When will gold stocks take off?

Many people looked at the crash of 2008 as being a repeat of 1929.

In the periods leading up to each crash, there were multi-year, expansionary bubbles in credit. Economies boomed. Asset prices flew. The world made merry.

Then came the busts.

There are so many parallels between the two periods that many – myself included – looked to the 1930s for guidance as to what would be the best-performing sector in today’s post-bubble contraction.

In 1930s the bigger winner was gold stocks. That hasn’t been the case so far this time around. While gold has done well, gold stocks haven’t followed suit, despite a strong showing from late 2008 to early 2011.

Data-wrangler Nick Laird of www.sharelynx.com (with whose wonderful charts you will no doubt be familiar by now) and I have been exchanging emails on this subject this week.

I’d like to share his theory with you …

The upside of gold confiscation

Sometimes – in my darker moments – I wonder if gold stocks have already had their big day in the sun.

The HUI (also known as the ‘Goldbugs’ Index), is the index of ‘unhedged’ senior gold stocks. In other words, these are large gold mining companies who more or less sell their gold as they produce it, rather than locking in a price in advance.

In late 2000, the HUI hit a low of 35. In early 2008, it rose to 520. Quite a gain. Then, after collapsing to 150 in 2008, it rose to 640 by August-September 2011, as gold hit $1,920 an ounce. Now it sits at 440.

Let’s compare that to the 1930s. Dome Mines and Homestake Mining (now Barrick) were two of the leading miners back then. Homestake started to climb in 1931 from a low of around $60-70. Dome made its low a few months later in 1932, at just about $5.

The big year for both was 1933. This was when President Roosevelt confiscated Americans’ gold, making it illegal for them to own it. He then revalued it upwards from $20 to $35 an ounce.

Dome more than tripled from $10 a share to over $35. Homestake went from around $100 to $360.

In this first chart, we see the HUI from 2001 to late 2007, and Dome from 1932 underneath.

Gold Bugs index vs Dow Mines

(Click on the chart for a larger version)

There were two simple reasons behind the gains in Homestake and Dome in the 1930s. With the Roosevelt revaluation, the profits rose dramatically overnight. If they were producing gold at $10 an ounce, and the gold price suddenly went from $20 to $35, when they were making $10 an ounce, suddenly they were making $25.

On top of that, Americans could not own gold. Gold stocks were the closest thing. So gold bugs’ money was forced into gold stocks.

In 2012 on the other hand, there are many ways to own gold – from exchange-traded funds (ETFs), to futures, to physical holdings – so there is not the same upward pressure on gold stocks. If anything, all these ways to own gold mean that less money has gone into gold stocks.

Perhaps owners of gold stocks should be praying for another round of confiscation.

The cyclical view and what it means for gold

Or perhaps not. Perhaps the real problem is that we still haven’t seen the worst for this particular bout of deflation.

Nick Laird has a simple, cyclical view of things. He gives great credence to the theory of long-term Kondratiev waves. A Kondratiev wave – named after the 19th century Russian free-market economist Nikolai Kondratiev – lasts some 40-60 years (some say 54).

Within each cycle, Kondratiev theorised, there are periods of innovation, expansion then contraction – of boom and bust in other words. There’s not a lot anyone can do about this except prepare.

The illustration of the cycle is taken from a 1984 essay on the subject by economist Murray Rothbard. The Kondratiev wave is superimposed on an index of US wholesale prices. Interestingly this illustration predicts a low in wholesale prices in 2000. The actual low (in commodity prices) came in 1999.

Kondratieff wave

(Click on the chart for a larger version)

Now I have to say I always find cycles a little bit arbitrary. It’s too easy to modify a cycle and some dates to suit your argument. If the cycle fails to work as a predictor, you just say something like: “Ah, well, government intervened in the market place, suppressed interest rates, so the cycle was delayed”.

But you can’t refute the argument that we are in some kind of economic winter. The reason we haven’t yet seen gold stocks shine as brightly as they did in the 1930s, argues Laird, is that we have not yet seen “the deep mid-winter”.

In other words, we haven’t reached the modern equivalent of that 1932 low. The Dow has further to fall, reckons Laird. “Government – and everybody else – is still dealing with the forces of deflation. Gold stocks do best in the inflationary environment that comes next.”

How do we know when we’ve seen the low? “The ratio between the Dow Jones index and the gold price still has further to fall. It hasn’t bottomed yet. It will go back below 2, probably to 1”. (In other words, you will be able to buy the Dow with one or two ounces of gold. If the Dow is 10,000, then gold is $10,000. If the Dow is 1,000, gold is $1,000). This also happens to be one of my long-term targets for gold.

Gold price/Dow Jones ratio

(Click on the chart for a larger version)

This has happened many times before as you can see in the chart above: in 1980, 1932, 1873, and in the 1840s. (The chart below also shows a close-up of the period from 1980 to the present).

Gold price/Dow Jones ratio

(Click on the chart for a larger version)

The difference between the 1970s and 1980s and now, says Nick, is that the ‘80s were highly inflationary. But we’re now in a Kondratiev wave winter, which is highly deflationary.

“I believe the next great run for gold stocks will occur when the Dow / gold ratio hits a new low, the deflationary forces stop, and inflation starts to show. In the meantime, gold stocks will continue to go down with the share markets”.

In short, according to Nick, the macroeconomic conditions are not right. It’s winter, but we’re not yet at 1932.

So when will proper inflation kick in? It might be sooner than anyone thinks. My colleague James Ferguson, normally firmly in the deflation camp, now believes that quantitative easing (QE)-driven inflation may lie ahead. Given the amount of QE that’s gone on, when it does kick in, it’s likely to be forceful. You can read James’s latest warning about the impact of QE in his recent MoneyWeek magazine cover story: A bold step into the unknown – are we heading for hyperinflation? If you’re not already a subscriber, get your first three copies free here.

Meanwhile, I’ll be hanging on to my core holding of physical gold and my more speculative holdings of gold stocks. Wouldn’t it be nice if we could hurry up, get this winter over with, and suddenly see that speculative part of the portfolio finally come good?

If you’re interested in buying into gold stocks before the big inflationary pick-up, you should look at my colleague Simon Popple’s newsletter on precious metals miners. Simon has a particular type of gold mining company that he’s very keen on, for reasons he explains here.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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  • Chester

    Finally, we can agree on something regarding your view of gold. The Kondratiev cycle is likely to bottom in Q2 2016, as forecast by a small handful of deflationists, whose voice is growing louder as notions of “recession” are overtaken by reality. That means stock and asset prices, wich include physical gold, should hit bottom together. Forecast price for gold? Below $500, as cash rises in relative value

    Social mood is in charge, not central bankers or politicians who think they are. They normally fudge and tinker behind the curve, creating a longer and even more expensive final bust. So James is right to point to inflation as the end game, but not yet

  • S. D’Souza

    As such I am told technical analysis is only 60% reliable. In this world of inflated asset prices rife with rigged global markets how prudent is it to rely on TA to draw any dependable conclusion about any stock?

  • Roger

    If inflation is coming, salary will have to increase, so is the price of everything, including rent. That may imply property price will have to go up or interest rate has to go up. The Bank of England target is to improve economy while abndoning inflation target, so the interate may not go that much up in foreseeable future, then……

  • S. D’Souza

    Dear esteemed members of this forum I just wanted to know your feedback on the below article about the global gold supply. I very much would like to know if there is any truth in it.


  • Boris MacDonut

    Well Gold hasn’t even kept pace with inflataion in 2012 .Rising from $1670 last Xmas to $1694 this year. 1.5%. I see on the HUI index it is 30% off the 2011 peak.

  • 4caster

    You describe Nikolai Kondratiev (a.k.a. Kondratieff) as a “19th century Russian free-market economist”. He was just eight years old in 1900, and I have seen no evidence that he was a child prodigy. He published most of his economic theories between 1922 and 1928, and held various high government posts for much of that time. After the death of Lenin, Stalin obviously took a dislike to him, probably because he predicted the resurgence of capitalism, and had him imprisoned in 1930. In 1938 he was convicted of more political “crimes”, and was executed in September at the age of 46.

  • 4caster

    Kondratiev wave theory is based on gold standard currencies. It is no guide to the behaviour of the economy in the age of totally fiat currencies. For the first eight years of this century, and to a lesser extent ever since about 1950, western economies have been driven by the expansion of credit and hence money supply. In 2008 private sector demand for credit collapsed, but massive quantitative easing has both funded government deficits and kept the money supply from falling. Anyone who believes that governments and central banks will sterilise all the funny money they have created, if and when the economy picks up, is living in cloud cuckoo land. The government is already starting to monetise its debts, and must have inflation in order diminish their real value.
    Gold is a hedge, not against inflation, but against inflationary expectations.

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