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December 8, 2004
Gold Stocks Got It Right
But Will The Investor Be Able To Pick Up Some Gold Stocks On The Cheap?

Two weeks ago gold COT posted its second largest decline in open interest on record. Last week, even with the price of gold in a state of volatile-flux, open interest registered its smallest weekly change on record.  While two weeks ago the large decline in open interest was explained by GLD and CBOT, last weeks 7 contract difference in open interests suggests only one thing: both the commercial longs and speculative shorts remain deeply ensconced in their respective positions (as of Nov 30 ~ Futures & Options).

Who will budge first in this historic deadlock?  The commercials lost the first round last week (covering some short positions for a loss).  However, in response to a failed silver rally, a lingering correction in gold stocks, and - most importantly - a U.S. dollar that is on the mend, gold is down by nearly $10 an ounce this morning.  Should today’s sell off turn into full fledged price collapse the commercials will reap the benefits, as they always do…

Gold Stock Decline, But Valuations Still Way Up
 
The XAU index is off by nearly 9% on an intraday basis over the last 9 sessions (before today’s open) and HUI is down nearly 10% over the same period. The gold/silver industry (SIC Codes) currently trades with an average P/E of 44.84, ROE is 4.21%, and the averaged dividend yield is 0.88%. Save the more negative reading in ROE from non-metallic mining, each of these numbers is the least attractive of any basic materials industry.  Out 102 industries only two industries sport a higher average P/E than gold. As for the forward looking numbers, Newmont is currently trading at more than 30 times consensus 2005 EPS estimates, and Barrick is trading at nearly 20 times the highest Wall Street earnings estimate doubled.

Suffice to say, if a gold analyst says that gold stocks are worth owning at current prices this should remind you of Steve Harmon calling investors ‘chicken littles’ for not buying into Red Hat in 2000.  To be sure, gold stocks are overvalued by any valuation matrix you want to consider…except if the price of gold skyrockets.

Gold Bulls Bank on Dollar Crisis

Responding to the question “will the gold shares ever move like they did in the 70s? “, Mr. James Sinclair answers:

“You bet they will but they will not move because of the old gold crowd.”
http://www.jsmineset.com/

Yes, the story touted by specialists like Sinclair is that a ‘new’ gold bull market is underway. Does this mean that the ‘old’ rules of investing no longer apply? Mr. Sinclair goes on to say:

“What will propel the gold shares will be the coming volatility in gold driving the more conservative of the international currency crowd into the shares. The recognition will be that the end product of a company or the value of its properties will have to rise if the end product doubles in value. You think when gold goes over $500 on its way to $1625 that gold shares are going lower? That is in my opinion total insanity.”

Mr. Sinclair is absolutely correct – if gold goes over $500 an ounce and is on its way to $1625 an ounce most gold stocks will go higher. However, while longer term the ounces in the ground may be undervalued, it should be remembered that the ‘long term’ intentions of investors didn’t stop the XAU from losing more than 30% from its peak earlier this year. Part of Sinclair’s charm is that he continues to deny any serious pull back in gold stocks, but Chicken Little doesn’t lose money watching and waiting. 

As for
Fleck, he believes that GLD is stealing the show away from gold stocks and that short sellers ‘love to hate gold stocks’.  Fair enough.  Yet what Mr. Fleckenstein neglects to mention is that countless gold insiders have been selling and that valuations are extremely rich.  Show Fleck an overvalued tech stock with strong insider selling and he will attack it. For gold stocks he makes up excuses…

Ahh yes, gold will go to the moon and the price of Red Hat won’t crash…
 
What gold stocks to buy?

If the price of gold continues to retreat it is certainly possible that industry leaders like Barrick or Newmont will be sold down to attractive levels.  However, and save a serious crash in gold below $400 an ounce, the most popular gold stocks are likely to remain richly valued during any correction in the price of gold.  Quite frankly, and although I think that the majority of gold stocks are being held up by little more than investor excitement, I do not believe that gold stocks will trade at historically attractive levels for many years to come.  In other words, buying gold stocks after early 2002 became a gamble because downside protection vanished. The market may remain like this for some time.

Unknown companies or companies with new properties in development could be the only collection of gold stocks that reach attractive levels anytime soon. The investor needs to think long and hard about the pros and cons of buying a company based upon future prospects. Two companies worth an investigation on share price weakness in my opinion are Meridian Gold (turnaround company) and Dundee Precious Metals (in development).

In short, gold stocks lagged the price of gold because investors are getting tired of being burned by the COT, insiders and shorts were selling, GLD siphoned some liquidity out of stocks, and valuations were stretched.  Judging by today’s price correction in gold - now down more than $15 an ounce - I would say the gold stocks were right.  It would take a mighty dollar crisis for gold to get back on track this year.


No one at or associated with FallStreet.com has an investment position in any of the companies mentioned above.