Gold Stocks: A Cautionary Tale

A thought has been weighing on my mind in recent months: Are the gold stocks now overpriced?

The bottom of the recent bear market for gold stocks came in December '92/ January '93. Since then, many small stocks have moved up by a factor of 20-50 to one from their ultimate bottoms, based on little more than heightened optimism about the market.

Gold stocks and the general market

Part of the tremendous performance of the golds is probably nothing more than spillover enthusiasm from the general stock market, and it's not the first time that's happened. The most notable time was during the '60s, when the average Spokane silver stock ran 150 to one (a fact researched by Norman Lamb in his classic but now completely outdated and somewhat irrelevant Small Fortunes in Penny Gold Stocks).

There's long been a controversy as to whether gold stocks are basically procyclical (i.e. moving with the market), or countercyclical (i.e. moving opposite the market). I think the evidence shows they are basically procyclical, except when gold is making a major move. It's a well-known "fact," for instance, that gold stocks moved upward on the order of 1,000% during the last depression, while the DJIA slumped 90%. But the collapse of the DJIA occurred from 1929 to 1933, and the real move in the golds only occurred from 1933 to 1937, after the price of gold was raised from $20.50 to $35.00, and while the DJIA recovered smartly, from 40 to 170. So it wasn't at all a case of golds going up while the DJIA was crashing. More recently, gold stocks and the general market moved up together from 1971 to 1973, 1982 to 1983, and 1985 to 1987.

The bottom line: I don't think there's any question that the best time to be long golds is when both the market at large and gold itself are moving up.

This means that the past 18 months have been the best of all possible times for owning gold stocks. And the next year will almost certainly be far trickier, because we finally seem to be in a major bear market for common stocks. I've gone over the stocks listed in Crisis Investing for the Rest of the '90s, and am both gratified and mildly disturbed that most of them have gone up about 1,000% (the best ran 50- 1) from their recent bottoms to their recent tops. The good news is that a lot of money has been made; the bad news is that the higher they go, the less upside remains.

I don't think you need to worry at this point, for several reasons:

1) Almost all the stocks in question are still way down from their previous peaks;

2) the recent bear market was the longest and deepest on record for the secondary golds;

3) the con artists and slimeballs that populate markets at the top have not yet started to come out in this one;

4) there are very few stocks that have really been promoted to outrageous levels, although I have mentioned two in recent letters;

5) almost all the companies receiving attention today have experienced management and (usually) many millions in cash in the treasury, as well as properties that are far superior to those which typified past markets;

6) there's almost no involvement from the public this time around, and the people attending the various "hard money" conferences are still here from the last movie. Sophisticated fund managers are just starting to come on board.

I'm disturbed by the market caps of over US$50 million sported by many companies that don't even have reserves, not to mention cash flow. I also realize that, since many companies are trading 20%-40% off their highs, not a few shareholders are showing open losses. These are the most volatile securities in the world. And we're not going to get any help from the stock market in general from this point on. But this correction is over, and these stocks are on their way back up.

Gold stocks and gold

But what's far more important is that we're going to get a huge boost from gold. In the $380 area it's still very cheap and is only $50 off its bear market bottom.

Still, a caveat is in order. As Ian MacAvity points out, not only do the gold stocks move, historically, before gold, but in the late stages of the market, the metal actually outperforms the shares.

These stocks are going much higher, and the time to buy them is on weakness such as we're now experiencing. Go over the past 18 months of this letter and buy into the stories that had runs and have come back down. One of the best right now is Carson Gold (CQG.V, C$4.25). Every stock on the junior gold list is going a lot higher. I don't believe in the "random" or "dartboard" method of choosing mining stocks - that's why I do feature articles on companies - but you can choose randomly from my list because these stocks are the pick of the litter, and the list is always being updated. A major expansion of the list will occur next month.

My concentration will likely remain on gold stocks for at least the next year. My personal portfolio is hugely overweighted in them, and mostly in illiquid private placements, at that. So let there be no confusion: I'm still very bullish. But the market is very different from that of a year to 18 months ago. Other than occasional exotic investments, most of my new money will be going into gold, silver, and the stocks of companies that mine them - but ever more into the metals, relative to the stocks. And I expect to be more and more selective with the stocks. The days of shooting fish in a barrel are over.