Why It's Now a Very Good Time to Invest in Gold

With gold successfully holding the $1520 mark after three tests, David Galland believes savvy investors should use this pullback as an opportunity to purchase gold and gold stocks. ?I agree with him on gold, though I?m not yet convinced about the mining stocks themselves (more on this later today).

By David Galland, Casey Research

Glancing at the news most days, it?s hard not to feel like Bill Murray?s character in Groundhog Day. In the event you are unfamiliar with the movie, in it Murray?s character becomes trapped in the same day? day after day.

In the current circular condition, we have the powers-that-be assuring us that the next high-level meeting will finally produce a permanent fix to the broken economy, essentially solving the sovereign debt crisis. Then, in no more than a few days, or at most a couple of weeks, the fix is revealed to be flawed and the crisis again sparks into flames? followed shortly thereafter by yet another high-level meeting ? and the cycle begins anew.

While the characters may change ? one week it is Greece, the next it is Spain, the next it is France, the next it is the US, the next it is Greece again, etc., etc. ad nauseam ? the detached observer can only come to the conclusion that we are now well outside of the bounds of the normal business cycle.

As we at Casey Research have written on this topic at great length, I don?t intend to dwell on this topic, but I did want to loop back in just long enough to comment on the recent price action in commodities, especially gold, in the face of the continuing crisis.

Today, a glance at the screen reveals that gold is trading for $1,565. For comparative purposes, as revelers warmed up their vocal cords to sing in the New Year on the last trading day of 2011, gold exchanged hands at $1,531. And exactly one year ago to the day, gold traded at $1,526 for a one-year gain of a modest 2.6%.

A year ago, the S&P 500 traded at 1,325, while today it trades at 1,318, a small loss. Yet, have you noticed we don?t hear much about the imminent collapse of the US stock market, as we do about gold? This perma-bear sentiment about gold on the part of what some people lump together under the label ?Wall Street? is especially apparent in the gold stocks.

Using the GDX ETF as a proxy for the sector, we see that the shares of the more substantial gold producers are off by an unpleasant 24% over the last year.With that ?baseline? in place, let?s turn to the current outlook for gold, and touch on some of the other commodities as well.

• Gold. In the context of its secular bull market, and given that absolutely nothing has gotten better about the sovereign debt crisis ? only worse ? gold?s correction is nothing to be concerned about.I know the technical types will point to levels such as $1,500 as important resistance points ? and there?s no question that if gold was to break decisively below that level that a lot of autopilot trades would kick in and put further pressure on gold.Yet, when you view the market through the lens of hard realities, which is to say, by focusing on the intractable mess the sovereigns have gotten the world into? in Europe, in Japan, in China and here in the US? then viewing gold at these levels as anything other than an opportunity is a mistake.
• Gold Stocks. As far as the gold stocks are concerned, I consider today?s levels to be extraordinarily compelling for anyone looking to build up a portfolio or to average down an existing portfolio.I say this for a number of reasons, starting with the contrarian perspective that this may now be the most unloved sector of the stock market. No one wants anything to do with gold stocks, and hasn?t for some time now. As a consequence, the sellers will soon dry up, leaving almost nothing but buyers to push the sector back to the upside.This contrarian perspective is important because finding an honest-to-goodness opportunity to bet against the crowd is no easy thing in a world where literally thousands of competent equities analysts plop down at the desk each trading day with the sole purpose of searching for prospective investments. Many of these analysts are backed by huge firms with billions of dollars at risk in the markets, and so are armed with high-powered computational tools of the sort that was unimaginable even a few years ago. All of these analysts, armed with all their computational power, habitually scan a universe that totals about 4,000 publicly traded companies. Realistically, however, even a thin analytical screen will weed out all but perhaps 400 of those companies as being potentially suitable for investment.Thus, you have thousands of high-priced and well-armed securities analysts crunching pretty much the same data on a very small universe of possible investments. Given this reality, is it any surprise that securities are so tightly correlated? Which is to say, is it any surprise that these securities all trade right in line with the valuations that the analytical screens ultimately derive that they should? Which means there are really only two possible circumstances under which any of these stocks move up, or move down, by any significant degree

1. Broad market movements. The saturated levels of analysis mean that, within a fairly tight range, all the stocks now move more or less together. Thus, with few exceptions, a big upswing or downswing in the broader market will send almost all stocks up or down together. To help make the point, I randomly pulled a chart of IBM and compared it against SPY (the S&P 500 tracking ETF) for the last year. Note the lockstep price movements:OK, IBM is a big company, so it will have a lower beta than many companies, but the point remains that saturated coverage of the stocks greatly reduces the odds of any one issue breaking free from the larger herd, unless there is?
2. A surprise. All of these analysts, and all of their computerized analysis, help form a certain future price expectation for each security based on past financial metrics (earnings growth, return on equity, and so forth). Other than the broad market movement just referenced, or moves in line with a sub-sector of the larger market (e.g., if oil rises or falls, oil-sector stocks will tend to move up or down in sync), for a company to deviate in any substantial way from analyst expectations, by definition requires a ?surprise? to occur.Of course, such a surprise can be positive, but because these companies are so closely watched, it is more likely to be negative. In the former category, a positive surprise might come in the form of an unexpectedly strong new product launch ? la the iPad. In the latter, less happy category of surprise, it can be the blow-out of a big well in the Gulf of Mexico? or any one of a million other unanticipated vagaries of fate.

As investors, recognizing these fundamental realities is important because it points to where above-average market opportunities are most likely to be found (or not). And that brings us back to the whole idea of being a contrarian.

As mentioned a moment ago, ?Wall Street? has never much liked the precious metals, and by extension the gold stocks. Given the length of the gold bull market ? which, in our view, reflects systematic risk in all the fiat currencies, but which Wall Street views as an indication of a fatiguing trend confirmed by the underperformance of the gold stocks ? traditional portfolio managers are unhesitant in giving the boot to the few gold shares that somehow made it into their portfolios against their better judgment.

If our thinking is not clouded by our own bias, then it would behoove us as good contrarians to buy these shares from the eager sellers at such unexpectedly favorable prices. By doing so, we are able to position ourselves to make a killing once the broader financial community realizes that the problems associated with fiat money, dramatically underscored by the intractable sovereign debt crisis, are only going to get worse. At that point gold is going to head for new highs and gold stocks to the moon.

That said, as we always should do, let?s quickly assess whether our own bias is leading us astray in believing in gold and gold stocks when virtually the entire army of analysts won?t even consider them. Some inputs:

• Gold prices remain near historic highs ? and that has a significant impact on the bottom line of the gold producers. Barrick Gold Corp. (ABX), for example, currently boasts a profit margin of over 30%, better than twice that of IBM and almost ten times that of Walmart. While ABX sells for just 1.6 times its book value, IBM sells for 10X.
• Interest rates remain at historic lows, producing a negative real return for bond holders. Unless and until investors are able to capture a positive yield ? a potential stake through the heart of gold ? there is no lost-opportunity cost for holding gold. And bonds are increasingly at risk of loss should interest rates be pressured upwards, as they inevitably will be.
• Sovereign money printing continues ? because it must. In today?s iteration of Groundhog Day, the Europeans are once again meeting in an attempt to fix the unfixable, but the growing consensus ? because there is no other realistic option left to them ? is that they will have to accelerate, not decelerate the money printing. Ditto here in the US, where a fiscal cliff is fast approaching due to the trifecta of the expiring Bush tax cuts, mandated cuts in government spending from the last debt-ceiling debacle and the new debacle soon to begin as the latest debt ceiling is approached. The problems in important economies such as China and Japan are as bad, and maybe even worse.

• Debt at all levels remains high. With historic levels of debt, rising interest rates are a no-fly zone for governments, because should these rates go up even a little bit, the impact on the economy and on the ability of these governments to meet their obligations would be dramatic and devastating. This fundamental reality ensures a continuation of policies aimed at keeping real yields in negative territory, meaning that the monetization/currency debasement in the world?s largest economies will continue apace.To get a sense of just how bad things are and how soon the wheels might come off, sending gold and gold stocks to the moon as governments throw all restraint in money printing to the wind to save themselves and their over-indebted economies ? here?s a telling excerpt and a chart from a recent article by Standard & Poor?s titled The Credit Overhang: Is a $46 Trillion Perfect Storm Brewing?

Our study of corporate and bank balance sheets indicates that the bank loan and debt capital markets will need to finance an estimated $43 trillion to $46 trillion wall of corporate borrowings between 2012 and 2016 in the U.S., the eurozone, the U.K., China, and Japan (including both rated and unrated debt, and excluding securitized loans). This amount comprises outstanding debt of $30 trillion that will require refinancing (of which Standard & Poor?s rates about $4 trillion), plus $13 trillion to $16 trillion in incremental commercial debt financing over the next five years that we estimate companies will need to spur growth (see table 1).

(Click on image to enlarge)

You can read the full article here. While the authors of the S&P report try to find some glimmer of hope that roughly $45 trillion in debt will be able to be sold off over the next four years ? even their base case casts doubt on the availability of the ?new money? shown in the chart above. Note that this is the funding they indicate is required to fund growth. Which is to say that should the money not be found, the outlook is for low to no growth for the foreseeable future.

It is also worth noting that the analysis assumes that something akin to the status quo will persist ? which is very unlikely given the pressure building up behind the thin dykes keeping the world?s largest economies intact. The landing of even a small black swan at this point could trigger a devastating cascade.

We have said it before, and we?ll say it again: there is no way out of this mess ?without acute pain to a wide swath of the citizenry in the world?s most developed nations. While this pain will certainly be felt by sovereign bond holders (and already has been felt by those who owned Greek issues), it will quickly spread across the board to banks, businesses and pensioners ? in time wiping out the lifetime savings of anyone who is ?all in? on fiat currency units.

In this environment, gold isn?t just a good idea ? it?s a life saver. And gold stocks are not just a golden contrarian opportunity, they are one of the few intelligent speculations available in an uncertain investment landscape. By speculation, I mean that, at these prices, they offer an understandable and reasonable risk/reward ratio. Every investment ? even cash ? has risk these days. With gold stocks, you at least have the opportunity to earn a serious upside for taking the risk? and the risk is much reduced by the correction over the last year or so.

Now, that said, there are some important caveats for gold stock buyers.

• With access to capital likely to dry up, any gold-related company you own must be well cashed up. In the case of the producers, this means a lot of cash in the bank, strong positive cash flow and a manageable level of debt. (Our Casey BIG GOLD service ? try it risk-free here ? constantly screens the universe of larger gold stocks for just this sort of criteria, then brings the best of the best to your attention.)In the case of the junior explorers that we follow in our International Speculator service (you can try that service risk-free as well), the companies we like the most have to have all the cash they need to clear the next couple of major hurdles in their march towards proving value. That?s because a company can have a great asset but still get crushed if it is forced to raise cash these days? and the situation will only get more pronounced when credit markets once again tighten as the global debt crisis deepens.
• Beware of political risk. Despite the critical importance of the extractive industries to the modern economy, the industry is universally hated by politicians and regular folks everywhere. If your company ? production or exploration ? has significant assets in unstable or politically meddlesome jurisdictions, tread carefully. And it?s important to recognize that few jurisdictions are more politically risky than the US. This doesn?t mean you need to avoid all US-centric resource stocks ? but rather that you need a geopolitically diversified portfolio that you keep a close eye on at all times (something we do on behalf of our paid subscribers every day).
• Know your companies. Some large gold miners are also large base-metals miners. And at this juncture in time, personally I?m avoiding base-metals companies like a bad cold. While most base-metals companies have already been beaten down ? and hard ? over the last year and a half, the fundamentals remain poor. Specifically, they not only have the risk of rising production costs and political meddling, but unlike gold ? where the driving fundamental is its monetary role in a world awash with fiat currency units ? the base-metals miners depend on economic growth to sustain demand for their products. In a world slipping back into recession ? or perhaps, in the case of Japan and China, tripping off a cliff ? betting on a recovery in growth is not a bet I?d want to make just now.

While it is hard to accurately predict the timing of major developments in any one economy, let alone the global economy, there are a number of tangible clues we can follow to the conclusion that the next year will be a seminal one in terms of this crisis.

For starters, there is the next round of Greek elections on June 17, the result of which could very well be the anointment of one Alexis Tsipras as the head of state. An unrepentant ?ber-leftist whose primary campaign plank is to tell the rest of the EU to put their austerity where the sun doesn?t shine, the election of Tsipras would almost certainly trigger a run on the Greek banks, followed by a cutoff of further EU funding and Greece?s exit from the EU. And once that rock starts to slide down the hill, it is very likely that Spain and Portugal will follow? after that, who knows? As I don?t need to point out (but will anyway), June 17 is right around the corner, so you might want to tighten your seat belt.

A bit further out, but not very, here in the US we can look forward to the aforementioned fiscal cliff. Or, more accurately, the political theatrics around the three colliding co-factors in that cliff (the approach once more of the debt ceiling, the expiring tax cuts and mandated government spending cuts). While the outcome of the theatrics has yet to be determined, it?s a safe bet that the government will extend in order to pretend while continuing to spend ? and by doing so, signal in no uncertain terms that the dollar will follow all of the sovereign currency units in a competitive rush down the drain.

Bottom line: Be very cautious about industrial commodities as a whole, at least until we see signs of inflation showing up in earnest, but don?t miss this opportunity to use the recent correction to fill out that corner of your portfolio dedicated to gold and gold stocks.

To get more perspectives like this, plus sector-specific commentary in energy, technology, and precious metals, sign up for the free Casey Research daily newsletter, the Casey Daily Dispatch. It?s a great way to be introduced to the world of contrarian investing.

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