Gold stocks may be immune
to a common stock collapse
Dr Richard
Appel
April 29, 2005
April 24,
2005 - The
recent one week 450+ Dow Industrials point decline, combined
with similarly sharply lower prices for the majority of common
stocks, has prompted many commentators to predict an impending
resumption of the Bear Market in U.S. equities. This has again
drawn attention to the latent fear among many gold followers
that such a broad based downturn would similarly ravage the world
of gold equities. They believe that gold stocks will be forced
to participate in a major, widespread common stock fall. If these
gold enthusiasts are correct, a dire fate awaits the gold mining
industry when the equity Bear Market finally resumes. However,
given the experience of the great 1970's gold Bull Market, I
believe that their fears will likely prove to be overblown.
An increasing number of gold followers believe that when the
common stock Bear Market reasserts itself investors will differentiate
little between common or gold equities. They posit that a general
flight from common stocks will result when it is generally recognized
that their Bear Market has not ended. Those possessing this belief
are convinced that market players will sell their gold shares
just as they would any of their other stock holdings.
They anticipate that investors will jettison all shares regardless
of the sectors that they represent, for fear of further substantial
losses. In fact, this conviction appears to be supported by the
severe gold stock price reversals that accompanied the recent
general market decline.
While this widespread fear engulfs many within the gold community,
some experts believe that gold mining companies will only initially
fall in unison with the resumption of the equity Bear Market.
However, they believe that the gold miners will later regain
some strength while common stocks continue to be liquidated.
Their premise initially revolves around that held by the former
group. However, many in this faction differ in the outcome. Among
other reasons, this is because they are confident that the government
will open wide the monetary floodgate causing gold to act as
a safe haven and to rise in price. This in turn will carry the
companies that mine and explore for it to higher levels. While
they believe that gold will not suffer as greatly, in the end,
they all believe that gold stocks only represent ownership of
gold mines, and as such will not fare as well as the yellow metal.
The potential for different outcomes arises when one attempts
to anticipate the possible price movements of gold equities with
a general market decline. This results because it is impossible
to predict the duration and magnitude of any Bear Market downturn.
We may face a virtual waterfall equity collapse where stocks
cascade sharply lower. Or, we might experience a relatively controlled
decline where their prices essentially erode over an extended
time-frame. In fact, we might experience a combination of both
market actions. In each of these scenarios the fashion in which
gold equities react may be different! This factor makes a simple
description of an equity Bear Market's likely effect upon gold
stocks difficult to anticipate. Fortunately, a look into the
past might shed some light upon the future, and may help us better
prepare for its arrival.
To me, the best precedent for comparison occurred during the
gold Bull Market of the 1970's. Gold rose early in that decade
from $35 to its ultimate $875 an ounce peak in February, 1980.
Common stocks began that era with prices broadly rising only
to suffer a severe Bear Market decline. This was followed in
the mid-1970's, by the emergence of a new Bull Market. Significantly,
during the equity Bear Market segment, both gold and gold stocks
rose sharply in price.
One could also compare the reaction of gold stocks to that which
occurred during the great 1929 stock market crash and its aftermath.
This might allow one to get a glimpse of what might transpire
if a similar event was to be experienced today. However, a different
set of circumstances prevailed during that era: 1. There were
paltry few gold equities that investors could purchase, while
today there are thousands. Thus, any capital directed towards
gold stocks was focused upon the few available companies rather
than being dilutive in their impact. 2. Both the government and
the Federal Reserve had far less understanding of markets and
therefore had less willingness to influence them to prevent any
economic hardship. Today, they covertly intervene and possibly
actively manage a number of markets. 3. That era's citizens better
understood gold's position in the business and financial world.
Gold was not only used to back or collateralize the dollar, but
was often utilized in legal contracts. Contemporary investors
have been convinced to shun gold and gold stocks, and firmly
believe that the noble metal is essentially only useful in jewelry
and for filling teeth. This prevents them from presently even
considering gold investments. Finally, with most prices declining,
the yellow metal actually rose substantially in price. Today
it remains to be seen whether inflation or deflation are in our
immediate future, and the impact upon gold is questioned by even
many of its adherents. For these reasons, I believe that the
relationship between common and gold equities during that period
cannot be compared with those existing today. However, for completeness,
I believe that a brief discussion of how gold stocks fared during
the Great Crash and the ensuing years is important.
The few trading gold shares followed closely behind common stocks
during their October 1929 crash. However, shortly after
the initial price collapse, while equities first rallied and
later resumed their Bear Market, the trading pattern of gold
stocks separated from that of common shares, and began a substantial
advance. You have likely heard stories of the extraordinary price
performance of Homestake Mines during that decade; it rose from
a low in the $50 price range to over $500 a share before the
1930's decade ended.
The primary reason for this incredible event was the result of
the devaluation of the dollar. From 1920 to early 1934, gold
had a fixed price of $20.67 an ounce. However, after making it
illegal for Americans to own gold a year earlier, in 1934 President
Roosevelt devalued the dollar. This was achieved by officially
increasing the gold price to $35 an ounce; it then took 35 paper
dollars to purchase an ounce of gold. This presented Homestake
and the few other domestic gold producers with an enormous 70%
windfall profit on their sales. Further it gave them a guaranteed
price and a willing customer in the U.S. government, while the
general economy suffered from a depression and generally falling
prices. Further, Homestake's production costs actually declined
while the economy floundered and the unemployment lines swelled.
As you can see, the various conditions and events that accompanied
the crash and the Depression's aftermath coalesced to first take
Homestake's share price to lower levels, but later fostered its
incredible exhibition of strength.
It is important to understand how and why gold and gold stocks
performed in the 1930's. However, I believe that in attempting
to predict the fashion in which gold equities will today react
to a common stock Bear Market decline, the 1973 to 1974
period offers the best historical comparison. Further, to my
mind, studying it will likely give us much insight into what
may lie ahead for gold shares when equities ultimately enter
their next extended downward leg.
HOW GOLD
STOCKS FARED DURING THE 1973-1974 EQUITY BEAR MARKET
As
I stated earlier, the gold and gold share secular Bull Markets
spanned virtually the entire 1970's decade. Equities on the other
hand entered that period with stock prices in a broad based advance.
This was followed by a devastating Bear Market collapse to its
nadir in December, 1974, from which emerged a new Bull Market.
January, 1973, witnessed the end of the prevailing equities Bull
Market. The Dow Industrials peaked at about 1065 before the bear
took control. The following two years saw the Industrials enter
a period of unrelenting widespread decline. When the Bear Market
was finally exhausted many second tier stocks lost upwards of
90% of their former prices, and the Dow Industrials had plummeted
nearly 50% before posting its 577 low. Day after day and week
after week, the bear pummeled common stocks. It was seldom referred
to as a collapse until after it was over. Then, as now, hope
sprang eternal!
The relentless, unending price markdowns continued until the
last remaining earlier bullish investors finally gave up and
sold their shares. In so doing, they took whatever the market
would offer them. By the time that the Bear Market ended in late
1974, the majority of stockholders vowed to never again
purchase common stocks.
Gold on the other hand began its major advance in the late spring
or early summer of 1972. This was from the low to mid-$40 range,
and after the gold producers had already risen from their earlier
1972 lows. As I recall, when the Dow Industrials peaked in early
1973, gold was trading at about $100 and gold equities had already
posted impressive gains.
During the following nearly two years while common stocks were
devastated, the yellow metal simultaneously rose in fits and
spurts and posted a temporary top at $200. This occurred at the
end of December 1974, about a month after the Dow Industrials
bottom. Gold staged repeated new highs despite the equity Bear
Market which destroyed common share values throughout virtually
the entire 1973-1974 period. Across this era gold equities
followed gold higher in price and returned great profits to their
investors.
It is my contention that the effect of the rising gold price
upon the profits of the gold producers acted to spare them from
the great declines suffered by other stocks. This caused them
to be viewed in a different fashion than were most common stocks!
While most companies were experiencing smaller profits or severe
losses, gold companies amassed substantial profits and their
stocks exploded in price.
It was only the decline in gold from the $200 level that generated
a serious secondary correction for gold stocks. This began during
the last few days of 1974, just prior to the time when Americans
were again allowed to own gold. A terrifying gold correction
ensued until the noble metal posted its $103 nadir in the summer
of 1976.
The gold shares had touched their low points a few months before
gold struck $103. It was from those thoroughly depressed levels
that gold and its shares rose to their final spectacular highs
in February, 1980. Interestingly, and importantly, the latter
rise of the gold complex was accompanied by common stocks that
simultaneously advanced during the early stages of what was to
become their greatest Bull Market in U.S. history.
Given the fact that I believe that gold is in a secular Bull
Market, I feel that only in a major financial meltdown, such
as which occurred in the 1929 experience, will gold equities
be sold along with other paper assets. Barring such an event,
it is likely that gold shares will only periodically mirror the
fall of common stocks when their Bear Market resumes.
It is true that a sharp initial equities decline will likely
be accompanied by a similar reaction in gold equities. If such
a scenario unfolds it will occur because many gold investors
are convinced of its inevitability, and will sell in anticipation
of it. In essence, their belief and actions will produce a "self-fulfilling
prophesy". However, I am confident that even if this occurs,
it will be short-lived at worst.
In the end, it is my belief that the direction of both the major
and junior gold stocks will be far more influenced by the price
action of the yellow metal, than by a vicious Bear Market in
common stocks. As long as gold continues to trend higher, I am
confident that gold shares will trade in a like fashion as they
did in the 1970's. They will essentially rise and fall along
with the gold price. There will be periods when either gold or
its stocks will move higher and the other will hesitate. But,
it is my contention that the great fears of many gold followers
will not come to fruition when equities enter the next segment
of their Bear Market decline.
The above was excerpted from the May 2005 issue of Financial
Insights © April 24, 2005.
Dr Richard Appel
contact
website: Financial
Insights
Appel Archives.
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