Physical Gold vs. Gold Mining Stocks

Gold Mining stocks are "almost the polar opposite" of physical gold itself in terms of security...

EXPERIENCED in physics, economics and comprehensible technical writing, Louis James is senior editor of Doug Casey's International Speculator and the Casey Investment Alert.

Interviewer for the weekly free e-letter, Conversations with Casey – and fluent in English, Spanish and French, as well as conversant in German and Russian – Louis regularly takes his skills on the road, checking out highly prospective geological targets and visiting with gold mining explorers and producers in the far corners of the globe.

In this exclusive interview, he speaks to The Gold Report about how the US Dollar is on death row with no one prepared to grant a stay of execution, plus the outlook for Gold Bullion and other commodities that may ultimately stand in as the world's reserve currency...

The Gold Report: Last time you sat down with The Gold Report, you spoke articulately and persuasively about a US currency crisis of historical proportions. At that time you said, "The Dollar is on death row." It's been 14 months since then, and the Dollar's position seems even grimmer. Can't the US government find a way to grant the pardon that would prevent the Dollar's demise?

Louis James: This is one of those times when you hate being right. The short answer is no. The slightly longer answer is that while some actions might help the Dollar, those actions won't prevent pain in the near future and they aren't politically viable anyway. It would mean embracing the pain the market doles out to people who make bad decisions, and those in government won't want to do that. That's not just my supposition or theory. You can see they're doing the exact opposite of what needs to be done; they're creating more debt, more "bubbliness", if you will, which is exactly what got us into this situation in the first place.

TGR: Doesn't "embracing the pain" for bad decisions point to the financial markets as opposed to the government?

Louis James: Yes and no. The people in financial institutions caught in the subprime mess, for example, took risks, and one could argue that they deserved what they got. But it was the government that mucked about with interest rates and rules, and made those risks look sensible. Truth be told, I think all of this is a multi-decade long problem, a series of bad decisions, misallocations and distortions by government intervention in the marketplace that has serious consequences. Trying to put the pain of correction off longer only delays and exacerbates the inevitable.

Look at graphs and charts of these deficits. Look at the latest Treasury auctions – another $80 billion this week. The US government is on track for another trillion-Dollar deficit year. Not a trillion-Dollar budget, a trillion-Dollar deficit. These numbers were unimaginable to most people just a couple years ago. But you borrow that much, you create that much new currency, and the consequences are, as the saying goes, "baked in the cake".

TGR: We already have this trillion-Dollar bailout, though. What could be done going forward?

Louis James: They could stop. They could let the market correct the mistakes. But as I say, it's politically not viable. Because to actually do what needs to be done – to stop borrowing, cut down on debt, start producing more than we consume, put our financial house in order – would mean embracing the pain. It works the same way on a micro level in the family: sometimes you have to embrace the discipline, downgrade your lifestyle, stop dining out so often, stop going to movies all the time. Don't spend more than you make. That's what the overall economy needs. It's really no different just because it's larger.

But that's not politically viable. Nor is defaulting. Imagine the leader of the world's great superpower going on TV and saying, "Oops, sorry; we're not going to pay our debts." So the politicians are stuck doing things that sound good to the mass of voters but make things worse.

TGR: There's a lot of talk these days about being in recovery, we're seeing some good economic news coming out, and Warren Buffet just put a big bet on the US by buying Burlington Northern. What do you see in the economy that they're missing?

Louis James: Let's get to basics. None of the fundamental problems in the economy that caused the situation have been fixed. In fact, as we've just been discussing, the government's actions have exacerbated them hugely. So what are the grounds for being optimistic? I think politicians encourage people to forget the fundamental reality that a society, just like a family or an individual, needs to produce more than it consumes in order to get wealthier. (Well, there's war for plunder – or theft, on the personal level – but that causes a net loss of wealth overall.)

Pundits confuse people with talk about confidence. They say that with confidence restored, people will spend again, there will be jobs again, everything will get going again and we'll be fine. All we have to do is restore confidence. But it's not true; you can't buy groceries with confidence.

It's a shell game, a distraction. Confidence comes and goes, ebbs and flows. But in reality, either people can pay for goods and services or they can't. Either their production exceeds consumption or it doesn't. That's the key. If production exceeds consumption, you save, you accumulate wealth that can be used to create new businesses, to build new things, to hire more people. That – capital pooling – is what gets an economy going.

TGR: How can you explain how the market continues to rally?

Louis James: Well, as the saying goes: the market can remain irrational longer than you can remain solvent. I should say that we at Casey Research have been on the wrong side of the market the entire year, because we've looked at the fundamentals of the economic situation. We have seen a) no improvement and b) the government doing the opposite of what needs to be done for there to be improvement.

So we've been cautious. We made money; we bought when we found picks that looked undervalued, and certainly our oft-repeated call to buy gold has worked out very well. So, we're okay; but we'd be a lot more okay if we had ignored all the fundamental evidence of where the economy is headed. It's kind of ironic. Had we jumped on the bandwagon and deployed cash more aggressively – not to say foolishly – we would have made a lot more money. Instead, we've been calling for more correction, and still are.

TGR: Are you looking for another leg down that's as significant as the first or just for a more typical market correction?

Louis James: Bearing in mind that it's a good thing to have a daily dose of humble pie, yes, our consensus is that there's a lot worse to come. We see another and bigger leg down. The Dollar, in particular, is headed way lower. The government deficits and what's happening with the money creation is all very bearish, more serious than ever, and that's really bullish for gold – at least as long as it's priced in Dollars. But other governments are behaving similarly, and that too is bullish for Gold.

TGR: Just for gold?

Louis James: Our mid- to longer-term view on base metals is actually quite bullish, as well. The growth coming in China and India over the next 10 years is a major factor. But another serious leg down would knock the stuffing out of anything to do with industry, including the base metals, at least for the short term.

TGR: You recently noted a paradox of investing in gold – that is you buy the Physical Gold for safety and you buy gold stocks for its risk. Can you explain that?

Louis James: As we've been discussing, gold has excellent speculative potential right now because of the destruction of the Dollar. If Dollars lose 25%, 50% or even 75% of their current value in a few years, that's very bullish for gold. But if that happens, we'll have a lot of economic turmoil, which is the real reason to own gold. No matter what happens, gold is still going to be gold. It's the only financial asset that is not simultaneously someone else's liability. It is not a piece of paper; it's not a promise from somebody else. It's a physical thing you can hold in your hand, and if push comes to shove and you have to hop in your car and go down the street and buy food for your family, somebody will give you something for your gold because they recognize it and value it. In extremely volatile times, you want that security.

Gold Mining stocks are almost the polar opposite in terms of security. They are highly, highly speculative. Most gold companies don't have any gold; they are exploring for gold or developing projects that they hope will be economic. Only a few actually produce gold, and even the biggest producers are highly volatile, because the price of their product fluctuates constantly and strongly. So does the price of the electricity they use to produce it. All kinds of things fluctuate so much that these businesses – even the biggest ones, Barrick Gold Corp. and Newmont Mining Corp. – are so risky that traditional securities analyses, a la Graham & Dodd, just don't apply. This isn't investing; it's speculating. You want the wild fluctuations of the volatile commodities market to create opportunities for big wins.

TGR: And juniors would be even more speculative. Haven't you compared them to burning matches?

Louis James: Most of them are explorers with no substantial assets. All they have is money in the bank (hopefully) and an obligation to spend it trying to discover something. If they do make a discovery, they go from having literally nothing but a geologist's dream to having something of measurable value. The difference in valuation can be huge; this is how it's possible to get 10-baggers or even 50 times your money on one of these stocks.

The odds in any case are quite long. Even when you find a gold prospect, going from having a gold anomaly to a producing mine of any size, even a small one, the odds are something like 1 in 300. If you're knowledgeable and put a lot of effort into it, you may improve those odds, but the odds remain long. This is where the burning match comes in. The company burns through its money in the hope of finding something of value before the fire hits its fingers.

TGR: But the rewards can be commensurate with that risk.

Louis James: Absolutely. The juniors' very volatility provides the opportunity to have enormous wins. But you have to understand it's a high-risk proposition. You can apply intelligence to reduce the odds, and you can diversify your risk. Whether it's your overall speculative diversification, or whether it's within an area such as gold stocks, you don't just want to buy one company. It works best if you have a portfolio of companies.

TGR: Any other techniques for improving the odds?

Louis James: You tilt the odds more on your favor by betting on trends. If you didn't know anything about markets, if you had no idea whether gold was likely to go up or down, if you just liked gold and wanted to throw darts at the board, that would be pretty much pure gambling. But we have all this evidence we've been talking about regarding the economy to support the idea that gold is going to go up. A rising tide tends to lift most ships. If you pick the most seaworthy vessels with the most experienced management at the helm, assets of value already in hand and so on, you can do better than those 300-to-1 odds.

TGR: How about helping us wade through some of those juniors that have better assets in hand and better management, some that you're telling investors to watch because you feel good about them?

Louis James: Okay, but with a caveat emptor. With gold higher than $1000 for some time now, the market has grown quite heated. In 2007 and 2008, before the jitters, the market was overvaluing a lot of companies, practically anything with "gold" in its name. Some of these companies didn't even have any assay holes drilled into their prospects; all they had were theories and hopes, and they were trading for tens of millions of Dollars. Since last fall's crash, there's been quite a separation of wheat from chaff, and many of the companies that had nothing but theories or hopes have not recovered significantly.

But many of the companies with assets of potentially bankable value have had great recognition. Many have not only recovered but have soared to new highs. That's not a bad thing, but it means that the companies with the best potential are not particularly cheap. But as we saw last fall, gold wobbled and came back strongly and quickly, while the gold stocks took a huge hit and took months to come back. That will happen again in another market correction. So maybe these not-particularly-cheap companies are cheap in terms of where they could be a year or two from now, but if you buy heavily now, you're at considerable risk of flubbing the first half of the "Buy Low, Sell High" dictum.

At $1000 gold, even $1100 gold, people are getting excited and their buying is pushing prices up. I think gold will go much higher, but I don't know that it won't go lower first. Those who are psychologically disposed to follow the herd – nobody wants to think they are, but be honest with yourself – have to ask themselves whether they have the intestinal fortitude to resist selling if your shares drop strongly, for no company-specific reason, before the eventual payday.

Imagine a person who bought, say, in May 2008, when the market was near an interim top. You know how would they feel in October 2008, when it just kept falling and falling and didn't look like it was ever going to stop. Most investors think 5% to 10% is a big fluctuation. To see a stock drop 50% in short order is inconceivable to them; they panic when it keeps falling from there. It's very difficult for people to hold on and say, "This retreat is not justified – I'm not selling." Actually, the thing to do last October, November and December wasn't just to hold, but to buy. People who bought then made so much money it's not even funny.

TGR: So are you saying that smart money right now should stay in Physical Gold until some of the frothiness subsides?

Louis James: If you're psychologically predisposed to being nervous about your investment, and you know you'd have a hard time dealing with a drop of 30%, 40% in a month or two, maybe this is not a good time to be buying speculative gold stocks. That having been said, if you stick to quality companies, buy an initial slice of your ideal position now, and fill out the rest of your position at a lower average price if it fluctuates downward, and you preclude the possibility of missing out on a stock that takes off. But you have to believe in your picks strongly enough to see a sell-off as a buying opportunity.

Our general recommendation right now is to focus on the best of the best. Everything in the International Speculator portfolio has resources drilled off that can be defined by one of the regulation-complaint categories or another. And it's all gold and silver right now.

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