The bottom chart shows the federal budget, and the trend is readily noticeable—when the federal government is spending more than it takes in, gold stocks tend to outperform the broader market.

As indicated in the top chart, $100 invested in the S&P 500 at the start of 1971 underperformed the gold-stock index essentially for a quarter-century. In each of these years, the federal government engaged in deficit spending. The S&P 500 surpassed the gold-stocks in 1997, in the midst of the tech boom and budget surpluses under President Clinton.

When those surpluses reverted to widening deficits after the September 11 attacks, you can see the spread between the broad market and gold equities narrowing. At the same time, another important event occurred—China began to deregulate its precious metals markets. During that period, the S&P 500 dropped before largely leveling off, while gold stocks charged forward.

Gold stocks have delivered a 9.9 percent average annual return since 1971, while the S&P 500’s annualized return has been 9.6 percent. That $100 invested in gold stocks in 1971 would have grown to nearly $3,800 at the end of May, while the same amount in the S&P 500 Index would be worth about $3,400.

So now that we’ve established the relationship between gold stocks and the federal budget, let’s look at the current situation.

The federal government, which has spent huge amounts to save the banks and stimulate the domestic economy, is expected to see a $1.8 trillion gap between revenue and expenditure. You can see from the long blue line at the far right of the bottom chart that this is a deficit on a scale beyond what we’ve seen in the past.

If the federal budget projections are accurate, we can expect massive deficits to continue, which will likely fan inflation fears and keep downward pressure on the dollar. These large deficits, combined with China’s growing appetite for gold, create the potential for gold stocks to remain an attractive investment relative to the broader market for some time to come.

* Time series for Toronto Gold & Precious Minerals Index is a composite of this index’s returns from 1970 to 2000.  Thereafter, the S&P/TSX Gold Index is used.  Both series are analyzed based on their returns achieved in US dollar terms.

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Frank Holmes is CEO and chief investment officer at U.S. Global Investors, a Texas-based investment adviser that specializes in natural resources, emerging markets and global infrastructure. The company’s 13 mutual funds include the Global Resources Fund (PSPFX), Gold and Precious Metals Fund (USERX) and the World Precious Minerals Fund (UNWPX).

This commentary originally appeared in U.S. Global Investors’ Weekly Investor Alert. For more insights and perspectives from Frank Holmes, visit his investment blog "Frank Talk" at www.usfunds.com/franktalk.

Please consider carefully the fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk. Gold funds may be susceptible to adverse economic, political or regulatory developments due to concentrating in a single theme. The price of gold is subject to substantial price fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. We suggest investing no more than 5% to 10% of your portfolio in gold or gold stocks. Because the Global Resources Fund concentrates its investments in a specific industry, the fund may be subject to greater risks and fluctuations than a portfolio representing a broader range of industries. The S&P/TSX Global Gold Index is an international benchmark tracking the world's leading gold companies with the intent to provide an investable representative index of publicly-traded international gold companies.The Toronto Stock Exchange Gold and Precious Minerals Total Return Index is the total return version of the Toronto Stock Exchange Gold and Precious Minerals Index with dividends reinvested. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies.

-- Posted Monday, 8 June 2009 | Digg This Article