-- Posted Thursday, 10 August 2006 | Digg This Article

Metal markets have been in a strong bull market for four years. Currently a correction and sideways consolidation is in progress. Normally, pullbacks and consolidations are part of all long term up-trends in any market. Not withstanding all the bullish fundamentals in a world floating on printed money and debt there are always corrections and sharp pullbacks in the gold sector. This goes with the territory.

With the Fed still terrorizing all markets with their interest rate policies, actions and statements (all totally anti-free market) expect plenty of volatility for a long time. The Fed cannot stop inflation with rate hikes. This is a huge misconception by the Harvard-Yale-London School of Economics-NY Times-WSJ-Stanford-Goldman-Sachs-MorganStanley-WashingtonPost-Georgetown-dinner party axis. Please see The Fed Can’t Stop Inflation article posted on our website. Unfortunately some money managers and hedge fund managers with huge multi-billion dollar portfolios who are new to the mining sector and certainly the gold market can create havoc if they line up on one side or the other of the inflation-gold-interest rate equation. This will create opportunities and plenty of danger in the years to come.

Gold’s $200 advance during April and May might have implied the possibility that an unraveling of one of the many very extraordinary economic time bombs that are part of the investment landscape could be suddenly evolving. One can never be sure if a derivative meltdown is about to start or a global housing bubble causing defaults by the hundreds of billions (on risky adjustable and the new gimmick mortgages) or some major banking or insurance group in trouble could create some sort of monetary panic. The fact that global stock markets were also pounded in May and June makes one a believer in the value of gold assets despite the moves up and down. Gold has since recovered and is now around $640.

This recent volatility was unfortunately just a warm up to what is most likely in store for precious metal investors. If you were uneasy with this correction, are you prepared for gold going to $1,000 and then back down to $600 sometime in the future and then perhaps back up to $1,500. One needs to be able hedge with in the money puts, go short overvalued stocks or have a policy of taking some off the table on substantial run ups. Xerox back in its heyday went from $1 to $170 and then back to $45. A decade later it was at $4,000 (split adjusted). You would have had a hard time riding it down from $170 to $45 but you would have missed the great move up if you had bailed out. So an investing policy and basic strategy is vital to do well in the mining sector. I always tell people keep at least 50% invested always in case gold explodes one morning but don’t be afraid to take some profits on run ups and find new and better values to invest in with that cash….and buy on the pullbacks.

Money and Power Lining Up at The Gold and Base Metal Window

This pullback in the precious metals has allowed the more conventional global money managers, who so far have not embraced the metals, to start looking at gold related assets. Swiss giant UBS is the largest gold bullion trader in the world. In a recent report they noted that up to 20% of commodity portfolios tracked by their trading desk are being allocated to precious metals. AIG, one of the largest financial institutions in the world announced that their Japan unit alone may invest $4.4 billion (3% of assets) into commodity related assets to diversify away from stocks and bonds. Governments are also being heard from; Russian President Putin announced that the Russian central bank will raise their gold holdings from 5% to 10%. With $237 billion in reserves (expected to rise another $100 billion this year from oil sales) this allocation alone would require about half the global mine output this year. Yu Yongding, Chinese monetary committee member recently called for China to diversify a portion of their $875 billion reserves into gold. World powers live by, but also are beginning to lose confidence in, paper money.

China is now the 2^nd largest consumer of oil in the world versus only 10 years ago when it was 20^th. Oil consumption is a solid measure of economic activity and this stat is telling the world that base metals and precious metals will be in high demand next - as hundreds of millions of new middle class consumers buy jewelry, air conditioners, televisions and cars. Massive infrastructure projects will also require large quantities of base metals – and a U.S. or Chinese recession will not stop bridges and roads and power lines being built in China. Huge state projects (in any country) are financed by paper money or government debt and are recession proof.

Volatility and Value

So far, this spring and summer has been volatile for stock markets globally. Hong Kong was down 10%, Germany down 9% and Singapore down 18% in May and June. The Indian stock market lost 10% in one single day. Commodities, precious metals and mining stocks had large sell offs and swings. The US stock market had four days with over 200 point swings in the Dow (compared to only five such days the previous five months). The major cause of this global volatility was that the Bank of Japan had lent out hundreds of billions of dollars to domestic banks and this money was lent to large international hedge funds over a two year period. The Bank of Japan then abruptly called in these loans. Don Coxe, the extraordinary and brilliant strategist at the Bank of Montreal, called this “unprecedented in the history of modern central banking.” A global liquidation took place as these funds were forced to sell everything in sight to raise cash. The few hundred billion was significantly leveraged so somewhere between $750 billion and $1.5 trillion of global financial assets had to be liquidated in a very short time period….gold and gold shares were part of this liquidation.

It appears that many good mining companies have temporarily sold off more than fundamentals dictate. All markets experience sell offs that sometimes push asset values to very undervalued levels. This is what happened to the precious metal stocks, this conclusion is bolstered by the fact that over the last five years there have only been four instances where the Net Asset Values of the major and intermediate mining stocks have been trading at such a low valuation to their discounted cash flows. All four of these instances saw a significant rally occur from those levels. Also the senior precious metal mining sector is currently trading at only 9 times 2007 expected cash flow – historically very undervalued territory. In relatively mild to good metal markets these stocks usually trade between 15-25 times cash flow.

Own Good Merchandise

One owns mining stocks for various reasons: portfolio insurance, long term capital preservation, some alternative money versus printed paper, inflation hedge, and financial diversification. One also has to make sure the mining stocks owned have the minerals in the ground and have a good shot at economically recovering those minerals. The price we sometimes have to pay for these attributes, as well as above average performance, is above average volatility.

We are both a value investor and a production growth investor. We want the stuff in the ground and we want to see a 2-3 year growth profile for a company. In my opinion, the sweet spot in the mining industry are companies that are expanding and building mines that will produce gold on average for under $250 per ounce, allowing for significant cash flow, profits and upward share price valuations. The long term prospects are also excellent for base metal companies with multi-billion dollar deposits of valuable metals that a new global economy will demand in greater and greater quantities in the years to come.

Your portfolio should be diversified in various metals but concentrated in the precious metals. We are expecting strong capital gains in this sector. The best companies are the ones with quality mining projects coming on stream and are well funded and have substantial investment banks behind them to fund these and future projects. The worst companies are the risky exploration stocks.  For those who want some leverage and would like to trade warrants (long term options) you could check out www.preciousmetalswarrants.com They cover the Canadian and U.S. companies. Warrants are more risky, so be careful if you allocate some portion of your risk capital and go that route, and stick with established companies or those with plenty of resources.

In the long term the political-economic landscape for almost all governments is a policy of printing money and increasing debt levels to meet the overwhelming medical and retirement demands of their electorates. Gold assets are historically the most reliable and therefore the preferred asset class when a period of fiscal and monetary problems are coming on stream. This will surely happen in the future. Gold assets insure some wealth protection in an uncertain future plagued by paper money and debt. 

The graph below shows if gold stocks are over or under valued versus the underlying price of gold. The higher the ratio the more undervalued gold stocks are. At current ratios one should own the shares.

The summer is usually a slow time for the developmental mining companies. Most of the Canadian and European financial people are on extended vacations and taking constant three-four day weekends. The mining people are all out in the field drilling and expanding deposits. The summer work programs are usually extensive and the results are usually published at the end of August through November. This is usually a strong period for mining companies and it also coincides with strong gold bullion demand from wedding seasons in Asia and buying by jewelry fabricators for the holiday season.

The long term prospects for gold and mining stocks appear to be very strong and should prove to be the best asset class in the coming years to invest in. For more articles on gold and mining stocks visit our website at www.kengerbino.com

Ken Gerbino

-- Posted Thursday, 10 August 2006 | Digg This Article

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