Now Is A Great Time To Be Buying Gold Stocks

As I reported yesterday, gold stocks, as measured by the HUI Index, have not kept up with the performance of the metal. However, in my opinion this is about to change. In fact, I expect gold stocks to play catch up in spectacular fashion over the next 12 to 18 months. Here’s why…

Why Own Gold Stocks? Why Not Just Own The Metal?

Since the start of the current gold bull market back in April 2001, gold has risen 573%, while the HUI gold stock index has returned 907%. Thus far then the large cap gold stocks have provided leverage to the gold price of a little under 2:1, however that was while the price of gold was moving up in an orderly, linear fashion.

Over the next few years, I expect the price of gold to begin moving up more rapidly and as a result I expect the stocks to provide significantly greater leverage to the price of the metal – likely upwards of 4:1.

Why Do Gold Stocks Provide Leverage To The Metal?

The reason that gold stocks provide leverage to higher gold prices is that as a stockholder, you not only get a share of the gold the company currently produces, you also get an interest in all the ounces in the ground that are yet to be mined and all the ounces that the company is yet to discover.

Why Do I Think The Gold Stocks Are About To Play Catch Up?

Yesterday I spoke about some of the factors that have been holding gold stocks back – chief among which was the fact that 2011 was a ‘risk off’ year. Today markets are being fuelled by massive liquidity that’s coming from central banks. This is sending all risk assets higher, and with today’s announcement of a second Greek bailout I see the ‘risk on’ trade continuing.

With governments around the world repeatedly demonstrating their willingness to do whatever it takes to keep the system from imploding, I am reminded of a passage from the book Dying of Money, by Jens O. Parsons:

“Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the latter effects, but the latter effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation.”

In this environment of massive money printing higher gold prices are all but assured, and with higher gold prices comes even greater profitability for the companies that produce the metal.

Minting money…

The average cost of mining an ounce of gold is $515 an ounce and given that those ounces are selling for $1,738 the typical gold miner is making more than $1,200 on every ounce they sell. Therefore a company like Yamana which is producing 1 million ounces a year is generating $1.2 billion a year in cash flow.

Some of these companies are using the money to build new mines which will provide future cash flow while others are returning it to shareholders in the form of dividends.

Newmont Mining, the second-biggest bullion producer globally, announced 26 October that going forward its dividend payouts will be linked to the price of gold. This means that the higher the price Newmont achieves for the gold it sells, the more it gives back to shareholders in the form of a dividend. For every $100 rise in bullion, Newmont will increase its dividend by $0.30 a share and if/ when gold goes over $2,000 and ounce, Newmont will increase its dividend by $0.40 a share for every $100 increase in the price of gold. In an environment of negative real interest rates such dividend payments will likely prove very attractive.

The fact is, even if we don’t see a rise in the price of gold (which I think is incredibly unlikely) these companies look very attractive which is why they are starting to attract the ‘smart money’ – something that was revealed in the latest 13f filings.

A Possible Mania

According to Dow Theory, bull markets have three phases, the third of which is the steepest part of the assent. It’s during this third and final phase that the general public enter the market, and it’s the one in which fear buyers are joined by greed buyers in bidding up prices.

Extreme sentiment and mass participation often turn the final phase of a bull market into a mania – just as we saw in the dot-com bubble in the year 2000.

Between 10 March 1999 and 10 March 2000 the NASDAQ Composite rose 113% to close at 5,132.52. This final blow-off top was created as the public entered the market.

In a mania the gold stocks could reach levels that are simply hard to imagine, particularly as the sector is so small.

The 16 largest gold companies that make up the HUI have a combined market capitalisation of around $221 billion, while Apple Computers alone has a market cap of $468 billion. Therefore a mass influx of new money would send these stocks significantly higher.

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