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Gold Stocks to Soar as Credit Crisis Turns Into Currency Crisis

Commodities / Gold & Silver Stocks Oct 09, 2007 - 09:39 AM GMT

By: John_Mauldin

I get more questions about gold than other single topic. The fascination for the "barbarous relic" among my readers is clear. This week in Outside the Box we take a look at the gold market, its growth-to-date, and potential future investment opportunity. Doug Casey and David Galland of Casey Research provide an intriguing analysis of the gold market today.

I have known Doug and David a very long time. They take their research on gold stocks very seriously, and have been quite successful over the past years. While they are more bearish on the economy than I am, their analysis of the natural resource markets and gold stocks in particular has been spot on. In the mid-80's I wrote my first newsletter which focused on gold stocks. I sold it after about a few years as I became bearish on gold, but kept up the interest in the stocks.

But one thing I learned. If you are not on the ground talking to the men who are doing the work, getting into the behind the scenes facts, you are going to have a hard time making money even in a gold bull market. Doug is one of the few guys that truly knows what is going on in the market. He knows the difference between those who are serious about mining and those who are simply promoters.

If you are interested in specific gold stocks and gold stock investing, I really suggest you subscribe to Doug Casey's letter The International Speculator. They will send you his recent update which covers in-depth all the stocks he likes and a few he says to avoid.  For more information on how to subscribe, please click here .

John Mauldin, Editor
Outside the Box

A Trip Back in Time to Profit from the Unfolding Crisis Today
By Doug Casey and David Galland

At one point or another in your life, you've probably fantasized about going back in time.

Such fantasies typically involve visions of truckloads of easy money. From, say, buying beachfront property in Hawaii when it was still affordable. Or positioning yourself in the dot.com boom early on, then selling out before the collapse.

Well, I'd like to take you on a quick trip in a time machine, to when the team here at Casey Research looked into the future and saw the unfolding credit crisis, then told readers how to protect their portfolios and lock in extraordinary profits.

Then we'll return to the present and I'll demonstrate that the profit opportunities spotted then are still firmly intact, just waiting for you to grab them.

First the time machine part. For that, we turn to a direct excerpt from the "Users Guide to Fiscal Calamity," the lead article of the December 2006 edition of our International Speculator .

Admirers claim that the rapidly expanding use of derivatives helps to decrease overall economic risk by shifting particular risks toward the investors that can most easily bear them. It's a nice idea. And it's not really a bad idea. But it's launched a very big ship that has never had a real shakedown cruise. Derivatives may give an appearance of decreasing risk on a case-by-case basis, but when taken together, the risks to the economic system are not decreased but made worse.

A typical participant in the derivatives market is busy buying with one hand and selling something slightly different with the other. Whatever risk he takes on, he tries to offset with a derivative from someone else. And that someone else is doing the same thing with another someone else. And so on. The simple fact is that no one knows where the long rows of dominoes begin or end, or just how much shaking it would take to knock over the least stable of them.

To take just one example: Credit Default Swaps (CDS) provide guarantees against a bond defaulting. They carry the rating of the party granting the guarantee, which is usually AA. But if such an issuer were forced to make good on a big default, its credit rating could drop, lowering the value of every other piece of paper it has guaranteed – many of which are wrapped up in derivatives sold by other issuers... many of which are wrapped up in derivatives sold by still other issuers. The chain reaction could run far beyond the initial default.

By mid-2006, CDS issues had grown to $16 trillion, a 100% increase over the year before.

The individuals who manage banks and dealers in the derivatives market don't want rules so confining that they can't do business. We suspect most of the derivative operations are sturdy enough to withstand anything that has happened in the lifetimes of the people who run them. But they're not ready for anything rougher than that. If "6 sigma" is their standard, 7 sigma has implicitly – but dangerously – been assigned a probability of zero.

What happens when unprecedented events make the markets even more volatile? No building can be made absolutely quakeproof.

In that same article, we provided a summary of what's coming...

What This Means for Investors

The rapidly approaching dilemma for the Federal Reserve comes down to a choice between (1) engineering a standard sort of recovery from the next recession by speeding up monetary growth and reducing interest rates and (2) keeping the dollar afloat.

Choose the "solution" behind Door Number One and trigger a monetary crisis. Open Door Number Two and our heavily indebted economy is devastated by the higher interest rates needed to support the U.S. dollar. For all the reasons discussed above, and with the next presidential election season now kicking off, the odds heavily favor inflation.

In fact, Fed Chairman Ben Bernanke virtually gave the game away in a speech in Frankfurt on November 10, 2006.

"It would be fair to say that monetary and credit aggregates have not played a central role in the formulation of U.S. monetary policy."

In other words, the total amount of money in the system – what we "print" – plays no serious role in current U.S. policy. That's a politic way of admitting that the U.S. government is planning to paper over all its many obligations and accelerate a trend that has been in motion since the creation of the Fed in 1913.

Casualties

As the dollar loses purchasing power, interest rates eventually will rise – inevitably as lenders demand some compensation for inflation, and intermittently as the Fed attempts to slow the wholesale abandonment of the dollar by foreign holders. That will make bonds the worst investment and garden variety stocks the next worst.

That inflation should hurt bonds – with its double-whammy of rising interest rates and declining purchasing power – is obvious. But the damage that inflation does to stocks is nearly as bad, as a comparison of market action during the Great Depression with the sell-off during the inflationary 1970s makes clear.

As you can see, there are two noticeable spikes, in 1929 and in2000. But most of the movement in stock prices is hidden by changes in the value of the dollar (deflation in the 1930s and inflation in the 1970s). Correct for a fluctuating dollar, as in the next chart, and you see a whole new picture

A raging inflation – and we believe what's coming will be much worse than that of the 1970s – can have the same devastating impact on stocks as a depression. It is also worth noting how long the peaks loom over the years that follow. If you buy at precisely the wrong time, it can take two decades or more just to break even.

Beneficiaries

The biggest beneficiary of the flight from the dollar will be commodities.

A preview of what's to come can be seen in what has already occurred since the U.S. government gave the gold standard its last kiss goodbye in 1971. Fiscal restraint ended, the dollar became nothing more than a floating abstraction, and commodities took off.

While commodities in general will do well during the flight from the dollar, the biggest winners will be precious metals. Gold's story is the simplest: the flight from the dollar will be a movement toward a reliable store of value.

And, just in case you are reluctant to eliminate all stocks from your portfolio (other than those in the resource sector), we believe that certain industries in the U.S. and certain areas will be helped by a cheap dollar. Export industries, e.g., agriculture, will be helped.

It might seem shrewd to try to leverage your profits from a declining dollar by borrowing dollars to finance investment purchases. But that's a risky strategy. The flight from the dollar won't be a straight-line process. It will go in fits and starts, and there will be temporary reversals that can cut the legs off a trader who's playing with borrowed money – especially if it's margin money or any other kind of credit with a floating interest rate.

We prefer to find leverage from a different source – the kind of selected junior resource stocks that we follow in International Speculator. Their prices tend to far outrun the prices of the underlying commodities... without the risk of margin calls.

The bottom line is that we are in the early stages of a serious monetary crisis, a crisis you can make your friend by steadily and cautiously building a portfolio of resource stocks, the kind of investments we bring to your attention each month in this letter.

Back into the Time Machine for a Return to the Present

As you have just read, in December of 2006 we were convinced a credit crisis would unfold and gold would do particularly well, both of which have now come to pass. Back then, gold was $648 per ounce. Today, it sells for about $730. Given our view that the budding credit crisis will soon morph into a genuine currency crisis -- thanks to the unprecedented six trillion U.S. dollars held by foreigners showing increasing displeasure with the easy-money policy of the Fed -- we think gold is going much higher.

But what about the performance of the junior resource stocks? After all, that is the sector that got our nod as the most profitable way to play this crisis. Those stocks have largely underperformed. Could we have missed something?

Or has the opportunity somehow been frozen in time, allowing you to jump in today at yesterday's prices for spectacular profits as the current crisis regains momentum? While we are not afraid of admitting mistakes, in this case we remain convinced the big move is still ahead.

Here's why...

The junior resource sector is dominated by Canadian stocks, specifically those that trade on Toronto's Venture Exchange. These stocks have several attributes that give them explosive upside. In no particular order...

1. They are thinly traded. A lot of buying can quickly send prices to the moon, with daily moves of 10% or even 100% not that unusual. Great when a lot of people are trying to get in (and you are in ahead of them), the opposite of great when a lot of people are trying to get out. The rush for liquidity this past July and August, therefore, triggered an especially sharp correction in the illiquid juniors. Which makes sense, given that gold was still flying under the radar of most investors... and the next leg up in bullion prices had not yet begun. 
   
2. The industry is full of perma-skeptics. Ninety-nine percent of the Vancouver resource community, including brokers and exploration company executives, if pumped full of truth serum and asked four years ago – in the early days of gold's run-up -- how long they thought the bull market in gold would last, would have confessed the end is nigh.
   
   Why? Because experience shows resource cycles are short-lived. That has created a near DNA-level pessimism about the prospects for metals prices in general, and stocks in particular, over any period longer than it takes for the morning cup of coffee to cool.
   
   The consequences of this widely held attitude is an industry that speaks out of both sides of its mouth, cheering on investors with one side as gold prices rise, while calling their brokers to dump highly appreciated shares with the other. It is not possible to overstate the impact of this "psychological overhang" on the junior resource market.
   
   (By contrast, the stocks of larger producers that trade on the big exchanges operate mostly on fundamentals – for example, an actual P/E ratio – something totally lacking in most juniors... for the simple reason that until they actually discover something and go into production, the juniors have no P, or E.)
   
3. The old adage "sell in May and go away" rings especially true up north. During the summer months in the Northern Hemisphere comes the melting of snow, and access to remote exploration targets returns (and these days, most of the remaining good ones are remote). Exploration companies grab their gear, load up the helicopters, and get back to work searching for the glory hole that will secure a steady supply of champagne well into old age. Canadian brokers, knowing that the mine finders are absent and that news will slow as a result, take full advantage of the short summer months with long vacations.
   
   Completing this vicious cycle, the exploration companies tend to hold their news, figuring why send a report to an empty desk. In the midst of this self-reinforcing news vacuum, investors grow bored and then impatient, leading to widespread weakness.

I mention all of that, because as we headed out of July and into August, the junior resource sector was at its most illiquid and therefore most vulnerable. And as the red line in the chart below shows, while there was evidence of the normal summer doldrums in the junior sector, it was not excessive and, in fact, by early July the shares as a whole were turning up (that usually doesn't happen until the fall).

But then, as you can also see, in late July/early August, financial Armageddon peaked its horned head over the horizon. In the scramble for liquidity in all things, the seasonally illiquid junior resource stocks were elbowed off a high cliff. (Or, looking to the Thesaurus for further guidance, we learn the junior resource sector was "devastated, killed, collapsed, destroyed, slaughtered, ceased, withered and ruined.")

Important point #1 : The devastation to the junior resource stocks was quick and punishing, a loss of 27% nearly overnight. The S&P 500 would have needed to fall from 1,553 to 1,133 to equal such a loss, far more than the frantically discussed fall to 1,406 that the index actually suffered over the same period.

Historically, of course, the faster and steeper the excesses in any market are corrected, the sooner said correction ends. This is especially the case when the underlying sector, in this case gold – shown with the blue line -- is in a solid uptrend. 

Canaries in the Gold Mine

Further evidence of that contention comes from a glimpse at the recent performance of the large-cap producing and near-production stocks. These are the "canary in the gold mine" stocks that institutional investors look to first after deciding to move into gold.

The chart below shows the Gold Bug Index (the blue line) against the S&P 500 over the one-year period ending September 25. As you can see, after a somewhat sloppier dive than the one so crisply executed by the junior team, the large-cap gold stocks clearly caught the attention of the Wall Street herd and popped back up like a blue whale with wings and on steroids. That, no doubt, after a collective slapping of foreheads as realization dawned that the only hope of economic salvation remaining in the Fed's mostly empty tool chest was to reach for a wrench to turn on the money spigots – creating inflation – while also recalling the six trillion dollars in foreign hands and positing that they might be none-too-happy about the "fix."

Important Point #2: Looking over these present-day charts, one is drawn to an Aristotelian line of reasoning that goes something like this: If (A) gold is going up, as it has been pretty much throughout the period, and (B) stocks of gold producers are beginning to run ahead of the pack, then isn't it logical that (C) the recent momentum in the juniors will soon accelerate, providing the triple- and even quadruple-digit returns that are the hallmark of the junior resource sector in a gold bull market.

And, make no mistake, we are in a gold bull market.

Returning to the chart of the junior resource stocks, you can see they are starting to also track gold, clawing slowly back. They still have a long way to go to get back to the step-off point in July/August... the seeds of an opportunity, if you ask us.

In fact, not only do we remain unconcerned about whether prior recent highs for the juniors will be revisited, we remain, per our discussion from December 2006, convinced those highs will be greatly exceeded as the credit crisis turns into currency crisis that is now all but inevitable. (Especially as we are expecting to hear news any day of the next big discovery... that is all but inevitable given the amount of exploration money that has gone into the ground over the past few years.)

At the beginning of this modest treatise, I offered up the notion that the opportunity in the junior resource sector has been frozen in time. As you can see, a thaw is beginning. The time to take your positions is here and now. Waiting even a few months from today, while still not too late to profit, will be viewed with perfect hindsight as money lost.

The trend remains our friend.

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As I noted at the beginning of the letter, if you are serious about wanting to invest in gold stocks, you should make sure that you get and read the International Speculator.

Click here to find out more about a subscription to the International Speculator

You still a big gold bull analyst,

By John Mauldin
http://www.investorsinsight.com

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Copyright 2007 John Mauldin. All Rights Reserved
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273.

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