GOLD STOCKS MAY BE IMMUNE TO A COMMON STOCK COLLAPSE

By Dr. Richard S. Appel              April 28, 2005 www.financialinsights.org

April 24, 2005 – The recent one week 450+ Dow Industrials point decline, combined with similarly sharply lower prices for the majority of common stocks, has prompted many commentators to predict an impending resumption of the Bear Market in U.S. equities. This has again drawn attention to the latent fear among many gold followers that such a broad based downturn would similarly ravage the world of gold equities. They believe that gold stocks will be forced to participate in a major, widespread common stock fall. If these gold enthusiasts are correct, a dire fate awaits the gold mining industry when the equity Bear Market finally resumes. However, given the experience of the great 1970's gold Bull Market, I believe that their fears will likely prove to be overblown.

An increasing number of gold followers believe that when the common stock Bear Market reasserts itself investors will differentiate little between common or gold equities. They posit that a general flight from common stocks will result when it is generally recognized that their Bear Market has not ended. Those possessing this belief are convinced that market players will sell their gold shares just as they would any of their other stockholdings. They anticipate that investors will jettison all shares regardless of the sectors that they represent, for fear of further substantial losses. In fact, this conviction appears to be supported by the severe gold stock price reversals that accompanied the recent general market decline.
While this widespread fear engulfs many within the gold community, some experts believe that gold mining companies will only initially fall in unison with the resumption of the equity Bear Market. However, they believe that the gold miners will later regain some strength while common stocks continue to be liquidated.

Their premise initially revolves around that held by the former group. However, many in this faction differ in the outcome. Among other reasons, this is because they are confident that the government will open wide the monetary floodgate causing gold to act as a safe haven and to rise in price. This in turn will carry the companies that mine and explore for it to higher levels. While they believe that gold will not suffer as greatly, in the end, they all believe that gold stocks only represent ownership of gold mines, and as such will not fare as well as the yellow metal.

The potential for different outcomes arises when one attempts to anticipate the possible price movements of gold equities with a general market decline. This results because it is impossible to predict the duration and magnitude of any Bear Market downturn. We may face a virtual waterfall equity collapse where stocks cascade sharply lower. Or, we might experience a relatively controlled decline where their prices essentially erode over an extended time-frame. In fact, we might experience a combination of both market actions. In each of these scenarios the fashion in which gold equities react may be different! This factor makes a simple description of an equity Bear Market’s likely effect upon gold stocks difficult to anticipate. Fortunately, a look into the past might shed some light upon the future, and may help us better prepare for its arrival.

To me, the best precedent for comparison occurred during the gold Bull Market of the 1970's. Gold rose early in that decade from $35 to its ultimate $875 an ounce peak in February, 1980. Common stocks began that era with prices broadly rising only to suffer a severe Bear Market decline. This was followed in the mid-1970's, by the emergence of a new Bull Market. Significantly, during the equity Bear Market segment, both gold and gold stocks rose sharply in price.

One could also compare the reaction of gold stocks to that which occurred during the great 1929 stock market crash and its aftermath. This might allow one to get a glimpse of what might transpire if a similar event was to be experienced today. However, a different set of circumstances prevailed during that era: 1. There were paltry few gold equities that investors could purchase, while today there are thousands. Thus, any capital directed towards gold stocks was focused upon the few available companies rather than being dilutive in their impact. 2. Both the government and the Federal Reserve had far less understanding of markets and therefore had less willingness to influence them to prevent any economic hardship. Today, they covertly intervene and possibly actively manage a number of markets. 3. That era’s citizens better understood gold’s position in the business and financial world. Gold was not only used to back or collateralize the dollar, but was often utilized in legal contracts. Contemporary investors have been convinced to shun gold and gold stocks, and firmly believe that the noble metal is essentially only useful in jewelry and for filling teeth. This prevents them from presently even considering gold investments. Finally, with most prices declining, the yellow metal actually rose substantially in price. Today it remains to be seen whether inflation or deflation are in our immediate future, and the impact upon gold is questioned by even many of its adherents. For these reasons, I believe that the relationship between common and gold equities during that period cannot be compared with those existing today. However, for completeness, I believe that a brief discussion of how gold stocks fared during the Great Crash and the ensuing years is important.

The few trading gold shares followed closely behind common stocks during their October1929 crash. However, shortly after the initial price collapse, while equities first rallied and later resumed their Bear Market, the trading pattern of gold stocks separated from that of common shares, and began a substantial advance. You have likely heard stories of the extraordinary price performance of Homestake Mines during that decade; it rose from a low in the $50 price range to over $500 a share before the 1930's decade ended.

The primary reason for this incredible event was the result of the devaluation of the dollar. From 1920 to early 1934, gold had a fixed price of $20.67 an ounce. However, after making it illegal for Americans to own gold a year earlier, in 1934 President Roosevelt devalued the dollar. This was achieved by officially increasing the gold price to $35 an ounce; it then took 35 paper dollars to purchase an ounce of gold. This presented Homestake and the few other domestic gold producers with an enormous 70% windfall profit on their sales. Further it gave them a guaranteed price and a willing customer in the U.S. government, while the general economy suffered from a depression and generally falling prices. Further, Homestake’s production costs actually declined while the economy floundered and the unemployment lines swelled. As you can see, the various conditions and events that accompanied the crash and the Depression’s aftermath coalesced to first take Homestake’s share price to lower levels, but later fostered its incredible exhibition of strength.
It is important to understand how and why gold and gold stocks performed in the 1930's. However, I believe that in attempting to predict the fashion in which gold equities will today react to a common stock Bear Market decline, the 1973 to1974 period offers the best historical comparison. Further, to my mind, studying it will likely give us much insight into what may lie ahead for gold shares when equities ultimately enter their next extended downward leg.

HOW GOLD STOCKS FARED
DURING THE 1973-1974 EQUITY BEAR MARKET

As I stated earlier, the gold and gold share secular Bull Markets spanned virtually the entire 1970's decade. Equities on the other hand entered that period with stock prices in a broad based advance. This was followed by a devastating Bear Market collapse to its nadir in December, 1974, from which emerged a new Bull Market.
January, 1973, witnessed the end of the prevailing equities Bull Market. The Dow Industrials peaked at about 1065 before the bear took control. The following two years saw the Industrials enter a period of unrelenting widespread decline. When the Bear Market was finally exhausted many second tier stocks lost upwards of 90% of their former prices, and the Dow Industrials had plummeted nearly 50% before posting its 577 low. Day after day and week after week, the bear pummeled common stocks. It was seldom referred to as a collapse until after it was over. Then, as now, hope sprang eternal!
The relentless, unending price markdowns continued until the last remaining earlier bullish investors finally gave up and sold their shares. In so doing, they took whatever the market would offer them. By the time that the Bear Market ended in late1974, the majority of stockholders vowed to never again purchase common stocks.
Gold on the other hand began its major advance in the late spring or early summer of 1972. This was from the low to mid-$40 range, and after the gold producers had already risen from their earlier 1972 lows. As I recall, when the Dow Industrials peaked in early 1973, gold was trading at about $100 and gold equities had already posted impressive gains.
During the following nearly two years while common stocks were devastated, the yellow metal simultaneously rose in fits and spurts and posted a temporary top at $200. This occurred at the end of December 1974, about a month after the Dow Industrials bottom. Gold staged repeated new highs despite the equity Bear Market which destroyed common share values throughout virtually the entire1973-1974 period. Across this era gold equities followed gold higher in price and returned great profits to their investors.
It is my contention that the effect of the rising gold price upon the profits of the gold producers acted to spare them from the great declines suffered by other stocks. This caused them to be viewed in a different fashion than were most common stocks! While most companies were experiencing smaller profits or severe losses, gold companies amassed substantial profits and their stocks exploded in price.
It was only the decline in gold from the $200 level that generated a serious secondary correction for gold stocks. This began during the last few days of 1974, just prior to the time when Americans were again allowed to own gold. A terrifying gold correction ensued until the noble metal posted its $103 nadir in the summer of 1976.
The gold shares had touched their low points a few months before gold struck $103. It was from those thoroughly depressed levels that gold and its shares rose to their final spectacular highs in February, 1980. Interestingly, and importantly, the latter rise of the gold complex was accompanied by common stocks that simultaneously advanced during the early stages of what was to become their greatest Bull Market in U.S. history.
Given the fact that I believe that gold is in a secular Bull Market, I feel that only in a major financial meltdown, such as which occurred in the 1929 experience, will gold equities be sold along with other paper assets. Barring such an event, it is likely that gold shares will only periodically mirror the fall of common stocks when their Bear Market resumes.
It is true that a sharp initial equities decline will likely be accompanied by a similar reaction in gold equities. If such a scenario unfolds it will occur because many gold investors are convinced of its inevitability, and will sell in anticipation of it. In essence, their belief and actions will produce a “self-fulfilling prophesy”. However, I am confident that even if this occurs, it will be short-lived at worst.
In the end, it is my belief that the direction of both the major and junior gold stocks will be far more influenced by the price action of the yellow metal, than by a vicious Bear Market in common stocks. As long as gold continues to trend higher, I am confident that gold shares will trade in a like fashion as they did in the 1970's. They will essentially rise and fall along with the gold price. There will be periods when either gold or its stocks will move higher and the other will hesitate. But, it is my contention that the great fears of many gold followers will not come to fruition when equities enter the next segment of their Bear Market decline.

*******

The above was excerpted from the May 2005 issue of Financial Insights © April 24, 2005.

I publish Financial Insights. It is a monthly newsletter in which I discuss gold, the financial markets, as well as various junior resource stocks that I believe offer great price appreciation potential.
Please visit my website www.financialinsights.org where you will be able to view previous issues of Financial Insights, as well as the companies that I am presently following. You will also be able to learn about me and about a special subscription offer.

*******

CAVEAT

I expect to have positions in many of the stocks that I discuss in these letters, and I will always disclose them to you. In essence, I will be putting my money where my mouth is! However, if this troubles you please avoid those that I own! I will attempt wherever possible, to offer stocks that I believe will allow my subscribers to participate without unduly affecting the stock price. It is my desire for my subscribers to purchase their stock as cheaply as possible. I would also suggest to beginning purchasers of these stocks, the following: always place limit orders when making purchases. If you don't, you run the risk of paying too much because you may inadvertently and unnecessarily raise the price. It may take a little patience, but in the long run you will save yourself a significant sum of money. In order to have a chance for success in this market, you must spread your risk among several companies. To that end, you should divide your available risk money into equal increments. These are all speculations! Never invest any money in these stocks that you could not afford to lose all of.

Please call the companies regularly. They are controlling your investments.



FINANCIAL INSIGHTS is written and published by Dr. Richard Appel and is made available for informational purposes only. Dr. Appel pledges to disclose if he directly or indirectly has a position in any of the securities mentioned. He will make every effort to obtain information from sources believed to be reliable, but its accuracy and completeness cannot be guaranteed. Dr. Appel encourages your letters and emails, but cannot respond personally. Be assured that all letters will be read and considered for response in future letters. It is in your best interest to contact any company in which you consider investing, regarding their financial statements and corporate information. Further, you should thoroughly research and consult with a professional investment advisor before making any equity investments. Use of any information contained herein is at the risk of the reader without responsibility on our part. Past performance does not guarantee future results. Dr. Appel does not purport to offer personalized investment advice and is not a registered investment advisor. The information herein may contain forward-looking information within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the statements contained herein that look forward in time, which include everything other than historical information, involve risks and uncertainties that may affect the company's actual results of operations. © 2005 by Dr. Richard S. Appel. All rights are reserved. Parts of the above may be reproduced in context, for inclusion in other publications if the publisher's name and address are also included for credit.