Some Gold Thoughts

By: | Wed, Sep 27, 2006
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Gold keeps going up and down sharply lately trading in the 580-645 US$ range. Beside the serious volatility, did gold really move in such a way as to question the validity of the long term trend? Well, it depends on your time frame.

Short term, the drop has reached 140 CAN$ which is significant since it represents approximately a 15 % correction. But in the longer term, if you believe like us that gold is going over 4000 CAN$ in the next 5 to 7 years, there is nothing to worry about.

Assuming that you are still reading in spite of this bold statement, four standard choices are available to get onboard or add to an existent position: mining stocks and their derivatives (mainly funds, warrants and options), ETF, Futures and the yellow metal itself. Let's briefly discuss each option.

Mining stocks are suggested by many experts. They offer leverage. This is why they attract most investors who also happen to be active stock market investors. However, choosing a mining stock is not as easy as it sounds. The Toronto Stock Exchange and the Vancouver Stock Exchange offers the investors over 3000 mining stocks involved in various exploration and production stages all around the world.

By investing in some of the well-established producers, you can expect to reproduce the return that you would get with gold itself, not much more. Smaller producers could be an interesting choice if they were not the main candidates for early takeovers.

If you want to invest in mining stocks for superior returns, your best bet remains the numerous juniors at the exploration stage which are cruising under the radar screen.

Talk about a treasure hunt. Your biggest challenge will be that most of these stocks are empty shelves unfortunately doom to fail and keep diluting their shareholders value. Yes, some swimmers in that pool will become 50 and even 100 baggers. But most of them won't make it. If your odds of choosing a winner (a 100 baggers) are one out of 50, this still leaves you with only a 2 baggers, on average, which is a very poor result if gold raises another 8 to 10 fold in the meantime.

Some won't like the advice but here it is: you should forget about 100 baggers. Nobody ever, no investor alive or dead, made it from the rock bottom to the absolute high on any stock. Realistically, you could expect to be on board a ride for a 15 to 20 bagger. Factor-in the above odds and you have got yourself a loser compared to gold.

But let's assume for a moment that you did strike the potential big one. Your lucky horse, as any other mining company, will be subjected to dilution of the company stock as it grows. Depletion of its reserves and various risks such as nationalization will also hide in the bushes. In other words, unforeseen events could undermine a perfectly good call.

Our position is obvious. We believe that in most cases mining stocks are some type of fiat-paper, which are subjected to external events out of our control. If you are a gold bull, we do not suggest that you invest either in their derivatives such as funds, warrants and options for that matter.

What about the gold ETF? Well, in good times, it sounds like a great proposal. You get the gold but not the hassle of the metal which gets quite heavy fast as you accumulate more and more ounces. But what about the time when you have entrusted your gold to a company that short sale it for a «profit»? Safe keeping of your gold may not be as safe as you thought. Our advice may not be liked again: do not touch the ETF.

Then what about future contracts on gold? Futures are not for the faint of heart. Leverage has sent much more people to the poorhouse than to the penthouse. Still, if you are willing to play the game with 25 % to 50 % margins and can tolerate huge volatility in your portfolio, you may be on to something good. Perfect correlation with the price of gold and no bankruptcy risks sound good to us.

Only one problem remains. A future contract is nothing but a promise to get gold. Most of the time, future contracts are bought and sold just like that. However, in time of crisis, the future exchange can unilaterally decide on a settlement price. We believe that when gold crosses over 2000 US$, we will be entering that risk-zone. The biggest gain will still have to be seen in the game. You don't want to be out or short-changed at this crucial stage. Forget the future contracts, at least for most of your gold position. Consider them only if you intend to trade in and out of the market, something that we suggest you do very sparsely.

Finally, the metal. Our suggestion: buy the real thing and put it away. Gold bars and coins are good but settle for high purity, nothing less.

Yes, we believe that gold is going over 4000 CAN$ in the next 5 to 7 years. But your sitting power, as used to say a certain Livermore character, will be tested. We have not seen anything yet. In the mid seventies, gold corrected over almost a two-year period from near 250 US$ to just above 100 US$, losing over 50% of its value in the process.

We think that this is the stage of the game that we have now just entered.



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