The Bullish Case for Gold Mining Stocks

We have been invested in a mutual fund whose manager specializes in gold mining stocks.  His 5-year and 10-year annualized returns have been 24% and 25.4% respectively. His return for 2009 and for the seven months ended July 31, 2010 were 86.6% and 13.7% respectively. Most advisors recommend a gold holding in a range of between 5% and 10%.  After the run gold stocks have had, it seemed appropriate to review the arguments for continued investment in gold mining stocks.

Dr. Martin Murenbeeld, chief economist for Dundee Wealth Economics and an expert in gold investing, has released a chart book containing hundreds of visuals on gold and commodities. Many other money managers and writers on the subject have published articles on this subject. We will attempt to summarize their key points as concisely as possible.

Times of Turmoil

Gold prices rose to an all-time high in 1980 as the Iran hostage taking and the Soviet invasion of Afghanistan generated worldwide fears of an outbreak of war. In the current environment, Iran's pursuit of nuclear-power status in the Arab world is raising fears of an Israeli pre-emptive strike. Iran, Hamas and Hezbollah would surely retaliate. America would not be spared, as we are seen as the supporter of Israel. North Korea also is pursuing nuclear capability to protect the dictatorship of Kim Il Sung. Venezuela is also pursuing a military buildup. Wars and rumors of wars will continue in the twenty-first century, and that condition supports the holding of gold and gold mining shares.

Threats to Fiat Currencies

The United States, Europe, and Japan are awash in debt, trying to keep their economies going. These debts are growing relative to the gross domestic product output. If the trend continues, one or more countries can essentially wind up bankrupt in this regard, their debt obligation notes and bonds will no longer be accepted by other countries and their currency will no longer be acceptable as a medium of exchange. This actually happened to Argentina in the 1990s. Argentina did survive, but there was a lot of economic pain before it emerged as a going concern. Gold and gold mining shares provide protection against the debasement of a countries currency. As fears of a protracted economic malaise continue, gold prices should continue to move higher. 

Central Bank and Government Purchases

Central banks and the governments of Latin America, India and China are buying gold to build reserves. They are fearful like the rest of us. They want protection against debasement of their currencies. India has purchased 200 metric tons from the International Monetary Fund in the fourth quarter of 2009. China has built up its reserves from 395 metric tons in 2001 to 1,054 metric tons in the first quarter of 2010, according to Dr. Murenbeeld. If the bastions of conservatism are plunging into the treasured metal, spurring demand for tons of bullion, who are we to second guess them.

Investment Demand

Gold is being increasingly thought of as part of a separate asset class, under the general heading of Commodities. However, over the past couple of years, demand for most commodities has been flat while the demand for gold has soared. Certainly fear of currency debasement plays its part in driving the thinking that commodities should be considered an asset class and that every portfolio should have some allocation to them. In no recent period was the demand more apparent than in the second quarter of 2010 when gold purchases increased 118% over the same period in 2009, and accounted for over half the total demand for gold, according to Dr. Murenbeeld.

Commodity Price Cycles

Commodity price cycles tend to last by multiples of decades, not just a few years. Dr. Murenbeeld has traced gold cycles going back to 1800 and he found that the shortest cycle was ten years. The current bull market in gold began in 2001. The last great run started in 1968 when gold was $200 an ounce and run up to over $1,600 an ounce in 1980 before crashing down to$380 in 2001. The bullish run before that started in 1920 at $200 and ran up to aobut$580 in 1932 before slowly declining to $200 in 1968. Gold may have a few more years to extend its current bullish run. Investors look to decrease the up-and-down volatility in their portfolios and it is thought that gold contributes to a decrease in volatility in the short-term. However, based on cycles, there is significant volatility during 10 plus year periods.

Jewelry Demand

Out of the total of 1050 metric tons of gold sold during the second quarter of 2010, 407 metric tons were sold for production of jewelry. Asian markets, especially India, saw consistent demand. Jewelry is especially large in India because gold is a traditional gift for weddings and religious events. As the savings rate and general prosperity increases in Asian countries, demand will grow.

Industrial Demand

Computers and consumer electronics such as cell phones contain gold. In fact, industrial demand of the computer electronics segment increased 14% in the second quarter of 2010 compared with the same period last year. Gold is a highly efficient conductor and is found in relays, soldered joints, connecting wires and connection strips. Gold is also used for Olympic medals, Oscars, Grammys, crucifixes, ecclesiastical art, glassmaking, dentistry, etc.

Gold Supply

Worldwide mine production is running about 2,500 metric tons annually. While this is a 25% increase from the 1990 production figures, there are storm clouds on the horizon. Discoveries are fewer, they are lower in grade, and replacement costs are higher. These will constrain production growth and prices of the precious metal should rise, taking supply constraints alone.

Conclusion

Economic uncertainty is bound to continue in the world for several years, maybe for the next decade. If the cycle for gold and the history of 10 to 12 year bullish runs repeats itself, gold and gold mining shares have only a few years of appreciation left. Short term rallies and corrections are to be expected in a volatile world and volatile markets. Future performance in any investment cannot be predicted. For now, we continue to like our gold mining company mutual fund pick.

Sources for this article were as follows: