Why hold gold
stocks at all?
12 Aug, 2004
Why hold gold stocks
Our view that the US$ will
trend higher over the next several months and, as a consequence,
that gold stocks are likely to trade at lower levels at some
point between now and November, has prompted questions from subscribers
along the lines of: Why do we suggest maintaining a sizeable
position in gold stocks in the current environment? Wouldn't
it be better to just get out of all gold stocks and re-enter
later this year once the corrective activity comes to an end
and the next major advance gets underway?
Well, getting out of all gold stocks would be a reasonable thing
to do if we could be absolutely CERTAIN that the stocks we own
were going to trade significantly lower in the future, but that
isn't the case. Rather, there's a good CHANCE that the stocks
will be available at lower levels before year-end, but this is
a reason to be cautious and to maintain higher-than-usual cash
reserves (something we've been strongly advocating since January);
it is not a reason to be completely out of the market.
Being completely out of gold stocks would be akin to betting
everything on a single short- or intermediate-term call and would,
in our opinion, fly in the face of sensible risk management practice.
The reason is that while most gold stocks will PROBABLY be available
at lower levels the magnitude of the upside risk is generally
many times greater than the magnitude of the downside risk. We
can show what we mean by this by doing a 'back of the envelope'
valuation of NovaGold (TSX, AMEX: NG).
If things go roughly to plan then NG will have annual gold production
of around 700,000 ounces by 2008. Currently, the average market
cap per ounce of gold production across the entire gold sector
is around US$2000, so the aforementioned production would be
valued at around US$1.4B if the gold price were near current
levels (a higher gold price would increase the value of gold
production). Now, assuming that NG has to issue another 10M shares
over the next 4 years in order to finance project development
-- a reasonable assumption given the company's current cash reserves
and the likelihood that earlier projects will provide the cash
to finance later projects -- then a US$1.4B market cap in four
years time would be equivalent to a stock price of US$19 (C$25).
The above-calculated price of C$25/share for NG is 280% higher
than yesterday's closing price of C$6.44 and, as mentioned, assumes
ZERO increase in the gold price. However, we expect that the
gold price will be trading well north of US$1,000 by 2008 so
the actual stock price could be MUCH higher than our calculated
So, that's the potential upside over the next few years for one
of our stocks and against this we must balance the risk of a
drop back to around C$5.00 at some point over the next few months.
Most gold stocks don't have NovaGold's growth prospects so the
above example is not representative of the sector as a whole.
As far as the overall gold sector is concerned, though, a similar
argument can be made in that the upside potential over the next
few years can be shown to dwarf any short- or intermediate-term
downside risk. In particular, with current sentiment towards
the gold sector ranging from disinterest to pessimism (refer
to the below discussion on gold market sentiment) the probability
of another large down-swing in the prices of gold shares is low.
What would, instead, be more likely is a drop back to near the
May lows or, perhaps, to a few percent below the May lows; and
against this downside risk we must balance the potential for
another multi-year advance of similar magnitude to the one that
unfolded during 2001-2003.
When it comes to gold stocks something else that unfortunately
needs to be taken into account at this time is the very real
potential for another large-scale terrorist attack. As discussed
in our 26th July commentary, gold stocks would probably get hit
hard if the broad stock market tanked UNLESS the reason for the
plunge in the stock market was terrorism, in which case gold
stocks would move sharply higher if the September-2001 experience
was anything to go by. In other words, at this time it might
be appropriate to hold some gold stocks as a hedge against a
financial crisis brought on by the destructive acts of barbaric
Further to the above, we think it's important to be aware of
the downside risks in the gold sector as far as the next several
months are concerned, but not to allow the potential for additional
counter-trend moves in gold and the US$ to completely override
our longer-term views and all other considerations.
Gold Market Sentiment
TSI is not a "gold newsletter,"
but as mentioned in a previous commentary the level of interest
in the TSI web site tends to ebb and flow with the level of interest
in gold-related investments. Specifically, when rising prices
cause the public to become more enthusiastic about gold and gold
shares we see an increase in subscriptions (trial subscriptions
and paid subscriptions) whereas the level of interest in the
TSI service invariably drops off during corrections in the gold
market. In this respect this year's gold market correction has
had a similar effect as the corrections that occurred during
2002 and 2003, and even though the prices of gold and gold stocks
have made a moderate recovery over the past 2.5 months it appears
as if sentiment has remained quite depressed.
Other sentiment indicators paint a similar picture to our experience
at TSI. For example, the commitments of traders (COT) data show
that small traders were only marginally more bullish on gold
with the gold price trading above $400 in July as they were when
gold was trading in the 370s during the first half of May. Also,
the below chart shows that the total assets in the Rydex Precious
Metals Fund are now less than they were when gold and gold
stocks were near their lows in May. In other words, since the
May bottom the public has continued to lose interest in gold-related
investments. This is, of course, bullish from a contrarian perspective
and should help to limit the downside from here because it means
that a lot of the weak hands are out of the market.
12 Aug, 2004
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