an unfolding gold bull market, will you make more money with junior explorers…or with producers?

Is there a predictable stage of the market where you are more likely to make the biggest returns? Given a rising gold price, is anything else needed for gold stocks to take off? In particular, since gold stocks are stocks, can they rise without a favorable tone for the stock market in general?

Gold Bull Market: Gold Shares Are Burning Matches

You’re going to find good reason to love gold stocks. But I hope you won’t fall in love with them. Although I’m a philosophical gold bug, I’m not always a gold bull. I always keep in the back of my mind that gold shares aren’t heirlooms; they’re burning matches.

And while I still think this market will see gold’s biggest run in history, when it’s over these stocks will lose 90% of their value… as does any class of stocks when a mania ends. But the good news is that the mania hasn’t even begun. For a number of reasons, mostly related to the simple passage of time, digging up hard data from earlier gold bull markets – especially for the junior explorers – was surprisingly difficult.

Many old-timers from the bull market of the late 1970s are now retired or pushing up daisies; some stock indexes we would like to examine don’t actually exist; and the Vancouver Stock Exchange, the birthing ground of so many junior resource companies, has undergone many evolutions. I wish I’d kept my chart books from 25 years ago.

You probably already know the multitude of reasons why I believe the broader stock markets are about to meet a financial Freddy Krueger. I won’t repeat myself here, other than to say that we are fast approaching the point at which the U.S. government will have to choose between crushing hocked-to-their-eyeballs American consumers by continuing to increase interest rates (a rock) in order to keep the dollar attractive to the foreigners who lend U.S. markets about $2 billion per day… or letting the dollar tank (a hard place), triggering all sorts of fiscal unpleasantness. Given that less than rosy view, let’s start by testing the notion that because gold stocks are stocks, they will follow the trends of the general stock market.

Unfortunately, that idea doesn’t hold up. Gold stocks largely march to their own drummer, sometimes in the same general direction as broader stock markets, but sometimes distinctly contrary to same. Yet it is true that the strongest moves in gold stocks have occurred when the general market, as well as gold, was moving up (1971-73, 1983-1983, 1985-1987, 1993-1996). So gold stocks can move on their own, no matter what the S&P is doing. But what moves them?

Gold Bull Market: Three Forces That Move Shares Higher

Generally speaking, three forces can move gold shares significantly higher.

(1) The price of bullion. In my opinion, we have at least two more years of rising gold prices – including a blow-off top – yet ahead.

(2) Discovery. As a stimulant for investor interest, few things outside of runaway gold prices get things moving faster than a major discovery. A discovery almost always provides a halo effect for a multitude of companies with the (usually) dumb luck to have a property in the neighborhood, and sometimes to the gold stock sector as a whole.

(3) Promotion. A determined promoter can do wonders with an area play and, at least temporarily, take even a mediocre stock and run it up to the moon. That was the case with Nevsun, one of my personal bests – at least for short term returns – which went up more than 8 times almost overnight based on the frenetic efforts of a single broker. As you’ll read, in the 1980s, one particularly hard-working promoter was almost singly-handedly responsible for powering up two separate bull markets. With those drivers in mind, it’s time for a quick trip down memory lane.

For most gold investors, the quintessential bull market was the move that took bullion to $850 in 1980.

To help keep that happy ride in perspective, gold had bottomed at $104 in August of 1976. From there it rose 725%, to $850 in January of 1980, with most of the gain coming in 1979. In today’s dollars, gold would need to reach about $2,000 to match that 1980 high.

The next page in our story is trading activity on the Vancouver Stock Exchange (VSE), the world’s leading exchange for junior resource stocks. Despite 1979’s strong run-up in bullion prices, trading activity was nearly constant and at modest levels for most of the year, indicating remarkably little investor interest in gold stocks.

Somewhat predictably, the big trading activity didn’t come until January of 1980. Following gold’s subsequent steep fall to $482 in March, trading picked up again as gold rallied to a secondary peak of $711 in September.

While it’s tempting to view the trading history as another case of investors piling into an investment at the worst possible time – in this case, after gold had peaked at $850 – when you look at share prices, you’ll see that’s not quite the case.

Between December 1978 and the gold’s price peak in January 1980, gold stocks turned in stellar performances. It’s noteworthy that the peak for the stocks came well after bullion had peaked.

Even though the price of gold fell sharply – from $850 to $482, between January and March – it subsequently recovered and ran back up to $711 in September, giving gold stock investors a false hope that gold would retake its previous high and go to the stars. Unfortunately, the opposite happened, and the long dark night of falling bullion prices set in. Many stocks simply dried up and blew away.

Gold Bull Market: Why Junior Explorers Do Better Than Producers

Also notable is that junior explorers often do much better than producers in a bull market, even one driven by strongly rising bullion prices. To figure out why that is, think back to the dot-com boom, when the startups and miscellaneous cats and dogs far outperformed established companies.

Case in point: recall that, pre-merger, Time Warner, a going concern with tangible assets and an identifiable revenue stream, was able to command a market capitalization of "only" $83 billion… while loss-making AOL, rich mainly in blue sky, was valued at $163 billion. In the case of the former, the likely returns were predictable and clearly finite. In the case of the latter, investors paid up and paid big for the dream of untold riches… much the same as they do for junior explorers when hearts are beating fast for gold.

So far, gold shares have been relatively quiet compared to gold itself. That will change, and dramatically so, once the investment masses wake up to gold and the role it has to play in the new economic realities.

The investment masses will almost certainly wait until gold prices are significantly higher before piling in. But when they do, the upside for those investors smart enough to be building a portfolio of quality junior gold explorers at this stage – meaning now – will be truly stunning.

In fact, I’m convinced that not only will the returns be much richer than in the 1979/1980 bull market… they’ll be so rich that even I’ll be surprised at how high the better companies go. This will be one for the books… don’t miss it.


Doug Casey
for The Daily Reckoning

December 15, 2005

Doug Casey is the chairman of Casey Research, LLC. publisher of the highly acclaimed International Speculator. Of the 16 stocks recommended in that publication in 2005 – including those recommended as recently as December 1 – 13 are already up over 29%… 10 are up over 40%… 9 are up over 50%… 4 are up over 75% and 3 are up over 95%.

And those are profits made before the emerging bull market in gold and other resources has even begun in earnest!

What happened in the news yesterday? We haven’t had time to look.

So, we write only to pass along conversation.

"The trouble with all salesmen," began a conversation yesterday, "is that they begin to believe their own claptrap. That’s true of stock promoters. It’s true of politicians. It’s true of real estate investors. I don’t know; it might even be true of gigolos.

"Right now, all over America, people are becoming real estate brokers. There are thousands of new ones every day, because they think it is the royal road to riches. They figure they will get an inside track to making a lot of money. They figure they’ll get paid for doing market research. I mean, they’ll get to go around to look at houses that are for sale, and they’ll get paid to do it. All they have to do is sell a house now and then and they can earn a decent living from commissions, but the real money is when they find a gem of a house at a discount…then they figure they will pounce on it.

"What’s happened is that they’ve bought into the real estate industry’s spiel. They think it always goes up. And since it’s going up all the time, they want to be in on it.

"What you don’t see in the real estate numbers is a lot of buying and selling within the real estate profession. A guy gets a license to sell property. The next thing you know, he’s not selling a thing…he’s buying. He is fundamentally a believer, but his buying is not ‘normal.’ A few years ago, he was probably buying tech stocks. And before that, who knows what it was, but this is not a guy who will hold onto his house in a slack market. He’ll sell…either because he has to, or because he loses interest. There’s a lot of that kind of very petty speculation going on. These people will leave real estate when the going gets tough and move on to something else."

We have been thinking about property – perhaps because we are surrounded by it. When prices rise more than 20% per year, as they have in the greater Baltimore-Washington area, it draws attention. We went down to Baltimore’s Fells Point area last night for dinner. We felt as though we were in a new city. It was as if we had never been there before: New restaurants, new condominiums, and new parking garages.

(We recalled the days when you could get drunk and drive right down the main street directly into the water. Alas, those days are gone.)

And so, our own thoughts and opinions are bent towards the real estate market, as if by some powerful magnet. Pretty soon, we have a warped view of the world…in which "you can’t lose money in real estate."

Yet, we sit this morning in a building whose real value – even today – is probably less than it was 75 years ago. As near as we can determine, the value of central city property in Baltimore hit its high in the 1920s, or maybe before. Then, the city began a decline from which it has never fully recovered. By the 1970s or 1980s, it probably hit bottom with luxury apartments in the center of town selling for as little as $30,000.

Since then, prices have generally gone up, but even as late as the early 1990s, when we bought our office building, prices were depressed. Our place is an elegant mansion of 16,000 square feet. It wasn’t in bad shape when we bought it, but the price reflected a long period of malaise and discouragement with property. We paid only $500,000 – and worried about it. Now, the building is probably worth more than a million. We have no sure figures, but we recall a calculation that showed it was worth more than that, in real terms, a century ago.

Out on the plains the story is a little different. As reported in this space a few days ago, prices for Kansas farmland reached a peak in the 1880s. They have never recovered.

Does real estate always go up over the long term? We don’t know. If so, you may have to live as long as Methuselah to find out.

And now the news from Aussie Joel and The Rude Awakening…


Eric Fry reporting from the financial epicenter:

"Most successful investors position themselves for long-term trends and ignore everything else. If they react to the short-term sell-offs at all, they do so as buyers, NOT as temporary sellers."


Bill Bonner, back in Charm City with more conversation…

*** We heard some interesting news on the way in to the office today. NPR reports that, thanks to a new accounting system that is better able to track the private sector, China has discovered $300 billion in its economy.

Many expect revised economic data being released next week to show the country’s economy to be about 20 percent larger than thought.

We’ll keep you updated…

*** Addison joined the chatter yesterday…in an interview on CNBC’s early morning show, Wake-Up Call, anchor Michelle Caruso-Cabrera, asked him, "What could put a damper on the U.S. trade deficit?"

"Well, of course, we have no way of knowing what’s in our future," replied your Editor-in-Chief, "but with the deficit widening to a record $68.9 billion in October, the most likely candidate to feel the sting will be the housing market. Putting a damper on the housing market will unquestionably have an effect on consumers – so, the numbers to really pay attention to in the coming months are going to be consumer spending and retail figures."

*** "I tell you," began a Florida real estate developer, who was visiting us in Baltimore, "the problem in real estate is going to be worse than people imagine. I’m involved in dozens of different projects. What we’re seeing is a lot more speculation. Normally, we count on selling about 15% of our new units to investors. But now, we’re selling 60% to 70%. As builders and developers that poses no problem…at least not for right now. But everywhere I look in the real estate area in South Florida…I see fuses, and they’re lit.

"First, you have all this extra production being bought up by speculators. It’s a lit fuse, and it’s going to blow up because in a few months these units are going to be completed, and the speculators aren’t going to move in. They are hoping to flip them, but who are they going to flip them to? It’s a fuse, and I figure it’s only got a couple of more months left on it.

"Second, there are all these people who have bought more house than they could afford. A few years ago they were living in a $200,000 house, but they figure they want in on the boom…so they buy a $500,000. Why do they do that? Because that way they get more leverage, while they get to live in a better house. If the house goes up 20% in a year – which is what they’ve been doing – the guy makes $100,000 per year on his house, which is probably more than he makes from his job. Who can say no to that? But it’s a lit fuse, because it costs a whole lot more to maintain a $500,000 house than it does to maintain a house that only costs $200,000. You have to pay more insurance, higher taxes. If it’s in a development, you have to pay a fee to the community, or a condo fee. And, of course, you have to heat and cool the place, not to mention regular maintenance. It all adds up, and for many people, those bills are just coming in.

"It’s like other things, at first the whole thing is a dream. You’re living in a bigger, nicer house. You’re feeling very successful. So, you gradually expand your lifestyle to suit the bigger house. You can’t help it. Gradually, you get in trouble not only from the direct costs of having a larger house, but the indirect costs, too. I mean if you’re living in a fancy house in a fancy community, you have to have a fancy car parked in front of it. That’s just the way people are, but it’s a lit fuse, and it’s going to blow up on a lot of people.

"And third, the lenders are getting squeezed by both the regulators and by higher interest rates. They’ve got to pass the squeeze along to the borrowers. They don’t have any choice. So, gradually, a lot of people with interest-only mortgages, for example, are going to find that they’ve got to start paying principle as well as interest, and they’re going to have to make higher payments. New buyers are going to find it’s not so easy to finance 100% of a new house. People are going to get hurt because they aren’t going to be able to keep up with the expenses and the higher financing costs. They’re not going to be able to find a new buyer to bail them out. What I see is another lit fuse there. It’s burning now, but it’s got to blow up sooner or later."

These giant lenders are in no position to weather even a small downturn. But the downturn has already started, and it’s not going to be small. When these big companies fail, it will rock financial markets. Interest rates will soar. Even if you have no debt and you’ve lived in your house for 30 years, the end of the housing bubble can devastate you if you don’t take the right steps.

The Daily Reckoning