More Random Market Thoughts: Gold

An interesting phenomenon has occured during the recent market downturn. The XAU-to-Gold spot price ratio has reached historical lows*. As an example calculation, today XAU closed at 121.53. The gold spot price is right around $900. The XAU/Gold ratio is 121.53/900 = 0.135. A couple of days ago, when the XAU reached the low of 96.61, the ratio was even lower.

What does this ratio being so low mean? That depends on what the numerator and denominator represent to investors.

Gold itself (the shiny stuff) is rarely a good investment. Perhaps once or twice in a lifetime it reaches such levels. Rather than being a good investment, it acts as a great store of value--empircally the greatest store of value civilization has known. Being a great store of value, it would be very useful if and when society collapses. It would retain its value when the rule of law disappears and gangs roam the streets. I see physical gold as a survivalist tool. Everyone should have a shelter to hide out in, just in case, with at least a week's supply of water, ready-to-eat meals, guns, ammo, duct tape, WD-40, and toilet paper, and everyone should have some bullion. Just in case.

Gold mining companies are a proxy for the price of gold, and usually are highly leveraged to it, so that potential returns are much higher**. Thus, gold mining companies can be much better investments than gold itself. If civilization collapses, nobody will honor any shares, and there may not even be a stock market left. But if the meltdown is figurative, rather than literal, gold mining shares will do well. As long as civilization doesn't collapse, gold mining shares are the way to play a rise in the price of gold.


So what does the low XAU-Gold ratio mean? It's predicting, if my views above are correct, the apocalypse itself, a breakdown of society, not just economic hardship. That scenario seems very unlikely to me. Many people will lose their jobs and life savings, but it won't be Mad Max. The ratio is discounting a highly improbably scenario.

One more variable is noteworthy. As I said below, politicians and economists fear deflation with a passion that I don't understand. I'd rather have my money worth more rather than less after whatever is coming, recession or depression. But my views don't matter (and rightly so), so the next few months will see the greatest coordinated global reflation effort in human history. As the supply of money increases, the value of money will decrease, and the value of gold will rise.

For the ratio to normalize to historical levels, either the XAU has to rise significantly, or the price of gold will have to drop significantly. I see the latter as very unlikely. Thus, the most undervalued sector in the stock market is the gold miners. As I said recently, this is the time to accumulate. A diverse basket of gold mining stocks is an excellent way to begin taking advantage of this once-in-a-lifetime buying opportunity. Large profits await those who are brave.


* HUI - Goldbugs index. It only has gold stocks that do not hedge their positions. Relatively new.

XAU - Another older index of gold-related stocks. It contains companies that hedge their positions.

Here, I use the XAU instead of the HUI, even though the HUI would be a more accurate indicator of relationship to the gold spot price, because I can't find data on the HUI before 1996.

** As a simplified example, if a company can "make" gold for $250, and the price of gold is $300, it's profits are $50. If the price of gold rises to $350, profits have doubled to $100. On the other hand, if the price of gold falls to $245, the company is losing money and can potentially go bankrupt. It is unlikely that physical gold will ever be worthless. Leverage: higher returns, higher risk.

*** As always, if you take my advice, you deserve whatever life throws at you.

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If gold mining is so much

If gold mining is so much better than bullion, why not buy bullion, burry it, create a mining company to extract it and profit ?

Because you usually don't

Because you usually don't have to pay for naturally-occuring gold and that's why the profit is better mining this gold instead of processed gold ? Just sayin'

You usually have to pay for

You usually have to pay for gold mining stocks too :)

Seriously, a gold mining stock is really a spread between gold and oil. There's uncertainty on the amount of gold in the mine and you get paid for that, but there's no free lunch. If the company doesn't innovate (by finding new techniques or by prospecting) there's no reason to expect a stock premium.

Your "leverage" analysis misses the point.

The real explanation for the divergence between gold and gold companies is that a bar of gold provides no stream of expected future cash flows. It just sits there. You only make money from owning it if you later sell it for a profit.

By contrast, a gold company, like any company, generates a stream of expected future cash flows that (hopefully) accrue to the equity holders in one form or another (dividends, buybacks, a tender offer, etc.)

Stated differently: Buying gold is speculating. Buying gold stocks is investing.

Both entail risks, but very different types of risk.

Both entail risks, but very

Both entail risks, but very different types of risk.

There's cost of exploitation risk, and quantity of gold found risk. I don't know anything about the accuracy of geologists so I can't say much about that, but it's a gamble. Cost of exploitation depends mostly on energy prices since you need to crush tons of rocks, I know that much.

Much like all resource exploitation...

Science plays a huge part in determining "proven reserves". You can get those numbers from assaying samples from all over the prospective location, drilling deep in some cases. With these samples they can determine how many ounces to the ton (of ore) they can retrieve.

If it is too low, they wont do it, because of those risks you mentioned. Which would naturally help remove or mitigate those risks prior to large investment in the site.

It costs a lot to mine precious metals, and depending on the type of ore it may or may not be cost effective to retrieve it from the ground, yet.

As a side note: I go out as frequently as possible to do my own prospecting. I also own a small mining resource consultancy company. If any of you need a man on the ground to stake claims, map and take samples, assay, work a site... anything! let me know. Since the company is small, I offer extremely competitive pricing.

A great resource, http://www.icmj.com/

In liberty,
S.E. h

Gold

All the leverage out there collapsing will tend to cause cash to increase in value in the short term. However the government is going to do everything in it's power to prevent that and that will reify that leverage in real dollars. Which will result in inflation. Also do not forget all the foreign holders of US cash who are going to want to spend that cash as it falls in value. What will they buy? Food, Gas, etc. This will be an added inflationary pressure we didn't see in the 1970s.

So short term there will be downward pressure on gold, but it will be countered by the fact that gold is held as a store of value in crisis, and the knowledge that the currency is being devalued and will, long term, be worth a lot less.

Don't leverage yourself to gold prices by buying options as it could fall, and fully expect that you will not get delivery on any gold contracts you do buy.

If gold was not demonetized then people would be rushing for it even faster now than they are.

Buying or holding any paper

Buying or holding any paper at this point is fool hearted at best. That includes greenbacks.

Foolishness

I was and still am holding silver from early in the decade. When it reached $20 I was very tempted to sell and probably should have. Why? Because it dropped almost 50% since that point. Mainly because there was this crush for dollars.

The main reason I didn't sell was because of the illiquidity of the transaction, and the costs. Those costs look minor now but that's 20/20 hingsight. I'm still up more than 100% in five years.

Problem for people during a cash crunch is that they can't use either silver or gold to settle, because the contracts are in dollars, and the government forces you to pay dollars. That's why it's demonetized. So they have to sell the silver or gold to settle on their other losses and that drives down the their prices too.

Of course, it will be going back up but it's impossible to tell when or how high. It might head south from here also if the collapse outpaces the Fed, but with the Fed injecting lots of cash right now I think it's going up, short term and very long term with wiggles in between.

BTW, I'm holding lots of "cash" mainly because I have no other option. It's not because I'm fool hearted either. I'm restricted by the government. Once this crash is over and the recession in full swing I'm going to switch to a heavier stock loading. Probably lots of foreign stocks.