Stage Three Gold Rally

The Daily Reckoning PRESENTS: You can invest in gold stocks now – before the third stage of the rally begins (and while prices are trailing the overriding fundamentals). Or you can wait for confirmation from the herd. James Boric explains why it pays to be ahead of the herd, below…


The most profitable stage of the gold rally – stage three – has not yet begun.

The first stage of the recent metals rally began in 2002. That’s when the world lost faith in the U.S. dollar – the dominant currency of the world. Of course, it didn’t happen all of the sudden. Leading up to 2002, the stock market crashed, U.S. debt piled up to all time highs and the trade deficit swelled to epic proportions.

All of these factors, coupled with the geopolitical concerns around the globe, led foreign central banks and a handful of shrewd investors to question whether holding U.S. dollars was really a safe thing to do. A few brave souls decided it was not. So they smartly sold their paper assets (dollars) and bought gold – a true store of value in uncertain times.

For the first time since the 1970s, both demand and the price of gold increased significantly as the value of U.S. dollars fell in half. This marked the first phase of the metals rally.

Of course, not many people bought gold (or any precious metal) in 2001. The mainstream never catches an idea in its earliest stages. People are too afraid of being wrong and going against the herd. So they wait for confirmation from mainstream before they buy. That is exactly why noticeable buying didn’t occur in the gold markets until late 2004 and early 2005 – when the second stage of the gold rally began.

By 2005, global demand for gold was large enough that spot prices actually rose no matter what the dollar did. For instance, in 2005, the U.S. dollar gained about 9% versus a basket of other world currencies as it bounced off its 10-year low and as the U.S. stock market rose. Meanwhile, the shiny metal rose in tandem with the dollar – from $420 an ounce to $520.

This divergence from the U.S. dollar coupled with the first signs of retail interest in gold and silver as a legitimate investment opportunity marked the second phase of the metals boom. During the time, Barclays unveiled its iShares COMEX Gold Trust ETF (IAU:AMEX) and the first-ever silver ETF. Since that time, money flow and volume for the gold ETF proves that there is interest in gold as an investment vehicle.

Average daily volume for IAU has more than doubled in the last year and total assets have gone from nothing to $1.2 billion. But this interest in gold is still very tiny. Wal-Mart alone is a $200 billion company! In other words, despite the interest that has been drummed up in the gold world to date, it is hardly indicative of a mainstream rally.

The third stage (the “mainstream stage”) of this metals rally has yet to begin. But when it does, it will be quick, explosive and very lucrative. To understand what this mania phase will look like, we turn back to the 1970s. During the last metals boom, stocks rose fast and furiously in the final stages of the metals rally.

·            Bankeno rose from $1.25 to $430 a share
·            Resources rose from $0.40 to $560 a share
·            Steep Rock rose from $0.93 to $440 a share
·            Mineral Resources rose from $0.60 to $415 a share
·            Azure Resources rose from $0.05 to $109 a share
·            And Leon Mines rose from $0.05 to $385 a share.

Although many small-cap gold stocks have already risen hundreds of percent since 2001, we have not yet seen mania-buying like in the late 1970s. In fact, since May of this year, gold stocks have sold off to several year lows, despite better underlying fundamentals.

Last year at this time, an ounce of gold traded in the $470 range. As I write this essay, the shiny metal is at $601 – 28% higher. Yet many gold companies are selling for less than they were 12 to 24 months ago. For instance…

IAMGOLD is a junior mining company (market cap of $1.5 billion) with 4.6 million ounces of proven and probable gold reserves. At $8.50 a share, it is trading for the same price it traded for back in December 2004. Yet its reserves are worth $430 million more today.

Bema Gold is a mid-tier producer with 11.4 million proven and probable ounces of gold in the ground. Based on FY 2005 numbers, those reserves are worth an estimated $4.9 billion. Yet, Bema stock is trading for the same price as back in Dec. 2003 – when its reserves were worth about $1.1 billion.

And Newmont, a major gold producer with a market cap of $20.1 billion and 93.2 million ounces of proven and probable reserves, trades for the same price as it did in Sept. 2003.

Yet its reserves are worth about $4.1 billion today, versus $2.9 billion in 2004.

This price action is not, in any way, indicative of a fierce, mainstream metals rally. While the price of gold has significantly increased in the last year, mining stocks have not followed suit.

As investors, you have a choice to make.

You can invest in gold stocks now – before the third stage of the rally begins (and while prices are trailing the overriding fundamentals). Or you can wait for confirmation from the herd.

Those who buy now must have a stomach made of steel, patience and a thick skin. While it may be a rollercoaster in the short term, it will be these people that walk away with the largest profits in the end.

Of course, those who buy now will only have one group of people to thank for their riches – those that wait for confirmation from the rest of the market before they get in.


James Boric
for The Daily Reckoning
October 31, 2006

P.S. I recently stumbled onto a small-cap gold producer based in Africa that is about to increase production by over 100% in the next quarter. Currently this stock trades for less than $3 a share. And company insiders (including the CEO and two key vice presidents) just spent over a half a million dollars on their own stock. You think these guys know what’s coming? You bet they do. That’s why they are loading up now.

“The last shall be first,” says the Bible. “Shan’t the first, then, be last?”

The GDP growth rate fell 40% between the second and third quarters. According to Dr. Richebächer, consumer debt has risen 77% since the end of 2000.

Apparently, the gravity of it is now dragging Americans back down to earth.

And bond market investors seem to see it the same way. T-bond yields have fallen to 4.78% for the 30-year bond.

Are we right? Is the economy really weakening? Does gravity still work? Is the Pope still Catholic? Are there still Okies in Muskogee?

But stock market investors think we’re wrong. They’ve bidden up the Dow to over 12,000. Yesterday, even after the news was out about the slowing economy, stocks gave up only a couple of points.

And in today’s headlines, all we find is noise.

“U.S. Consumer Spending, Income Rise…Inflation Slows,” says Bloomberg. All is well, in other words.

But wait…

“Consumers hold onto their dollars,” adds CNN, noting that household spending is “weaker than predicted.”

“Wal-Mart, weakest monthly sales in years,” reports MarketWatch.

The data is contradictory, misleading and confusing. What can we do but stick with our old verities?

The way to become wealthy, we recall, is to make sure your outflow does not exceed your income. Because if you spend too much…and owe too much…pretty soon, your upkeep becomes your downfall.

Yes, we know…the stock market is booming.

But, wait…what’s this? Former Treasury Secretary Robert Rubin has some curious thoughts about the equity boom:

“I think there’s been a curious phenomenon in the equity markets, at least in the last few months: When there is news that the U.S. economy is slowing, the market often gets stronger because investors figure the Fed will stop raising rates, or maybe lower rates – or maybe they think bond yields will decline. For some reason, they don’t seem to say to themselves that earnings may be lower. I think it’s very strange.”

Strange indeed.

So, yes, of course, America has the biggest, most dynamic economy in the world – we grant that. But we also know that history grinds the ‘biggest’ down to the smallest…and it wears away the shine on the ‘most dynamic’ until it is as dull as everything else. We don’t claim to know how it all works, but we’re pretty sure that spending more than you earn is not a good formula for financial success. And we’re pretty sure that the more something looks as though it might lead to instant wealth, the more dangerous it is.

“China’s Dollar Reserves Approach $1 Trillion,” says another headline. Where did Chinese get all those dollars? It’s very simple, dear reader. China – along with other exporters – sells things to Americans. If the world economy were well balanced, it would turn around and also buy things from Americans so that it would come out about even. But China doesn’t want nor need what America makes, so it saves the dollars. China runs a trade surplus; America runs a trade deficit that is reaching up towards 7% of GDP.

And America has been running up its bill so long, it hardly worries about it. Trade deficits have become like the Nicene Creed – eternal and unchangeable. We think the Chinese will sell us things from now to eternity and take dollars at about the current rate of exchange for just about the same length of time.

Likewise, they have watched the Dow get whacked in 2000-2001…and bounce right back. So did the economy. And the dollar too!

‘That is just the way things are,’ they say to themselves.

But it is not really the way things are. Things – especially things in economics and finance – are cyclical. Sometimes, people are willing to buy a stock at 17 times earnings. Other times they want more for their money…even down to five times earnings.

And things work – as near as we can figure – according to rules that we can’t do anything about…but that we can’t ever completely ignore either.

When someone spends more than he earns (unless it is on capital investment) then somehow…sometime…he gets poorer. You can see this happening in the international accounts. Foreigners are taking their surpluses and buying more and more U.S. assets. They own 43% of marketable U.S. treasuries, 32% of U.S. corporate bonds, and 16% of U.S. stocks.

Twenty years ago, America crossed the threshold from being a net creditor to the rest of the world, to being a net debtor. Now, it’s – by far – the biggest net debtor in world history.

The Okies in Muskogee still fly Ol’ Glory down at the courthouse. Our guess is that things still work as they always did.

More news…


Greg Guenthner, reporting from Charm City:

“…Sometimes boring is good. In fact, there are plenty of amazing companies out there that make completely boring products — and make a lot of money doing it…”

For the rest of this story, see the latest issue of The Sleuth


And more views…

*** A note from our small cap superstar, James Boric:

“For the past three months, I’ve been waiting for the right time to get back into gold stocks. Since peaking this past May, the AMEX Gold Bugs Index is off 22%. But could it drop further?

“Surely it could. And two smart investors I work with think it will.

“One is waiting for gold to fall below $567 (a supposed support level) before he gets back in. And another will start buying when the HUI falls to 250 (19% lower than today’s levels).

“Both of these guys may be right on target. But in the long run, you have to ask yourself if a few dollars (or percentage points) will matter much when gold runs to $1,000 an ounce? Is it really necessary to time the market perfectly to make a profit? I don’t think so. And it seems a few top gold executives agree with me.

“Since the May metals correction, insiders at one small-cap gold producer (based in Africa) have spent over $500,000 buying shares of their own stock at market prices. These guys aren’t worried about gold falling a few bucks before they start buying. They believe in the long-term gold argument. They obviously like gold around $600 an ounce. And they like the fact that their company is about to increase production by 150% in the next quarter or two.

“Seems to me, gold is worth buying again.”

*** Tomorrow, we remember the dead.

Yesterday, we went over to the little cemetery near our house to put flowers on Aunt Jacqueline’s grave. She’s the only one in the family buried in France. She loved the place.

“You mean, she wanted to be dead in France?” asked Edward.

“Well, not exactly. But if she had to be dead,” Elizabeth explained, “France was as good a place as any.”

We cleared off the granite tomb and put chrysanthemums on it. That is the custom in France. All around us, there were so many chrysanthemums it looked like a flower shop.

The dead made no remark.

Except for the very recently deceased, none of them had ever heard of adjustable rate, minimum payment, low-documentation mortgages. What a pity; the poor old stiffs had to pay for their houses! They had to save money for down payments. They had no ‘Neg Am’ options. Instead, they had to make payments every month, or risk having the house taken away from them. And then, they never got to ‘take out’ equity. What equity they had, they had actually paid for. Taking it out made no sense. If they hadn’t wanted to own the house they wouldn’t have bought it in the first place.

Nor were houses expected to go up in price. They didn’t go anywhere. They were worth what a buyer paid for them; rarely were they worth more. The poor saps never realized what a money machine a house could be.

You wonder how previous generations could be so stupid.

*** Meanwhile, from Forbes, comes a report on what an opportunity the housing industry offers to people who are still alive:

“The real estate market has never offered such opportunity for graft. Since the housing market started to soar in 2001, mortgage fraud has become the fastest-growing white-collar crime, according to the FBI. Last year crooks skimmed at least $1 billion from the $3 trillion U.S. mortgage market.

“Now that the market is slowing, fraud is only rising. As business dries up, there’s increasing pressure on lenders, brokers, title companies and appraisers to be profitable. That means loan and title documents aren’t scrutinized as carefully as they might be, and courts – many of them so low-tech they resemble Mayberry – can’t keep up with the volume of paper.

“Then there’s the mad rush to sell, particularly by people who paid high prices for homes and suddenly can’t afford the mortgages.

“It’s like a tasting menu for con artists and grifters, so tempting that in some cities drug dealers have turned to mortgage fraud, plaguing lower-income neighborhoods with crooked mortgages rather than crystal meth.”

The Forbes article tells the story of a pair of thieves, known as the Bonnie and Clyde of mortgage fraud. The two would forge documents and steal identities in order to borrow money to buy houses – and then disappear with the cash. We read the article carefully and still didn’t quite understand how it worked. Apparently, they were able to get several lenders to put up far more than the actual value of the houses…pay the seller…and pocket the difference.

Why the lenders would do such a thing is a bit of a mystery. And why all the money didn’t have to clear through the respective lawyers at closing is also a bit of a mystery. But then, we’re not up with the latest practices of the mortgage industry. In our experience, the lender actually knew us personally – which made him reluctant to lend anything at all – and certainly nowhere near the actual purchase price.

As near as we can tell, today, a borrower can show up at settlement, present a phony drivers license, and walk away with hundreds of thousands of dollars.

How is this possible?

The Bonnie of the duo was caught, and now awaits trial. She explained to Forbes how Clyde “tried to convince her that theirs were victimless crimes – that no one really ever got hurt, and everyone was in on the con.

“Hell, one of the owners of a bank was in my office the other day, and he told me that as long as the borrower makes his first mortgage payment and the bank sells the loan to his secondary investors before the loan goes into foreclosure, he really doesn’t give a crap whether the loans contain fraudulent documents or not.”

Maybe it is so.