I know of two actual bear attacks since July — I guess that is not all that surprising in the Pacific Northwest. Just last week, my neighbor surprised one rummaging through my garbage in the middle of the night. On Wednesday, as I was driving back home from my usual 4:00 a.m. coffee at Starbucks, I too came face to face, or grill to bum, with a bear. It was neck deep in one of my neighbors’ garbage cans, which it had dragged half way onto the road in front of me.

It is going to be a long winter, I thought to myself, as I wondered why this big fellow wasn’t getting out of my way. Stubborn bastard. Big too. I flashed my high beams. Then anxiety began to grip me and I started worrying that it might mall my paint job if I made it mad, or even chase me into the driveway, which was just a few houses down. Should I call the police? Should I honk and wake the neighbors?

Stay cool, I reassured myself. I have raised dogs almost as big as this ole bear.

No sooner did I calm down then he moseyed on off the road, and I made my escape. Whew.

Is The Gold Bear Gone?

Talk about synchronicity, it occurred to me later that night/morning, when we saw the gold market make its biggest one day reversal in nine years.

The bulls went straight through all manner of intermediate resistance to end up $84 at over $860 on the day, and then continued on Thursday to print a high of about $910 before the cash market settled back at around the $845 level going into the Friday morning session in Europe. Gold traded as low as $736 only one week earlier.

As in my bear confrontation before the market open, I was just beginning to think about accepting the possibility that the gold bear would not go away until next year when, suddenly, it made its exit. Or did it? Is this just another false start? A sharp bear market rally? The answer is important to your investment strategy. Stay tuned.

What Has Changed in One Week?

The ink had hardly dried on the U.S. Treasury’s socialization of Fannie and Freddie, and thus half of the U.S. mortgage market, when it realized it would have to reconvene over whether Lehman was too big to fail the following weekend. Apparently, it was not, and so began the filing of the largest bankruptcy in U.S. history.

Then the dominoes really began to fall. Merrill Lynch was taken out, and then speculation turned on AIG, Goldman (until Buffett threw his support last night), Morgan Stanley and many others. The Treasury ended up taking control of AIG, but not before giving rise to fears about the exposure of “safe” assets, like money market funds, to Lehman or AIG or whatever failing counterparty might be guaranteeing this or that in your portfolio.

The events reminded investors that there is nowhere to hide, except, perhaps, in the one asset that is “no one else’s liability” — gold. The government is grabbing at straws. The Federal Reserve’s balance sheet is wearing so thin that the Treasury is raising money for it on Wall Street now. Talk about wash trades. It is not just the U.S. markets. Loan markets are stressed all over the world. Russian markets froze this week too. The Chinese central bank cut rates and its government kicked off a plan to start buying stocks for its sovereign wealth fund to stem the bearish tide.

We’re not sure where any of this will leave the world’s stock markets. But we do know one thing: Gold will continue to rise.

Good trading,
Ed Bugos
September 25, 2008

Investing in the Gold Rally was originally featured in the Penny Sleuth.

In grading a junior miner I have five main concepts, they include:

Management assessment: Track record, interview, insider buying/selling records, and word of mouth — I try to determine whether management is an asset or liability (only assets pass).

Share structure: A good share structure is one that hasn’t seen any chance for distribution yet, and where insiders and key people still have a meaningful enough stake in the company.

Capital structure: Does the company meet my solvency tests (past and future)?

Scope: Risk versus reward: Is there enough upside relative to the risk category of the deal — for risky juniors I like a 10:1 ratio…for blue chips a 3:1 ratio…etc.?

Valuation: Absolute and relative. This is not really objective. Typically I will want to understand the reason for the market’s current valuation — relative and absolute — and if the reason for an expected favorable change in valuation is plausible. I’ll be looking for areas that the junior is undervalued — where you can pick up shares for a hefty discount.

After I’ve taken into account all of these concepts and if the junior company passes all of my filters, I may make a trip to the mine site if practical, and “kick the tires.” This is also a very important step in ensuring the quality of a junior miner — and more importantly, this step helps avoid small fly-by-night operations and shell companies.

Along with my basic concepts for grading juniors I’ve developed five additional criteria to identify which companies are most vulnerable to buyouts. In my search for takeover candidates I’ve focused on the following themes I call them my takeover checklist:

1. How big is the company’s deposit? The majors are thinking big here. Companies like Newmont threw every possible resource it had at growing its reserves in 2005 — and at the end of the process, had fewer reserves than it started with? A deposit of at least 5–10 million ounces will add a lot of gold to the books in very short order. So the juniors with large deposits are always favorable.

2. How far along is the deposit’s development? The majors don’t want a company that’s just begun drilling and doesn’t have a clue how much gold it’s actually sitting on. They want a sure thing — something that’s just been discovered, or something that’s just about to go into production.

3. Is the mine located in a mining-friendly country? The third thing the majors don’t want is what happened recently in Ecuador. After a huge gold discovery Ecuador’s government suspended mining for six months so it could rewrite the country’s mining law — and undoubtedly seize more or the profits for itself.

The lead developer of that site, Aurelian, got whacked 31% the day of the announcement. So it’s essential the government in the country where the mine is located is mining-friendly.

4. Is the mine economic at current prices? If there is not enough information on the resource or if the grades aren’t high enough — some mines may never pass a feasibility test.

In these cases the mine may not end up proving to be economic — this is a clear barrier to any major buyouts.

5. Does the company have the ability to put the mine into production? Some companies are looking to “flip” a mine. Essentially I don’t want to look at companies that are just looking to be bought out. I want to make sure a junior has the capability and assets to develop a mine. Major gold producing companies will avoid buyouts if the junior looks to be flipping a mine without any intention to mine it themselves.

All of the information that I gather about a junior comes from various places. I’ve been watching the mining industry for the past 18 years so many of my junior picks will come from my contacts as an insider in Vancouver’s mining and investment industry.

But along with that “insider” information I will always perform my due diligence which includes: tracking research, analyzing annual reports, searching through other filings, scanning industry news, attending company board meetings, and scanning charts for unusual bullish or bearish activity.

But finding the right junior miners takes all of this and more. It really is a full-time job. So when you’re looking for the right junior miner to invest in this gold bull market, remember to do your due diligence.

Good trading,

Ed Bugos
July 18, 2008

The Junior Miner Checklist was originally featured in the Penny Sleuth.

But before I tell you what it is, I want to give you a sense of how big this really is: It’s exactly like being there for the birth of the offshore oil and gas industry.

This industry, born of the 1970s energy crisis, now produces about a third of the world’s oil output. But back in the ‘40s and ‘50s, it was still a frontier…a pipe dream, to many.

Geologists today know of some 115 billion barrels of oil and 633 trillion cubic feet of natural gas reserves in the Outer Continental Shelf surrounding America’s coastlines alone. There are some 450 operating platforms in the North Sea today, and several thousands in the Gulf of Mexico. It is a trillion-dollar-per-year industry, plus or minus.

Thanks to the mother of inventions, offshore drillers have overcome many obstacles (mostly political). And in the process, they have unwittingly laid the technical and legal groundwork for a whole new industry…

There is one company I’m looking at. It is this industry’s leader. Its founder led the group that co-discovered the 40 million ounce Lihir gold mine in Papua New Guinea (put into production during the late ‘90s). He is still a founding director of Lihir Gold and a fellow of the Australasian Institute of Mining and Metallurgy. He surrounds himself with old mining hands, including former Placer Dome and BHP executives.

I bet you’ve already figured out that we’re talking about a mineral deposit.

What’s so new about that, right?

Get this: It’s under the sea. Yes, we are about to see the first major startup in the deep-sea mining industry. If it’s anything like the boom in offshore drilling, you’ll want to be there.

The world’s largest gold companies together own over one-third of this company.

These players are so bullish on the prospects of this industry they all entered into non-competing and anti-dilution clauses just to get a tiny foothold… Teck Cominco and Anglo American have paid millions of dollars for a mere option to participate in a potential future joint venture. And millions more in direct investments.

Anglo and Teck’s investments total more than $50 million.

Placer Dome alone spent more than $13 million earning a joint venture interest with this company.

And in 2006, shortly after Barrick took Placer Dome over, it decided to convert Placer’s JV interests into a 9.6% equity interest (which has since diluted to less than 5%) at a deemed price of $2.86 per share.

But wait, you may wonder, just how new is this?

Outside of a few dredging operations for diamonds off the African coast in recent years, the extraction of minerals from the seafloor is virtually untapped. No one has mined the seafloor, though geologists have long known of its potential…

For a long while, they thought that these minerals were deposited as sediments from eroding deposits on nearby land. But it was later realized that the source of massive sulfides on land was the ocean, and that hydrothermal events beneath the ocean seafloor precipitated into a mineral deposit upon contact with the water. In fact, in 1985, seafloor massive sulfide systems were discovered off the coast of Papua New Guinea by a research vessel at a site claimed by our company.

Given a few modifications to technology produced by the offshore oil industry over the last few decades, the outcome of a new international treaty on deep-sea mining in the ‘90s, advances made by our company toward the establishment of the first-ever deep-sea mine this decade and the growing worldwide demand for scarce mineral resources, the time is right for this industry to emerge…and the deep sea mining profits should follow!

Good trading,

Ed Bugos
June 20, 2008

Investing in Offshore Mining was originally featured in the Penny Sleuth.

With that said, I think we’ve had our seasonal low and now it’s gold’s turn to shine…as the most preferable commodity…and better yet, to become money again.

Just writing that makes me realize how early in the game it still is. Who today would believe gold will become money again? Yet, at the top of the market everyone will. Here is the best opportunity for us right now…

Most of the small-cap and junior resource market has been in decline since gold first broke the $700 level back in 2006. But that’s all about to change, I have five reasons why you should buy juniors now before the window closes — lets get started…

Reason #1, is that, several depressing factors have come together to produce an early seasonal low, at least for the precious metals sector.

Reason #2, as implied in the introduction, gold has lagged the commodity cycle because the market is infatuated with the growth in developing countries, and has inferred a “realness” to their demand for commodities. I’ve never disputed that the growth exists… just that there is a lot more inflation, and that inflation is what drives prices higher.

I believe the gold market is at a bullish inflection point — a point of recognition of sorts.

Reason #3, the precious metal juniors have hardly benefited from the bullish trends in these commodities to date, especially since 2006, never mind the future.

Lots of money found its way into the junior segment over recent years, to be sure, but this expansion in capitalization has been dilutive. The Canadian Venture Exchange (CDNX) has had a hard time keeping up with gold itself, and is at its lowest level relative to gold since 2002. Simply put, the juniors should be tracking gold — and right now they have a lot of catching up to do. The result is a widening gap between the values of majors and juniors. In my mind, that gap will soon contract.

With that said I think it’s the best buying opportunity in this segment since 2002.

Reason #4, the money that has poured into the junior precious metals segment over the past few years has been soundly invested. I am impressed with the value that I’ve seen many juniors create throughout this cycle — the development of assets discovered back in the nineties has been astonishing.

Finally, the best reason to own these juniors now…

Reason #5, the next takeover wave!
      
Many of the large-cap producers are priced for growth, and they know that if they want to sustain those multiples, they’ll have to buy or find reserves. That’s the incentive.
        
Meanwhile, the juniors spent lots of investment dollars proving up their assets, and the market has ignored them. So they are ripe for acquisition.
         
And, the majors have plenty of cash, thanks to the latest run in gold prices.
         
Some, such as Agnico Eagle have said they’re on the hunt, while others like Gold Fields are obviously in need of assets outside of South Africa. Corrections in the price of gold won’t discourage them.
         
There’s your ammunition, five solid reasons for you to invest in small-cap and junior miners. These miners won’t remain at these levels long, so now is your chance to get in!
          
I’m working on a more comprehensive target list as we speak. I see a window of opportunity between now and the end of this gold price correction to buy the good quality small-caps and juniors before they take off. The window could close earlier than you think.

Regards,

Ed Bugos
May 27, 2008

P.S.: While most juniors should do well over the next few months, or even years, not all will. As with any investment idea, you have to find the best of the best. That’s why I developed my 22-point ARC Trigger System.

The Five Reasons Why Now’s the Time to Buy Junior Miners was originally featured in the Penny Sleuth.

Today, with progressive calls for action in the face of crisis, the Fed’s tentacles are potentially reaching directly into the credit and securities markets. This week alone, the headlines are rife with news of its “sweeping” new powers under Treasury Secretary Hank Paulson’s “plan.”

The Federal Reserve is in the midst of another historic interest rate-cutting campaign. Its official policy stance is that it recognizes the inflation risks, but worries more about growth, so it will inflate to sustain “growth.”

Its message has been, more or less, that money grows on trees, which is why Ben Bernanke’s moniker, “Helicopter” Ben, is catching on with the press. Gold bugs could not be more thrilled. Just recently, I wrote that we are seeing the best of all worlds for gold to shoot straight up a few hundred points.

But wait! “It’s not such a sure thing.” At least that’s what I thought I heard…from a voice in the wilderness. “What do you mean it’s not a sure thing? Look at ‘em flood the markets with liquidity. $100 billion here, a few hundred there.”

As I was about to sign off, the voice continued: “No, they are not inflating. They’re just creating confidence in the credit markets. Look at the ‘money’ numbers,” said the voice. “Forget credit. Look at the level of bank reserves and the adjusted monetary base. They haven’t grown since August. The Bernanke Fed is just pretending to inflate!”

It has not escaped my attention that the narrow constituents of money supply are not expanding. I’ve written about it.

This disinflation was first apparent as far back as 2005, under Alan Greenspan’s tenure, when M1 growth hit 0% on a year-over-year basis. He set it in motion through the rate hike campaign. The total value for U.S. M1 has not changed in three years. But our “voice” insists that Bernanke is running a different, more deflationary, policy than Greenspan — even though under Bernanke’s reign, since 2005-06, the broad credit aggregates have reaccelerated and the tightening campaign abandoned, and reversed.

Clearly, the Bernanke Fed is running a different policy.

But it is difficult to call it a more deflationary one:

OK, so it has kept M1 flat, and slowed the growth in the monetary base a wee bit further (which has no doubt contributed to the crisis). And since August, the Fed has not expanded bank reserves overall, even though it has slashed its policy-setting interest rate by 300 basis points, has taken other measures to ensure short-term liquidity and talks as if it is ready to underwrite almost any insolvency.

We may point out that if the Fed wanted deflation, it would have already arrived.

If, for example, Bernanke actually did nothing, the monetary base would have probably shrunk.

At a minimum, the Fed is inflating just enough to replenish erosion in bank reserves and the market’s confidence. The thrust of all of its actions has been to cheapen money and credit and inflate.

That is not to say there aren’t any deflationary forces in the system — just not ones produced by the actions of the Federal Reserve System so far. If there is deflation in the system, stable money proves the Fed is inflating. If it were pursuing a deflationary policy, you’d have seen a few more Bear Stearns by now — and it is unlikely that the broader credit aggregates like M3 and MZM would be expanding so furiously.

Sure, there is a run on risk, and this risk aversion is causing some asset deflation, which in turn is producing a lot of short-term liquidity. So the Fed hasn’t had to create a lot of net new notes to push rates down, yet. Consequently, so far, it is merely underwriting a lot of the market’s current confidence, rather than monetizing it. But it does not necessarily follow from stable money supplies that the Fed is deliberating a deflationary policy.

The Deflation Equation Doesn’t Add Up

So deflation has not set in yet, but our normally credible source is still convinced that Bernanke is secretly pursuing a policy of deflation while pretending to inflate. But from the central bank’s point of view, the costs of such a policy are prohibitive. So why am I still listening to this “voice”?

Because it believes the Fed wants to hijack the gold market… In other words, the Fed is trying to quell the rise in the gold price.

A central bank’s general incentive to dampen gold fever is a given, but why would it want to so bad that it would be willing to risk political suicide? Our voice explains that some of the large bullion banks still hold massive derivative short positions in gold, which they borrowed from the central banks to sell into the market in the ‘90s. We have not heard any of them report large losses on those positions yet.

They are potentially huge.

But are they huge enough to motivate the Federal Reserve to orchestrate a deflation policy in order to save these banks from ruin?

The last genuine deflation in the U.S. (1929-33) wiped out almost all the banks. Are you telling me that the gold shorts held by a few select bullion banks can cause more total pain than a deflation policy?

I doubt it, especially since the central banks are so forgiving on the terms of the gold loans. This voice is right that the Fed is not expanding narrow money.

It is wrong about the Fed targeting deflation.

So Is the Fed Targeting Gold?

It should be. Bernanke may well be trying to keep the monetary base stable to discourage speculation in the gold and oil markets, while at the same time boosting confidence in dollar-denominated assets.

This kind of a balancing act (or “sterilized” inflation) is not foreign to the Fed’s modus operandi .

In fact, it was well accomplished by Bernanke’s predecessor.

Conclusion

While the idea that the Fed is deliberating deflation in order to undermine gold makes little sense, the fact that the monetary base is not growing is relevant and deserves further monitoring. Regardless of the explanation, when the central bank is not inflating, it is not bullish for gold. I say this even though, empirically, the relationship between money (i.e., M1) growth rates and gold prices is not cut and dry.

If you bought and sold gold based on the requisite changes in M1 growth rates, you’d be on the wrong side of the trade most of the time, at least since the ‘80s. You’d have turned bearish after 2004, missing the last $400 rally. It is important to monitor. But we live in a global world today. The effects of inflation produced by China’s central bank are felt in America, and vice versa.

It’s especially a bad idea to short gold. But it is a good time to pick away at values created by the “Chicken Littles” on the way up to $2,000 — if you believe that the Fed is inflating.

I’m not going to tell you that gold is going to go up whether we have deflation or more inflation. I don’t believe that. I believe gold prices would fall in a monetary deflation. But I don’t expect one soon.

Until next time,

Ed Bugos
April 4, 2008

The Fed, Your Money, and Gold was originally featured in the Penny Sleuth.

You tell yourself that these things are not fundamentally bearish for gold prices. One of them is even bullish. But you know the gold’s are probably due for a correction anyway, and any one of these, or other factors, is just as good an excuse as any fundamental when confronting a risk averse crowd.

What do you do?

You could weather the storm. You’re in it for the long term, right?

The trouble is gold stocks can fall a lot during even a typical correction.

Most everyone already knows that markets do not go straight up. If every dip led to higher and higher highs nobody would ever lose sleep over it. Trouble is, the company could always screw up, or one of those dips could turn into a bear market. I have seen the conviction behind many buy/hold strategies melt at the tail end of a normal correction, just because it is invariably worse than expected.

In my observations, investors are more likely to get bucked off a bull market because one of the corrections discourages them than because they took some profits by selling into strength.

Goldcorp, one of the world’s largest miners today, has already seen three corrections of 40-50 percent on the way up to $45 from its $3 (split adjusted) share price back in early 2001. That’s a 15-bagger! And it’s not over. Goldcorp will see a few more like corrections, and maybe one that’s even larger, on its way to $150. Hardly anyone who bought at $3 will still be aboard, and even fewer will sell the top.

However, there are ways to improve your long-term returns and reduce the impact of market volatility on your portfolio without ever having to trade in and out of your shares, and risk getting bucked off the bull too early. Options! Options allow investors to take advantage of leverage and limit their risk.

They represent a way to benefit from most of the change in the value of the underlying property, or shares, without ever having to buy it. Due to this leverage they can sometimes increase hundreds and thousands of percent in the space of a week, or even a day, as in the case of Bear Stearns Put options when the stock halved that fateful Friday before last. Consequently, they don’t only draw speculators; they draw gamblers ready to stake the farm on getting rich quick, by abusing the available leverage.

But gambling is in the method. If you don’t know what you’re doing, you’re gambling. Otherwise, you are speculating, hedging or investing:

Today I am going to show you how to “insure” a portfolio of gold stocks emulating the AMEX Gold Bugs Index against an “intermediate” correction using a few basic option strategies. The term intermediate just means like any of the other 4-5 corrections that are most evident in a chart of the 7-year bull market to date.

They averaged 10-15% prior to 2005, but with the accelerated rallies post-2005 they are more likely to look like the 27% correction in 2006 from now on. A correction in the primary (7-yr) sequence would be more like 40-50 percent, or more, which I’ve judged as a low probability event from these levels.

In any case, the first thing to do is nail down a few scenarios that you think are likely. That is, try to quantify the risks.

Let me walk you through some scenarios…

IF last week’s sell off is the beginning of an intermediate correction in gold prices, which is possible, gold could fall back into the $700-800 range and/or remain rangebound until next year.

The “tape” is telling us this IS the likely scenario. The gold stocks traded up with gold but they lagged it, as if they were tired. And not all of them participated. Many of the juniors sat out the last $300-400 gain in gold. The breadth of the advance was thus narrow and the leadership extended. And the way gold prices came off their peak is itself often a bearish marker, indicating more of the same to come.

I’m assigning this scenario a 35% likelihood, and a 10% chance of something worse. The most likely (55%) scenario in my outlook is that the bulls will hold the line at the $850-900 level for a few weeks, and then continue their unfinished business — i.e. developing a real top well above the $1,000 barrier.

But that analysis goes beyond the purpose of this article.

If you think the likely scenario is an intermediate correction, or worse, the easiest option strategy is to “write” (or short) a Call. Writing calls is effectively the same as shorting them, except that options are contracts representing but a “right,” so the short-seller is technically the underwriter of the contract. If the underlying asset goes up, he will have to either buy the calls back higher, or deliver the asset(s).

If you don’t own the asset it’s a naked short, and the theoretical risk is unlimited. If you own the asset, your risk manifests in the form of reducing or limiting your profit on the underlying position. Since we are talking about insuring a portfolio of gold stocks against a correction, we are talking about the latter.

In our hypothetical scenario, with gold falling to between $700 and $800, the HUI might fall to the 350 level, plus or minus 25 points — which is about 90 points (or 20%) below the current level of about 440.

A note of caution: In this example, I am assuming that your portfolio of gold stocks mirrors the HUI; if it does not, you are better off writing those calls on the specifically optionable stocks in your portfolio.

Otherwise, there can be no assurance that your risk will be limited.

Last week’s bid on the AMEX Gold Bugs Index (HUI) 375 SEP 2008 Call was around $8,960/contract — or U.S. $89.60 per each hypothetical index share. This means that if the gold share index falls below 375 before the option expires in September, you can pocket that entire amount less commission, and time value. You only start losing money on your underlying position if the HUI falls below about 350.

If the index falls less than expected, say to about 400, you might make between $20 and $60 points per hypothetical index share, depending on days left to expiry, which would likely cover the correction.

The downside is that gold shares brush this correction off and continue to truck higher, in which case you do not participate in any of those gains until and unless you close out your short call position.

It would not be advisable to buy Puts in this situation because premiums are too high to protect you against an intermediate drop, at least in the index. The SEP 2008 HUI 435 Put was offered at $54 on Thursday, which means it would cost you about 13% to protect your portfolio from a 15% correction.

It only makes sense to buy a Put to protect your portfolio from a much larger correction. If you thought the gold share averages were in for a nasty 40% decline, or more, then it would make sense.

Effectively, it would limit your portfolio against any losses that exceeded a 20-25% correction.

The nice thing about options is that they are flexible. There is a myriad of strategies available to suit almost any situation. You could write the SEP 2008 375 CALL and buy the SEP 2008 375 PUT, which would net about $5900 per contract and cover most of your downside, but eat into your gains more.

Alternatively, if you’re not so bearish you could write an out of the money Put…

Subscribers to my upcoming Gold and Options Trader will receive timely ideas and strategies designed to help the gold share investor protect his/her portfolio from volatility, and maximize their returns.

Until next time,

Ed Bugos
March 27, 2008

Option Strategies to Insure Your Portfolio was originally featured in the Penny Sleuth.

Now remember another one: “Don’t fight the Fed.”

Well, what happens when the Fed fights the trend, as it has been recently?

Which axiom to believe?

Historically, the Fed loses that fight until the trend is ready to turn back around. Admittedly, the central bank’s inflationary policies will likely help this occur at a higher nominal dollar value than otherwise.

Nevertheless, the historical odds favor the trend over the Fed when these two maxims collide.

But putting aside my autistic wisdom for a moment, let’s consider what the Federal Reserve is doing for the trend in gold prices — a trend, I am loathe to inform you, which it is not fighting.

Let me sum it up by reminding you that the trajectory of this bull trend shifted north when Bernanke took the helm of the Federal Reserve System, and that the policies pursued by the Bernanke Fed have confirmed the investment thesis driving the bull market in gold. As one pundit recently noted during a Bloomberg interview, “You gotta go with the inflation theme…it’s the only thing still working.”

After upping the size of its new Term Auction Facility from $60 to $100 billion last weekend, the Fed revealed another innovative tool that might help it manage liquidity in the banking system.

The new facility, the Term Securities Lending Facility (TSLF), will offer up to $200 billion in Treasury securities to primary dealers in exchange for a wide variety of collateral the Fed has never before accepted, including private-label mortgage securities. It also eased swaps with other central banks.

The controversy is that although the Fed has been allowed to accept mortgage-backed securities as collateral since 1980, it has never outright bought them, and only recently enacted legislation that allows it to actually monetize them — which means buying them without having to sell other assets.

Gold bugs have followed the Fed’s legislative changes with interest. This move should not surprise any of them, but it does hold a special significance in its long-term implications, and for gold prices.

And even though the Fed hasn’t expanded bank reserves or the monetary base much since August, it is helping the banking system postpone an increase in reserve demands triggered by criteria built into the Basel II framework, a generally accepted model for capital adequacy standards. By boosting the quality of bank reserves, even if temporarily, the Fed hopefully won’t need to increase the quantity of bank reserves, which have been sufficient to fuel an $800 billion expansion in the broad U.S. credit aggregate, MZM, since August. That is 11%, or 15% year over year. The highest rate since 2002.

That is a bullish recipe for the precious metals. There is nothing more bullish for gold than a situation in which the central bank refuses to acknowledge that it is pouring gasoline on a raging fire.

Forget the dollar and oil. Those were just interim preoccupations.

The real bull market is about to stand up.

If gold prices are going to continue to drive through $1,000, they are going to do it because the central banks are all inflating madly at the worst time. This means that a good old-fashioned bear market on Wall Street is sufficient to keep central bankers’ collective pedal to the metal and sustain the gold bull.

So far, the precious metals stocks have bucked the general stock market trend since August.

This is as it should be, and it is impressive because, by most counts, gold stocks are quite expensive relative to today’s gold price. But investors are complaining about the underperformance of those stocks relative to gold, and also about the lackluster performance of their junior mining assets, which haven’t participated in the precious sector rally at all since August — when the current leg started.

There are a few explanations for this.

Perhaps John Embry said it best at a gold conference in Vancouver, British Columbia, recently, when he remarked that gold shares sometimes act like a bet on gold, but sometimes they just act like plain old shares.

We should leave it at that.

However, that is not like me.

Historically, I have found that gold shares are susceptible to market declines, except occasionally during a major bull market advance in gold, when they tend toward counter-cyclicality — the more so as the bull market progresses. They will still fall during stock market panics, as all shares do, but they are likely to come back harder and hold their trends better. Still, since 2004, I’ve held the position that, as an asset class, gold shares would not outperform gold prices for the remainder of the primary leg.

I continue to think that, with the qualification that we are talking about the average gold stock.

Junior markets are wired differently. They do not correlate that well with the underlying commodity trend in the first place. In my experience, they correlate better with market attitudes toward risk.

Junior and small-cap markets have never fared well in a general market meltdown, because they are typically risky assets, and in a selling panic, the crowd is averting risk.

The larger-capitalization precious metal producers are different. The reasons for this are sound. But as a rule, speculative assets do well when the gambling environment is friendly.

However, within the small-cap resource sector, there will invariably be exceptions. Many of them are cheap now, and the supply fundamentals for gold are tightening.

Production from many gold-producing regions of the world is currently constrained by power shortages, and rapidly inflating development costs are causing the postponement of several otherwise promising development projects around the world.

Meanwhile, gold producers need reserves!

The large-cap producers are on the hunt for sound mining assets.

And they aren’t going to be discouraged by a 20-30% drop in gold or stock prices.

I’m lining up several potential takeover targets for my new report right now. These include small-cap gold miners that have either just finished developing a new mine or soon will be, or whose assets are otherwise overlooked. And we’ll be publishing option strategies to profit from swings in the large-cap miners, too. Regardless of which way the markets go, I’ll show you how to profit from trend changes…

Regards,

Ed Bugos
March 19, 2008

Hidden Gold Shares Will Play Well in Down Markets was originally featured in the Penny Sleuth.

Despite a persistent drop in annual gold production since the 1970s that has reduced output to an 85-year low, South Africa is still the second largest gold producer in the world. With gold and platinum prices breaching record levels every other day now, especially in terms of the struggling South African currency, you would think that investing in South African miners would prove to be a winning formula.

Yet many of the South African gold shares have all but sat out the bull market of the last eight years.

Smaller producers are trading near their worst levels since 2000. Harmony Gold Mining (HMY: NYSE) is up only 100% since 2001. Same with Anglogold. Gold Fields is up a little better (200%) since 2001. A 200% gain sounds pretty good, until you realize that gold itself has gained nearly twice as much over the same timeframe.

What’s more, the modest of gains of the South African mining stocks pale in comparison to the Gold Bugs Index (^HUI: AMEX), which is up some 600%; let alone some of the leaders of that group, such as Goldcorp or Agnico Eagle, which are up 800% and 1,300% respectively, since 2001.
  
Then, just when a soaring gold price started to breathe fresh life into the South African mining stocks, a severe electricity crisis struck the country. In late 2007, South Africa’s electricity utility, Eskom, started imposing “rolling blackouts,” due to an overloaded grid. The power shortage prompted Eskom, which provides 95% of South Africa’s electricity supply, to halt all electricity exports to neighboring countries. The crisis worsened nevertheless. South African mining stocks tumbled.

Five days later, the South African mining industry reported an emergency power outage that lasted several days — where all production was lost. The utility “indicated that the current quota of 90% of average historic electricity consumption will remain in force for at least five years, through to 2012.”

The problem of course is underinvestment, thanks to poor government planning. And unfortunately, no easy solution is in sight. Although Eskom and the South African government are trying to rectify the situation, no new power supplies are due to come on stream until 2012.  In the meantime, the mining companies must simply put up and shut up.

Like many other South African mining stocks, Gold Fields (GFI: NYSE) has slumped badly since the electricity crisis became a front-page story. But the truth is that this story has been on the back pages for quite a while, and Gold Fields has already been adapting to it.

South African operations comprise approximately two-thirds of the company’s operating mines. The rest lie outside the country. Obviously, the blackouts do not affect the foreign operations.

In a teleconference, management said power has been tight for three years already, but Eskom’s latest announcements have acted like a catalyst, forcing the company to prepare for the worst going forward. But the worst is not that bad for Gold Fields, which is why its stock seems unjustifiably cheap.

Gold Fields expects its South Africa production to fall as much as 25% this quarter, then 10% to 15% on a “steady state” basis thereafter. After considering its international operations, this translates into a 15% production shortfall this quarter, and afterwards management expects growth in its international assets to offset the domestic decline and fill the void altogether. The company expects operating costs to increase by up to 25% this fiscal year, but gold prices are already up 50% on GFI’s averaged realized FY2007 prices. So these rising costs should not reduce profit margins.

The South African electricity crisis is just the latest in a series of short straws that the South African miners have drawn, and that have worked to depress valuations in the segment. The first blow occurred in 2003 when mining companies in South Africa were required to give up 26% of their interests (over 10 years) to the locals — under the Black Economic Empowerment (BEE) charter. Since then, the industry has faced several obstacles, from a strong Rand (2002-2004) to soaring labor costs, to safety problems at some mines.

Technically, the climax in bearish sentiment occurred in 2005. The current crisis is anticlimactic. That’s where I see a potential buying opportunity in Gold Fields…

The stock market is valuing each of Gold Field’s proven and probable gold ounces in the ground at only U.S. $110. That valuation is less than half the market valuation of Newmont’s reserves — which boast lower grades and less exploration potential.

But just comparing raw values…

In terms of its overall “measured and indicated resource,” Gold Fields is trading at one-fifth of Newmont’s value.

At a $10 billion market capitalization, the market values Gold Fields roughly equal to the intermediate producer Agnico Eagle, a Canadian company with only 20% of the proven reserves that Gold Fields controls, and only 10% of the probable reserves, and only 25% of the annual production. In other words, Agnico Eagle is roughly the size of Gold Fields’ international assets. At these prices, that’s like getting Gold Field’s South African operations free!

This comparison demonstrates the dramatic difference between investing in gold shares and investing in gold itself. The investor who buys gold does not worry about operational risks, or rolling blackouts or the valuation differences between various types of mining companies. The investor who buys gold, owns gold…pure and simple.

But the investors who buys gold shares assumes a variety of risks…and potential rewards. Now that the South African mining stocks have lagged behind the gold price for so many years, and have also suffered from the recent electricity crisis, they probably offer a lot more reward than risk.

The electricity crisis in South Africa may well represent a small window of opportunity to buy some of the best quality mining assets in the world on the cheap. 

Regards,

Ed Bugos
March 12, 2008

Editor’s Note: As always, send any questions or concerns to us at jim@pennysleuth.com

The Nearly Free South African Opportunity Made of Gold was originally featured in the Penny Sleuth.

In December, the gold price raced off to record highs for the first time in almost three decades. Now it looks to be closing in on 1,000 U.S. bucks. That is, four digits. It will also be four times the 1999 low.

The market has added dollars to the gold price for seven consecutive years now, making it the longest-lasting such stretch in history without more than a 25% correction. Even in terms of magnitude, it is the best move since 1979-80. This suggests two things right off the bat. First, it is a bull market; second, the market needs to blow off more upside if it is to give the bears anything more than 25%.

(Although, this latter idea does rest on a few other premises.)

John Kaiser of the Kaiser Bottom-Fishing Report believes the market is nearing a flashpoint where the skeptical public finally turns into believers and comes rushing in. It’s pure mathematics from his point of view. He reasons forecasts for gold $2,000 are more plausible now that it is but “a mere double”!

It may be a little early to say that gold bugs have been proven right.

Undoubtedly, it is getting tougher for the bears to argue that they have been wrong.

But what exactly might they be right about?

Gold Is Sounder Money!

The market has once again started looking at gold as money, rather than as a mere commodity. The following excerpt from the Jan. 8 Financial Times article, “Gold Is the New Global Currency,” highlights this increasingly frequent theme in the leading financial papers:

Gold’s rise shows investors are nervous. That is an important message for central banks contemplating interest rate cuts. The Fed must show it is not prepared to allow inflation to take off. Keynes called gold a barbarous relic. It has life left in it. But it is in the interests of business and consumers that its most bullish fans are proved wrong.

I like this quote because it highlights two important and typical contrasting insights.

The first underlined sentence reveals the most important rule that the Fed and its peer central bankers are breaking, which is one of the main factors driving gold prices higher today. The second underlined sentence reminds gold bugs that their clairvoyance is unwelcome and unhelpful, just in case they feel any vindication in others’ misery. This will continue. As legendary broadcaster Ed Murrow once said, “Most truths are so naked that people feel sorry for them and cover them up.” This is one of those.

But that won’t make it go away.

The fact that getting rid of a dishonest monetary regime might cause depression is a bad reason to stick with a system that promotes that injustice in the long term. But if central bankers want to preserve such a system, above all, they must avoid prompting too many headlines like these:

• “The Helicopters Start to Drop Money” — Financial Times, Dec. 12, 2007
• “Cheap Money Is ECB’s Answer” — Wall Street Journal, Dec. 12, 2007
• “World Bankers Resort to Firebreak” — Telegraph, Dec. 15, 2007
• “Flight to Gold as Investors Lose Faith in Money” — Telegraph, Jan. 6, 2008
• “Bernanke Opens Door to ‘Substantive’ Rate Cuts” — Wall Street Journal, Jan. 11, 2008

One of the mainstream criticisms of the Bernanke Fed is that it should have lowered interest rates sooner and more aggressively. One reason it didn’t was because Bernanke had tried to fight the spreading of the idea that the Fed was going to continue inflating. But that resolve is now buckling under peer pressure. We are probably not yet at the inflection point where the public has become convinced the Fed will inflate endlessly, but recent actions are not helping to discourage this expectation.

So prices will continue to rise, eventually resulting in unemployment and some sort of depression.

The pundits will call it stagflation.

If the Federal Reserve fails to heed the aforementioned rule by then, it’ll lead to hyperinflation, or worse. So far, there is no reason to believe that it plans to abandon the inflationary policy.

What with squadrons of central bank choppers swarming like locusts over the major cities on both sides of the Atlantic, hurling bank notes into the thinning air as gold, oil and wheat prices charge to record highs, it would seem rather that central bankers believe money should be able to grow on trees.

Central bankers continue refusing to accept the idea that the cause of these crises is their very own inflation. In a recent interview I read, an old partner of Milton Friedman’s, Anna Schwartz, was the first of her kind to point out that Greenspan was responsible for the current crisis by keeping rates down too long. But she said that mistake is behind us now and the current Fed should step up to the plate and inflate like mad in order to prevent making the mistakes of the 1930s Fed.

What were those mistakes?

Apparently, Washington and the moral ethics of Fed officials prevented the Fed from inflating after the 1929 stock market crash. This thinking is a prerequisite for central bankers. They ignore the fact that the ultimate cause of these crises is the intervention required to manipulate interest rates.

That is, inflation.

Until they change their thinking (they probably won’t), and while the pool of skeptics about this evil remains large, gold has nowhere to go but up. We will continue to have booms and busts and crises, and price and interest rate spikes, and wars, and so on as long as paper money backed by nothing remains the motive power of the world economy. Thus is the general message of gold bugs.

Don’t shoot the messenger…

Regards,

Ed Bugos
February 4, 2008

P.S.: When gold is on the rise, it is usually accompanied by its little sister, silver. This bull market is no different. Silver is hitting new highs along side gold. In spirit of this silver surge, your editors Greg Guenthner and Jim Nelson have recently recommended one tiny junior silver miner, that will be taking over as the industry leader in a few short months. Now is the time to get in on this penny stock.

Lowered Interest Rates Bring Higher Gold was originally featured in the Penny Sleuth.