Gold Consolidation

Gold is currently very strong in terms of other asset prices. Might we see short-term consolidation...?

LAST WEEKEND I dropped in on the Cambridge House gold show in Vancouver, writes Ed Bugos for The Daily Reckoning.

It was busy. People were generally upbeat and felt smart about the bargain Gold Mining stocks they loaded up on during the recent rout.

The analysts were confident about valuations going forward, especially long term. Company execs swore their deals didn't need any money, while brokers and bankers alike had a gleam in their eye about the financing opportunities amid the debris – even a sense of urgency.

One broker – my former business partner, actually – wondered whether the fundamentals for gold have ever been as bullish in our lives.

The answer was unambiguous. The market has answered too. Newmont and Freeport last week filed documents in conjunction with potential underwritings by J.P.Morgan and Citigroup, worth $1.2 billion and $750 million respectively and totaling just under $2 billion.

Also last week Kinross sold UBS about $400 million worth of stock, while Lundin's Red Back also negotiated a bought deal worth about $150 million with a group of underwriters led by Cormark Securities and BMO.

And earlier this month, Yamana closed a $135 million share offer and borrowed $200 million, while in December, Agnico-Eagle raised some $300 million from stock issuances after borrowing $300 million in September.

Where's the deflation?! Money is coming into the Gold Mining sector. The Canadian National Post reported last week that gold miners are "raising cash with ease...Many generalist funds have jumped onto the precious metals bandwagon."

Many juniors have also reported financings where needed. Some are turning them away. Share issues are just too dilutive down here, and any company that doesn't need money to survive 2009 is prudent to refuse.

Asked about the ability of miners to raise cash in this environment, the analysts at the podium at the Cambridge House investment conference in Vancouver all agreed there is always funding for assets that have sound economic fundamentals. They finance themselves. Indeed, in my experience, it is often better to buy the shares of companies with good assets that need cash than companies with cash and no assets, even if the latter are trading at a discount to cash breakup, and even if funding is relatively scarce.

Why? Because companies with a lot of cash can sometimes get lazy and put up their feet, or insiders waste it – or even steal it, if they lack integrity. Cash itself yields nothing. It's a depreciating asset, as you know. So it's one thing to buy a company at below cash breakup and then break it up and keep the extra cash. It is another thing to invest in a company at cash breakup or less. We invest to earn profits.

If you want to buy cash at a discount, buy a T-bill or term deposit. Otherwise, you're just sharing in potential losses due to debasement, negligence, debauchery or theft. That doesn't mean you should avoid the deals that have a lot of cash. It's just that cash isn't what you're investing in. You are investing either in the underlying asset, which yields profit (i.e., more cash in the future) or investing in the management's abilities.

And ultimately, sound "assets" will hold their value better than idle cash in an inflationary environment.

Now, it is obvious that throughout this financial crisis so far, and despite some turbulence, Gold Prices have held up better than just about any other asset, commodity or currency (other than the Japanese Yen) you can name. From the point of view of a gold miner, this is a very good thing. Even better is that the price of oil, a significant cost input for miners, has fallen a lot relative to gold. This is bullish for Gold Mining margins.

Also bullish for gold miners is that the slump may have freed up capital and labor for the development of gold assets, where previous scarcity drove up capital expenditure estimates so much that some projects had to be abandoned.

The combination of strong Gold Investment demand and lower input costs makes gold stocks one of the only sectors poised for any growth in operating results (i.e., earnings and cash flows) in 2009. But on the other hand, the ratio of current Gold Prices to many of the commodities – and the major stock-market averages – is at more than a 10-year extreme, and that is not sustainable, I believe.

As a matter of fact, I think it could be a drag on Gold Prices. Gold is the only commodity challenging the resistance point of its post-March 2008 downtrend. And as it looks poised to break upwards, the other commodities appear to be bottoming, too.

However, while the extremity between gold and other "hard asset" prices continues, it could cap Gold Prices.

My feeling is that the gold ratios – meaning the Gold Price relative to other assets, commodities and currencies – are going to ebb in the short term while commodity prices catch up a little. I continue to think that this catch-up phase will include a rally in stock prices, and a general recovery in risk appetite, even if short-lived.

While it lasts, this consolidation in gold relative to other investment assets is likely to shave a few safe-haven points off gold. It hasn't started yet. But I'm not looking for new lows in the Gold Price here...Just some backfilling and consolidation while the other commodities and assets catch up a little.

This could happen over the next few months. Then look out! Once the Gold Market has been "reloaded", I expect further sharp moves higher again. And either way regardless, I expect Gold Mining shares to benefit from the general return of risk appetite too. Besides some ebb and flow, I expect gold stocks to do well whether gold goes up or not short-term – just so long as it doesn't go down too much. As long as gold holds the $800-850 level, gold shares are a buy.

Keep in mind though that you're not buying blue chips here. Small-cap miners (and options) are extremely volatile and risky. I'd recommend this is for 10-20% of your financial assets at most – never any more than you can sleep with at night.

Some people can sleep with more, and some can't sleep anyway. I guess the analogy doesn't apply to insomniacs.