Gold Stocks Crushed

The price of gold is up about 30% from this time two years ago, though it’s down from its peak last year.

The fiscal relic is flattening out in a consolidation pattern consistent with a long-term bull market.

Another break above $1,650 an ounce and we should get a sharp upward thrust.

We saw the same chart pattern in 2006 and 2008…

The reasons for the current 12-year gold bull market are simple:

1. The world is in massive debt and is currently unwinding that liability. One of the three ways to deleverage is to make fiat currencies less valuable.

2. After two decades of selling gold, central banks are now net buyers of gold. This not only removes the cap on the upside, but provides a solid bottom. To wit: In 2009, India’s central bank bought 200 metric tons from the IMF below $1,200/ounce. This boosted India’s reserves 56% and set a solid floor.

3. Major gold producers reduced the practice of hedging forward production.

4. Exchange-Traded Funds allowed easy access to the retail investor and spurred demand.

Gold vs. Junior Miners

On the surface, one would think a bull market in gold would equal a bull market in gold mining stocks. But the view from the pits is quite different.

Junior gold miners have not only crashed, they’ve been eviscerated. The Toronto Venture Exchange has been one of the world’s worst performing indexes this year. In May, one-third of the junior mining stocks hit a 52-week low on the same day.

We are getting into a baby-with-the-bathwater scenario here.

Diamonds in the Rough

Small-cap mining stocks are notoriously volatile. There are a great many that go bust.

They are constantly underfunded, and I’ve yet to meet a gold miner whose property wasn’t “the best they have ever seen — a true once-in-a-lifetime, ground-floor opportunity.”

So why buy?

Because when they hit, they go big — fast. You get one 1,000% winner and it takes care of all the losers. It’s exciting and profitable. And the winners come in bunches.

So with the washout in the junior minors, we are starting to see some interesting values. There are some stocks with cash on the balance sheet, profits and low debt, and solid properties that trade below book value.

We aren’t quite at the point where gold companies are trading at less than cash, but we could be soon.

Junkyard Gold Stocks

The last time I was digging through the wreckage of the junior miners was the fall of 2008. There were four gold stocks like Allied Nevada Corp (ANV) that were trading for less than the cash they had in the bank.

I recommended all four.

They all returned triple digits.

Here is how ANV did:

That’s the type of return you can find if you have the cojones to buy into a market bottom.

In December 2008 I heard the proverbial bell ringing at the nadir. Gold was going up fast. Hedge funds were getting crushed by margin calls and were selling everything to free up cash. The market couldn’t have been more pessimistic.

This was a clear contrarian buy signal.

As I write this, the bears are out in force on the junior gold miners. Long-term gold bugs are moaning and saying they got it wrong.

Again, like 2008, we are closer to the bottom than we are to the top.

The chart needs to show a clear bottom signal followed by a new up-trend confirmation signal before I make a large bet. But we could be there by August.

Price and Costs

There are two drivers for junior miners: the price they get for gold and the cost of production.

A large percentage of the cost is energy and other industrial commodities like steel. These costs are dropping.

According to Forbes:

From 2000 to 2008, even though gold nearly quadrupled in price, industrial commodities rose even faster. For example, oil sextupled from $25 to $147 per barrel.

Using the Goldman Sachs Commodities Index as a proxy for the costs of mining (because it is heavily weighted towards industrial commodities), the real cost of mining gold jumped by nearly 50% during this period, explaining why gold stocks did not provide the leverage that gold investors expected.

However, since 2008, the ratio of gold to commodities has surged, slashing the real cost of mining gold by over 60%. It is in such environments that gold mining bull markets are born.

Right now you have low share prices, falling costs, low interest rates for long-term project financing, and a stable-to-upward gold price.

The best-case scenario is we’ll have a number of 1,000% winners over the next two years.

At the very least, we’ll see consolidation in the industry and 30% to 50% winners as the big fish eat the little guys.

Sincerely,

Christian DeHaemer

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Christian is the founder of Bull and Bust Report and an editor at Energy and Capital. For more on Christian, see his editor’s page.