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Four reasons why gold stocks are so hated

Five full years on from the financial crisis, stock markets have regained lost ground and are within striking distance of new record highs.

Yet, it’s only NOW, after all the gains from the bottom have been made, that the investing crowd is starting to put money back into stocks.

Curious. When stocks were CHEAP, nobody wanted them. Now that they’ve breached record nominal highs again (Dow 14,000++), investors are piling back in.

It’s almost a cliche, but to make money investing, you generally have to buy something when nobody else wants it, and sell when everyone wants to buy.

For example, I wrote in early December that the Shanghai Stock Exchange (SSE) index was due for a bounce. Sentiment had hit rock bottom. Retail Chinese investment accounts were dormant. And the headlines warned of impending doom as the index hit a 4-year low.

But, as I suggested, BUYING was the right call, and we’ve made about 20% since then.

However, the rebound has played out. If you followed me on this trade, I suggest taking profits. I’m personally unwilling to risk holding Chinese stocks long term.

That’s because, just as in the West, the Chinese government is engaging in a giant game of “extend and pretend.” Chinese banks have just rolled over 75% of all loans to local governments, which were supposed to have been repaid by the end of 2012.

We’re talking about at least 3 trillion Chinese Yuan, or nearly half a TRILLION dollars worth of debt. It’s an enormous burden.

The China trade was a short-term idea, speculating that sentiment would bounce and the index would recover. We were right. And looking around today, I see another opportunity along the same lines– GOLD STOCKS.

As a group, gold stocks are down between 20% and 30% over the past year. Yet in that same timeframe, the price of the gold has risen.

As a result, sentiment toward gold stocks is pitiful. Even diehard gold bugs are tired of losing money in gold stocks and have been dumping their shares in disgust.

There are 4 main reasons I can think of why gold stocks might be so cheap:

  1. Now that the talking heads on TV are all telling us that the financial crisis is over, people expect the gold price to fall.
  2. The presence of many alternative gold investments (Exchange Traded Funds like ‘GLD’) provides a means for people to have gold exposure without having to buy mining stocks.
  3. Some investors may perceive that the increased cost of extracting gold is outpacing the price of gold, meaning that profit margins of gold mining companies may be deteriorating.
  4. The prospect of a deflationary credit crunch would eliminate the availability of project financing, putting new mines at risk, particularly among the smaller miners.

Let’s examine these in turn.

Reason 1 is unrealistic. Stocks are hitting 5-year highs, but the root causes of financial crisis, namely too much borrowing and spending, have not been addressed.

There is more money and debt in existence now than ever in history. Central banks have created trillions of dollars out of thin air. And debts have merely migrated from the private sector to public balance sheets.

In our view, gold remains an EXCELLENT hedge against systemic risk in our view.

Reason number 2 is partly true. A lot of money that might have gone into gold mining stocks has instead gone into the many paper gold and ETF products that have proliferated in this bull market.

But with gold stocks now RELATIVELY cheaper against gold itself, a reversion to the mean seems a reasonable expectation.

Reasons 3 and 4 are possibilities. Mining costs are rising, and a deflationary credit crunch could really affect production if mining companies lose their financing.

Initially, this scenario would likely put downward pressure on both gold prices and the equity value of mining companies who would see their project financing opportunities diminish.

To me, these are among the chief risks we would be assuming by buying gold stocks over the long-term.

But I’m not suggesting this trade for the long-term. It’s like the China recommendation in December. I’m suggesting that there’s money to be made buying a HATED sector of the stock market while it’s out of fashion and nobody wants it.

Right now, this means gold stocks. More than likely, sentiment will rebound, the crowd will come back, and we’ll be able to lock in short-term profits.

About the author: Born to a Danish father and British mother, in Dar Es Salaam, Tanzania, Tim Staermose has led an international life since the day he was born. Growing up, he also lived in Egypt, Denmark, and Singapore, before eventually settling in Australia, where he completed his education and took out citizenship. Since then he has also lived and worked in Hong Kong, and Manila, Philippines, in the field of equity research — both for a bulge-bracket Wall Street investment bank, and for an independent investment research firm. Today, when not traveling the globe looking for investment and business opportunities for the Sovereign Man community and catching up with his diverse, multinational group of friends, he divides his time between Hong Kong, and the Philippines.

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