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Gold Stocks - Poised for an Epic Bull Run?

By Justice Litle      Printer Friendly Version Bookmark and Share
Sep 9 2009 2:21PM

Gold stocks could be headed for an epic bull run, of the sort not seen since the heady inflationary days of the late 1970s. Justice explores the logic behind a sustainable bull move.

Yesterday we highlighted the drivers behind the major breakout in precious metals stocks.

Today we’ll touch on a few factors as to why this move could be sustainable... the opening stages of a major bull run.

Gold Stocks Bull Run Reason #1: Volume Tells the Tale

As mentioned on Tuesday, the big breakout in gold stocks came on a major volume surge. If you compare the volume bars for last week’s big GDX up days to the more typical volume of the past few months, the visual is that of a 7-foot NBA center (Shaquille O’ Neal or Yao Ming maybe) signing autographs for a crowd full of midgets.

Volume is a useful tool in separating real from fake when it comes to range-expanding moves. Volume is also a useful market tool in that it speaks to the beginning and ending of things.

A surge in volume, when accompanied by a surge in price, is like an exciting chapter in a mystery novel. The story can be just unfolding, or it can be resolving to a powerful conclusion, depending on the context.

The logic here is simple to understand. When investors and traders pile into (or out of) a market in huge size, that indicates either a major shift in sentiment or a major climax in existing sentiment.

For example, when a market has been going up and up, and then there is a huge surge in both volume and price, that suggests a blow-off top. (The same is true in reverse for bear markets on the downside.)

Conversely, when a market sees a major surge in price and volume that runs counter to the current trend... or comes after a period of consolidation and quiet... that suggests that sentiment is resolving in a powerful new direction.

This is what the price and volume action in gold stocks seems to suggest. After a peak in late May, GDX went mostly nowhere – down and sideways – for months, as investors grew preoccupied with speculative fly-by-night plays like junky financials, dicey consumer retail and the rest.

Of course, volume is not a fool-proof indicator. (In fact no such indicator exists – unless one is willing to require so much confirmation that half the move has already happened before one gets on board!) That is why it’s important to judge the story itself... to make sure that the narrative makes sense.

And in this case the narrative makes a lot of sense. Cash-flush money managers and uneasy investors are rotating their money into gold stocks because, in the back of their minds, they know the V-shaped recovery story has holes in it big enough to drive a Mack Truck through. They know it makes sense to find a place to hide. Last week’s surge in volume tells us that this anticipated shift in sentiment is now well underway.

Gold Stocks Bull Run Reason #2: “Double Dip” Recession Odds Are High

Rather than hit you over the head with a phone book full of depressing facts, your humble editor will ask you to take his word for it on this one. At this point in the cycle, odds of a “double dip” recession are very, very high.

There are numerous reasons as to why this is so... reasons we have painstakingly enumerated in Taipan Daily (and which we will surely be revisiting).

The trouble is, in his post-depressive manic hope-jag, Mr. Market has failed to consider the odds of a double dip recession. In fact he has pretty much failed to consider anything, except the hole cards right in front of him.

To expand on a poker analogy, novice players often make the mistake of only playing their hole cards (the cards in front of them). Such players are oblivious to the nature of their opponents, the texture of the flop, or anything else that would normally be a factor in decision making as to when to check, raise or fold.

When such a player decides that, say, pocket tens are a “strong” hand, he will not fold and not back down, regardless of what ominous signs are staring him in the face.

But this bubble of obliviousness can only last for so long before it gets popped. Now that bubble is in the process of being popped as harsher realities come to light. Factors that were successfully ignored for months, swept aside by an extremely favorable run of cards, loom large.

It may not be polite to say in mixed company, but the very factors that make for a coyote-ugly economy also serve as a very strong backdrop for gold stocks... it’s no coincidence that gold stocks did well, for example, in the depths of the Great Depression.

The Biggest Bugbear: Deflation Pressures

If one had to lay out the most serious risks to a “bullish gold stocks” thesis, they might run as follows:

  • The broader economy thoroughly revives, making gold stocks passé as an investment choice.
  • Cost factors like fuel, equipment and skilled labor grow so high as to erode gold miners’ earnings.
  • Deflationary pressures grow so strong that the entire market is dragged down – gold stocks too.

The first factor does not present much of a worry. Via massaged government data points that look shiny on the surface but rotten underneath, we are already getting a clearer picture of the U.S. economy, and it is not a pretty one. Bullish noises from traditional stats like unemployment and ISM merely serve to make a mockery of the real carnage taking place, with the pain landing squarely on the shoulders of small businesses and unemployed (or involuntarily “self-employed”) workers who do not show up on the jobless rolls.

The second factor does not present much of a worry either. Ironically, the deflationary headwinds (in the form of falling wages and profits) bearing down on the market are good for the gold miners in terms of reducing fuel, equipment and labor costs.

It may indeed be that oil makes its way back to $200 per barrel at some point... but gold would likely be $2,000 an ounce (or more) in such an instance, as $200 oil is practically synonymous with U.S. dollar collapse.

The real reason to doubt a bullish gold stock outlook, then, comes down to deflationary pressures. While commodity prices are walking an intriguing tight rope thanks to factors like Chinese stockpiling and U.S. dollar erosion, other major factors are pointing very much in a deflationary (falling price) direction:

  • falling wages
  • falling revenues
  • brutal cost cuts
  • imploding state budgets
  • contracting credit lines
  • rising unemployment
  • rising credit defaults
  • rising construction loan defaults
  • rising government debt issuance
  • rising consumer savings (long-term trend)

Hard assets aside, such factors are powerful bad juju when it comes to deflationary risks. If a “double dip” recession indeed takes hold – a possibility more likely than not in your humble editor’s estimation – the result could be a classic equity implosion, of the sort to send equities back to the general vicinity of the March 2009 lows (if not guaranteeing an actual test).

The grizzliest of deflationary bears argue loudly that the U.S. Federal Reserve (and various central bank counterparts around the globe) are helpless in the face of such headwinds, doomed to the prospect of “pushing on a string” – that is to say, flooding the economy with liquidity to no avail.

The classic liquidity trap is one in which all the excess liquidity created simply pools unused in bank vaults... like water in underground reservoirs that never gets distributed to an economy in drought.

And yet, and yet. Central bankers may be dumb and blind, but they are not deaf! They have heard this deflationary drumbeat ringing in their ears all too clearly. Which leads us to...

Gold Stocks Bull Run Reason #3: Central Banks Are Getting Creative

The Bank of Sweden, known informally as the “Riksbank,” is the oldest central bank in the world. Official Riksbank operations began in 1668, some 245 years before a cabal of top-hatted schemers convened on Jekyll Island to dream up the Federal Reserve.

Now the Riksbank has made financial history again by being the first to go “negative.” As the Financial Times recently reported (underscore emphasis mine),

  • For a world first, the announcement came with remarkably little fanfare.

    But last month, the Swedish Riksbank entered uncharted territory when it became the world’s first central bank to introduce negative interest rates on bank deposits.

    Even at the deepest point of Japan’s financial crisis, the country’s central bank shied away from such a measure, which is designed to encourage commercial banks to boost lending.

    But, as they contemplate their exit strategies after the extraordinary measures of the past two years, central bankers will be monitoring the Swedish experiment closely.

What does this mean? In practice it means that modern day central bankers can look deflation in the eye and say “liquidity trap be damned... we will do WHATEVER IT TAKES to win this war... including measures far above and beyond what timid Japan was willing to do.”

Japan was perpetually timid, in part, because the majority of Japanese government debt is held “in country,” that is to say, by Japan’s own corporations and citizens. America, in contrast, has no such natural restraints. If the Riksbank can impose negative interest rates on bank deposits, then you damn well better believe the U.S. Federal Reserve can too.

The Fed, in other words, can all but come around to your house and set fire to the mattress if it chooses. Those who stuff cash under the bed in anticipation of an unavoidable liquidity trap could see that cash burned up by measures never before seen... which the centuries old Riksbank has already shown the way on implementing.

And that leads us to perhaps the biggest reason of all why gold stocks could run...

Gold Stocks Bull Run Reason #3: The Biggest “Side Pocket” the World Has Ever Seen

To quickly recap, we know there has been a major sentiment shift in favor of precious metals (as indicated by surging volume after a period of consolidation). We know the broad economy story is ugly and getting uglier, and that gold stocks historically did well in the Great Depression. We also know that traditional “liquidity trap” fears, of the sort that sucked Japan under, may also be invalidated by the willingness of central banks to try fantastically aggressive never-before-used measures (like negative interest rates on bank deposits).

Finally, we know that democratically elected governments are dumb as a general rule of thumb... and that mass stimulus efforts essentially never work.

By their very nature, democratically elected governments are shortsighted to an almost crippling degree. This can be chalked up to short-term political time horizons. With politicians overwhelmingly focused on how to get re-elected in a short period of time – the window between campaigns measured in months rather than years – long-term solutions requiring short-term pain never get implemented. Instead, lip service, pandering and reckless splurging are the constant choice.

So ask yourself, then, what happens when the following three elements are combined:

  • An economic situation that is virtually guaranteed to get far worse before it gets better.

  • A central bank (actually a whole host of central banks) hell bent on beating deflation “no matter what,” with a willingness to implement measures Japan never contemplated... which in turn means not just keeping interest rates low for years, but setting proverbial fire to bank vault cash if need be by way of negative interest rates.

  • A rapidly eroding faith not just in the U.S. dollar, but in the solvency and viability of virtually all Western World fiat currencies, as the corrupt incompetence of Keynesian thinking comes to light.

The net result of this unholy trinity is a massive pool of artificially generated liquidity with absolutely nowhere to go.

Government efforts to kick start the economy will prove to be the equivalent of flooding a lawn mower engine with gasoline. Beyond a certain point, the extra effort doesn’t do a damn bit of good. Meanwhile, all that extra liquidity created and force-fed into a low-appetite economy will have to go somewhere... and as general faith in the system hits new low after new low, it could pour directly into the “side pocket” of gold and silver stocks. After all, money flows to where it is treated best... and if the Feds beat the crap out of money held in bank vaults in a deflation-dominant environment, it will flow to the next best proxy of safety and soundness – precious metals and the miners who produce them.

This is a potential multi-year trend we are talking about here. Think back to the great oil run of the late 1970s, and the incredibly entrenched nature of inflation psychology that gripped the nation by the time of the 1980 peak.

When gold stock mania is as thorough and entrenched as housing mania was circa 2006, with all the media circus and breathless hype that entails, that’s how you’ll know the run has played itself out.

Justice Litle,
Editorial Director, Taipan Publishing Group



Justice Litle is the Editorial Director for Taipan Publishing Group and the e-letter, Taipan Daily, the free financial e-letter that introduces readers to breaking global trends and investment strategies.