What’s Driving Gold and Gold Stocks (Part Two)

Justice Litle, Editorial Director, Taipan Publishing Group

In part two of “What’s Driving Gold and Gold Stocks,” Justice looks at the reasons why 2009 could still be a great year for the yellow metal (and the companies that mine it).

As we explored yesterday, the near-term outlook for gold and gold stocks has cooled off a bit. But I continue to believe that gold stocks could be setting up for one of the best trades of the year, once this short-term cycle plays itself out. Here are a few reasons as to why.

Bullish Gold Stocks Reason #1: Excess Volatility.

In normal market conditions, a sudden upswing in volatility can be a powerful sign... a “clue” of sorts that an important shift is taking place. If the big surge higher or lower comes with above-average volume to match, that’s an even more powerful indication that “something’s happening here.”

But with that said, it’s important not to look at charts in a vacuum. Rather, one should try and make sense of the logic behind these moves to determine what’s likely to happen next. What drove the buying? What drove the selling? Are those drivers lasting in nature, or subject to quick reinterpretation on the fly?

In terms of gold and gold stocks, the market has been in a near-constant tug of war with itself over some very big questions for months now. Will we have inflation? Will we avoid deflation? Did we just see the bottom? Was that just a sucker’s rally? And so on.

The level of uncertainty regarding these key questions – whether we will see inflation, whether the present recovery is for real, and so on – has played a big part in whipping gold and gold stocks this way and that. The crisis protection dynamic has further swung sharply in and out of favor along with investor moods.

And because those feelings of uncertainty have been so constant and intense, large volatile swings on the chart wind up carrying less weight. When Mr. Market turns into a neurotic, in other words, he just needs more elbow room. From that perspective, the bigger picture for gold stocks remains attractive in spite of the excess volatility... or at the very least, the “signal” should not be discounted too heavily by the extra “noise” we’re getting now.

Bullish Gold Stocks Reason #2: The “Wall of Money” Cometh.

As John Dizard in the Financial Times sharply puts it, “However bumbling the execution, the Treasury’s wall of money is hitting like a slow-motion tsunami.”

This is very true. Investors haven’t yet gotten their heads around the incredible measures taken so far to fight this global crisis. For example, the U.S. government and the Fed have already “spent, lent or committed $12.8 trillion,” according to Bloomberg – roughly an entire year’s worth of U.S. economic output.

If that doesn’t raise your eyebrows, consider this: The U.S. government has already spent three times as much as what was spent fighting the first Great Depression (in proportion to then-versus-now GDP). And we may not even be through the worst of it!

Meanwhile the Fed’s balance sheet has topped $2 trillion with a clear trajectory towards $3 trillion... and the rest of the world is getting into the multitrillion-dollar stimulus game too. The G20 meetings in London led to commitments of $1.1 trillion. The European Central Bank is quietly loosening up accounting rules for Eastern Europe. Fiscal watchdogs in the U.K. have warned that Britain is on the verge of heading toward Banana Republic status thanks to its big spending. Countries wrestling with deflation, like Switzerland and Japan, are on the verge of nuking their currencies and kicking off another major round of “competitive devaluation,” also known as “Top This” or “I Can Print Faster Than You.”

All of this is wildly, radically, mind-blowingly unprecedented. The scale and scope of what we are seeing now has simply never been dreamed, let alone tried. Against this backdrop, gold is the only alternative currency not subject to the whims of a printing press... and gold stocks are leveraged to the price of gold.

Bullish Gold Stocks Reason #3: Many More Banks Could Fail.

Texas billionaire Andy Beal – described as a “56-year-old poker playing college dropout” by Forbes – is looking like the smartest banker in America thanks to his moves of the past few years.

The eponymously named Beal Bank, which Beal 100% owns himself, made virtually no deals between 2004 and 2007. Instead of working, Andy Beal spent much of that time going out on long lunches, playing backgammon and racing cars, all to resist the temptation of doing something dumb. At the height of silly season for the rest of the banking world, Beal’s friends were getting a constant earful from him about how the world was awash in “stupid loans.”

But now that most other banks have either blown themselves up, puked their guts out, or both, Beal Bank is stepping out big time, raiding the distressed loan market with a huge war chest of cash. The billionaire expects to make a killing, calling it the opportunity of his lifetime.

That doesn’t mean he thinks the bottom is in, though. Here is Beal’s prediction for his lemming-like competitors: "Banks are on a prayer mission that somehow prices will come back and they won't have to face reality... Unemployment is going over 10%, commercial real estate hasn't even begun collapsing and corporate credit defaults are just getting started.”

Beal further thinks as many as 4,000 more banks would fail if they were forced to provide a true accounting of their toxic-asset-ridden balance sheets. These banks have seen a short-term fix in the suspension of mark-to-market accounting rules (as noted yesterday), but that doesn’t improve their true health.

If we see another round of bank failures, investors will quickly revert to crisis mode and start loading up on gold stocks again. If the Treasury, Fed and FDIC try to prevent a new round of bank failures from happening, on the other hand, the only option they’ll really have is throwing yet more stimulus at the banks... shoveling hundreds of billions more into the gaping maw. The dawning of that reality could crush the rally in financials and, in turn, boost gold and gold stocks.

Bullish Gold Stocks Reason #4: Consumers Not Out of the Woods.

Another scary development is the upcoming wave of “mortgage resets” – the calendar-driven process by which a low monthly mortgage payment suddenly transforms into a high monthly mortgage payment.

As of now the pig is less than 40% of the way through the python, meaning more than 60% of U.S. homeowners signed up for a mortgage reset haven’t been hit with the higher payment schedule yet. Just stop and think about the implications of that for a second.

Worse still, if one matches up the timing of the reset schedule with the price arc of the housing bubble, one sees that the wave of resets about to hit corresponds to the highest prices paid (all those poor folks who top-ticked with their buys in late 2006). Those resets are going to big and nasty.

That means the coming hit to consumer wallets will be a doozy... which in turn argues for another inevitable massive round of consumer belt-tightening, with knock-on effects for the U.S. economy and a further big drop in the value of all kinds of consumer-related bank loans.

On its face, the news of yet more consumer contraction is deflationary, not inflationary. But you have to remember that as the situation grows more extreme, so will the extreme countermeasures instituted by the Treasury and the Fed.

When the fire department has to battle a raging house fire, in other words, they don’t worry about first determining the appropriate quantity of water to use. They just set out to drown the fire as quickly as possible with overwhelming liquidity. The government will inevitably do the same thing, and they will overdo it by a very large amount.

There is an element of political calculus in here too. The Obama administration inherited this crisis from the Bush administration. That means the problems of first quarter 2009 could logically be blamed on the “other” guys.

But if we see a return to darker days now, after the big market rally and after the new administration has had time to settle in, Team Obama (and Turbo Timmy at the Treasury especially) will take the blame full-force from the American public.

This reality will concentrate White House minds, and give them even more impetus to bring out the heavy-duty fiscal artillery in the event of a return to economic crisis mode.

What’s more, with the media finally buzzing about how grossly conflicted this White House is – the latest bit of news being top economic advisor Larry Summers’ multimillion-dollar payouts from the hedge fund industry and Wall Street – it is further likely that the next Hail Mary pass from the Obama camp could involve some form of check-writing directly to consumers. That would set us up for one heck of a light show.

Bullish Gold Stocks Reason #5: Cramer Called the Bottom.

The pièce de résistance: “Mad Money” madman Jim Cramer declared an end to the depression last week, telling his TV audience it was time to buy bank stocks with both hands once again. That call took some real chutzpah, especially coming from the guy who, just over a year ago, pounded the table while shouting at the top of his lungs, “Do not take your money out of Bear Stearns!!!”

With all due respect, Mr. Cramer, sir, I think I’ll pay more attention to Andy Beal.

I could give you more, but that feels like enough for now, so here’s the bottom line. As impressive as the recent stock market rally has been... and it’s been a doozy, giving the S&P its best four-week winning streak since 1933... odds are strong, nearly overwhelmingly so, that we are not out of the woods yet.

And even if we are out of the woods and off on a romp to reflationville, a certain piper still demands payment for the global ramming and jamming of multitrillion-dollar paper stimulus on a scale never before seen or comprehended in all of human history.

So that gives us two ways to win: If we go back into crisis mode as banks implode and consumers get hit with reset shock, gold stocks could run again just as they did in the 1930s.

If, on the other hand, we safely transition to a stimulus-driven “funny money” recovery in which paper assets get bid up to the moon, inflation will make its late-but-grand arrival and gold stocks will party.

These are the key reasons I still think gold stocks will eventually, if not sooner rather than later, set up for one of the biggest slam-dunk trades of 2009.

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