Stocks and gold trade places
Bullion coming off bottom, while Dow may have peaked
Jonathan Chevreau
Financial Post
This week we began to see an interesting divergence between the faltering levels of the Dow Jones industrial average and a resurgent gold price.
This is nothing new, since stocks and gold have been out of lockstep for almost two decades. Most of that time, U.S. equities were rising while gold slumped.
What's different this time is that gold seems to have bounced off a bottom of about $255 (all values in U.S. dollars) just weeks after the Dow hit a seeming top at a little more than 11,300.
On Tuesday, the Dow fell 225 points while gold soared $5, despite a gold auction by the Bank of England that was over subscribed by a factor of eight. The last time the bank sold some reserves, gold tanked; this time, buyers were eager to bid up the price.
Take a look at the accompanying chart for a clue as to whether this apparent trend reversal can be sustained. It shows how many units of the Dow were needed to buy an ounce of gold over the past 100 years.
At various times in history -- for example in the late 1890s and late 1970s-- a unit of the Dow and an ounce of gold were roughly equivalent. Gold reached $800 an ounce at a time when the Dow was at 800 points. The ratio has become so far out of whack that the Dow/gold ratio neared 44 in mid-July (11,300/260).
The previous two times gold was so underpriced and the Dow so overpriced was in the late 1960s when the ratio was 28 and in 1929 when the ratio was 18. Notice the subsequent returns to a ratio of one or two.
Twenty years ago, all the gold in the world, including that held by mining companies, was worth $1.5-trillion at a time when the U.S. equity market was worth about $1-trillion.
Today, the equity market is worth $15-trillion, while gold still amounts to only $1-trillion, says Nick Barisheff, president of Bullion Management Services in Toronto.
If the Dow were normalized to to the average P/E ratio of 12, it would be at just 4,700, Mr. Barisheff estimates. If the price/earnings ratio of Dow stocks fell to previous bear market levels of six, the Dow would be at just 1,700, he says.
Mr. Barisheff is, admittedly, a gold bull, and about to introduce the Millennium Bullion Fund -- which will hold gold, silver and platinum directly for Canadian RRSP investors, pending approval from the Ontario Securities Commission.
He wants to release the fund before January, 2000 because he expects various forces, including global Y2K problems, to push the price of gold far higher in coming months.
John Embry, manager of Royal Precious Metals Fund, is one of the few in the financial community who agrees Y2K could be dicey for financial markets and a boon for gold. "I think it's being stuffed under the rug while knowledgeable people are worried ... Heaven help us if what happens to the total stock market is what's happened to the gold market."
Ironically, gold's possible bottoming comes when Canadian mutual fund investors have been jettisoning their resource-heavy Canadian equity funds for the seemingly greener pastures of 100% RRSP-eligible foreign equity funds.
Gold stocks make up 4% of the Toronto Stock Exchange 300 composite index, but the broader commodity complex, which includes gold, other precious metals, paper and oil make up 22% of the TSE.
The irony is that Canadian investors have one of the better opportunities to participate in a domestic commodity rebound in their registered retirement plans, and they don't need to skirt the 20% foreign content limit to do it.
Most gold or precious metals funds sold in Canada are 100% RRSP-eligible. Those seeking more diversification can invest in similarly unconstrained domestic resource or energy funds.
While RRSP investors can't yet hold bullion directly they can buy the stocks of senior producers, such as Barrick, or more speculative junior exploration stocks, of which prices have been hammered not only by the general bear in gold but also by the fallout from the Bre-X fiasco.
Precious metals fund investors need to compare several strategies -- some funds invest in the senior producers, others in juniors and others directly in physical gold or silver. At least one closed-end fund, Central Fund of Canada Ltd., holds bullion for investors directly.
In theory, investing in gold stocks or funds based on them will magnify gains from a pure bullion play -- should the bullion price rally prove real. With a 2% jump in bullion this week, prices of some gold stocks jumped 15% to 33%.
However, many gold companies that have entered into forward contracts will not benefit as spectacularly from a price rise as those that did not. On the other hand, as long as the bullion price stays low, forward contracts act as a nice hedge for the producers.
Space precludes a discussion of the many forces now at play, including central bank sales, short sales by hedge funds, imbalances in supply and demand, closure of many marginal gold mines, dramatic changes in the gold lease rate and various machinations by the political and banking elite.
A Web site, www.gold-eagle.com, offers several insightful essays into the possible future directions of gold. It has a bias in favour of the gold bugs and reveals much antipathy to governments, central banks and the Wall Street investment houses and hedge funds that, they allege, are conspiring to keep the price of bullion artificially depressed in order to prop up their worlds of "fiat" electronic money.
Philip Spicer, president of Central Fund, predicts some shocking rises in bullion before year-end, as the shorts start to cover at $265 to $280. He also expects individuals to snap up more gold and silver coins as a Y2K-preparation hedge.
Vancouver-based investment advisor Hans Merkelbach has long been trumpeting gold's imminent revival. The downside for gold has been repeatedly tested, he says.
In mid-summer, he said "the best reason to buy gold sector mutual funds is because so many investors are eager to get out of the gold sector. Thirteen per cent gold bulls and 87% gold bears is healthy for an imminent rally." He expects the Dow to fall 40% to below 7500.
But on the Gold Eagle site, an essay written before the British auction maintained that "October tends to be a poor month for gold stocks. We therefore suggest a cautious approach to this market and recommend that new buying of gold stocks be only undertaken on strength."
Jonathan Chevreau can be reached by e-mail at jchevreau@nationalpost.com
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