How to profit from the next stage of the gold rally

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 US 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, US 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 US 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.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

For the first time since the 1970s, both demand and the price of gold increased significantly as the value of US 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.

The second stage of the gold rally: the start of retail interest in gold

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 US dollar gained about 9% versus a basket of other world currencies as it bounced off its 10- year low and as the US stock market rose. Meanwhile, the shiny metal rose in tandem with the dollar - from $420 an ounce to $520.

This divergence from the US 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 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 of the gold rally: will gold go mainstream?

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.

Why are gold mining stocks so cheap?

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.

Should you invest now - or wait for the herd?

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.

By James Boric for The Daily Reckoning. You can read more from James and many others at www.dailyreckoning.co.uk

Editor's note: James Boric is one of the leading small-cap analysts in the US. He began his finance career on Wall Street successfully picking winning stocks. With time and experience, James realized his goal: to figure out how an average, everyday investor with little capital could become wealthy.