Sunday, July 30, 2006

HOW WILL GOLD STOCKS PERFORM IF THE STOCK MARKET CRASHES?

By Greg Silberman29 Jul 2006 at 11:58 AM EDT


ATLANTA - I have been receiving lots of e-mails from subscribers asking me what I thought would happen to gold stocks if the stock market (SM) crashes.
Before I answer that I would like to chime in and say I find it very interesting that the question is even being asked.

Inflation / Deflation Argument (Yet Again)
Many readers have told me I’m outright NUTS for considering a SM crash. Now I accept they may be right, I probably am nuts but certainly not for considering the possibility of a deflationary SM meltdown.

Inflationists tell me the Fed would step in to avert a crash the same way the did in 2000 to 2002 - MASSIVE monetary inflation! They tell me nominal prices just cannot go down in a material way when the Federal Reserve is ready, willing and able to buy up every asset with newly printed dollars.

Their arguments are very persuasive. I mean, who wouldn’t accept a check from the Fed for the original purchase price of your home even whilst its value is catering?

I think the inflationist view is flawed for one major reason.
Psychology!

Most of us have now felt the rising level of fear that accompanies War. We’ve seen it either in our stocks, in the worried faces on TV or merely talking with friends and family.

Confidence is a very fickle trait. When it’s with us we feel as if it will never depart. When it leaves it disappears so quickly we are convinced it can never return.

As we speak, the same dynamic is underway in the Stock Market. Confidence can and is being shattered in an instant and irrational behavior will take over in a heartbeat!

Yes, the Fed can turn on the monetary spigots, and yes they probably will. But based on debt levels and a World War, the speed and ferocity of this collapse will be BREATH TAKING.
The Fed may (believe it or not) find all out inflation to be too costly.

If the world is crashing around you and some Government official tells you that they will buy your assets, your home for example, for exactly the same amount of money you paid for it 1 year ago, do you honestly believe that original $500,000 would buy you the same goods and services today as it did then? Of course not, all prices would adjust accordingly. That’s inflation you say! Hear me out.

The U.S. borrows a ton of money from the rest of the world. In effect, the greatest asset the U.S. possesses is its capital markets and its reserve currency. What do you think foreign debt holders (who stand to lose the most from reckless inflation) would do if the Fed started swapping assets for paper as above? They would dump our debt and our dollar and destroy our biggest assets.

There is a cost to too much Inflation and that is the destruction of our reserve currency and our capital markets. Now unless you think Americans are willing to commit outright financial suicide (I don’t) then mark my words, the inflationary route may prove too high a cost and deflation may be allowed to have its day.

After Deflation

What happens after deflation is another story altogether. After enough debt has been cleansed (through bankruptcy) there is much less risk of monetary inflation destroying capital markets. Then it will be no holds barred and most likely hyperinflation.
You like roller coasters? I hope so because we’re on the big boy!

Gold Stocks

There is no denying that gold stocks have sold off with the stock market even though the price of gold has been rising.

The fact that gold stocks fell whilst physical gold rose does not surprise or worry me at all. It is quite common that during an advance gold stocks get ahead of physical. This can result in physical ‘catching up’ after gold stocks have topped out - and we see this divergent behavior.

However, the correlation with the stock market is the million dollar question. Yes, gold stocks are equities and yes, they will be influenced by the broader stock market. But fundamentally gold stocks are counter cyclical because the product they mine moves in an inverse relationship to paper assets.

Once irrationality sets in and the stock market really starts to fall I would say, based on recent experience, gold stocks would initially fall alongside.

However, at some point investors in gold stocks will focus on their business and not the fact that they are stocks. When will that happen? When the fed starts to panic and ‘attempts’ to restore confidence through the printing press.

Keep your eye on the BIG picture:


Gold stocks (red) vs. S&P500 (blue) vs. gold/HUI ratio (green)

Rest assured, the stock market and gold stocks will ultimately detach and gold stocks will perform their counter cyclical duty.

Chart 1 shows how gold stocks rallied whilst the stock market fell during late 2000 – 2002 (grey block). In fact, chart 1 shows gold stocks led gold bullion higher (green line HUI outperformed physical gold) during the panic moments of the SM crash.

Will gold stocks violate long term trend lines? How low will gold stocks go before detaching from the SM? The answers to these questions are unknowable at this time.

So what do we do? When faced with a credible risk to your position it is prudent to purchase put option insurance.

Copyright © GoldandOilStocks.com 2006

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