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Intrinsically Coupled Leverage: Are Mining Equities the Blue Chip Stocks of Tomorrow?

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If we take a look back in time to one of the most horrendous economic hardships ever faced in the United States – The Great Depression, we find that Homestake Mining and Dome Mines were two gold producers that made their shareholders wealthy during that time period.

Before Barrick Gold acquired Homestake, I used to be fond of stating that from the original Dow companies Homestake, was one of the few originals! In other words, gold and gold mining, truly stands the test of time.

Much of the current economic commentary today revolves around a large contraction in the financial landscape, with the Baltic Dry Index hitting lows, some of the largest banks being basically insolvent, and even China showing clear signs of slowing considerably. Many financial commentators are clearly looking for a possible recession or deflationary period before the Central Banks can force currency into the system and get inflation started again on Main Street.

At the peak in 1938, a $1,000 investment in Homestake grew to $6,760! However, this is only part of the story because this is nominal growth, but during this deflationary period every “dollar” is more valuable over time.

Moreover, during the next six years Homestake Mining paid out a total of $128 in cash dividends. In fact the 1935 dividend alone reached $56 per share. That’s almost a 70% dividend yield payout (basis 1929) in only one year! Indeed, hard asset investments (gold mining shares) were islands of economic refuge during the gruelling years of the Great Depression.

We must remember that gold was revalued, exploding the margins for gold miners. It was hard to lose money when your newly hiked sales price was guaranteed and your costs stable or falling. It was a bonanza of gargantuan proportions. The Hearst family, which controlled the Homestake mine, rewarded themselves, and minority holders, the bounty via dividends. Today, it’s hard to imagine any gold miner paying out most of its earnings in dividends, however paying “handsome” dividends is certainly probable.

So where does this put us today? First we need to clarify that gold is a crisis hedge and not only an inflation hedge. As the above example clearly illustrates, gold mining did extremely well during the 1930’s depression. However, we need to realize that gold could not be owned by U.S. citizens during this time, gold had been revalued upwards, costs were decreasing, and the only proxy for gold ownership was through the mining equities.

Further, if one is to study Professor Roy Jastram’s work, “The Golden Constant” is a unique examination of how gold’s purchasing power has remained consistent over the centuries. The book is the only in-depth examination of how the purchasing power of gold has performed over the centuries in both England and the USA. It contains a thorough explanation of how the gold market evolved and how this is related to economic and political developments, from 1560 in England, and from 1800 in the USA. I can state that academics, economic historians, and economists interested in monetary and financial history will find this book extremely valuable.

What is not always evident is that during much of the analysis, the world at large was on a gold standard or had some tie to gold, which means to analyse the market in terms of a system with no tie to gold whatsoever, requires looking at that metric.

It has been examined numerous times and determined that every time a “monetary system” (read – currency) was not tied to money, (gold and/or silver) there has always been a failure of that currency. Period. End of story. There is not a single exception to this fact. Yet, today we find many in the academic and economic realm that either insist it cannot happen, or that paper (currency) will trump gold. Yes, that for the first time in all of recorded history, that a piece of paper (digital currency) will reign supreme over a substance that has been known as money for thousands of years. It must be stated that authorities in many jurisdictions are implementing requirements for no cash transactions, and fully digital systems. In other words, the effort is being made by the banking system at large to make sure that paper does win over gold.

IS IT DIFFERENT THIS TIME?
In certain ways it is different, because the failure of the reserve currency of the world, the U.S. dollar will affect nearly every person, business, bank, and financial institution on the planet. Furthermore the demand to escape the financial breakdown is unlimited when one asset class – precious metals, is sought by anyone and everyone that is motivated by fear of losing their security based upon a faith in a system that is failing before their eyes.

Every time this psychological shift in conscious has taken place in the past, it is swift and moves in an uncontrolled manner, which means all the propaganda from the mainstream press cannot stop the “run to gold.” It is possible with the very tight and strongly held positions in both gold and silver, that they will become unobtainable in size. Which means large hedge funds, ETF’s, Sovereign Wealth Funds, etc., will not be able to find gold or silver in the quantity they want and the price will be bid up to extremely high levels.

Every time there is a financial panic, fear drives the decision process and clear judgement is rare. If we truly witness a run to gold, the large
gold dealers may decide to keep their inventory and not transact business until the currency markets stabilize.

All of this seems almost fanatical because these types of events occur rarely in history and usually skip generations so there is little memory of the hardship imposed by a system that pretends to print wealth, when in fact it must be produced.

All of this, leads to the reason that the mining shares could go into a once-in-a-lifetime bull market extreme that has not been seen since the 1930’s, because when people cannot buy gold or silver- they will race to the mining shares as a proxy for gold and silver in the ground.

Think about it…You run a huge hedge fund and see what is coming ahead of your peer group. You cannot buy physical gold because the mandate is that for you and many in the industry, you are not allowed to buy commodities. This is the main reason ETF’s were started, to comply with legal regulatory issues because ‘stock only’ restricted money managers are allowed to buy them, even though in theory they are buying physical metal.

Back to the main point; there are so few top-tier precious metals companies, that the amount of money flooding into these issues will take them to extreme valuations. Because the costs of extraction are dependent upon several factors with energy being the most important, the margins could be compromised, depending upon how the oil market does during a financial crisis.

Regardless, the overall margins in the mining shares could be so unbelievable that the normal leverage of about three-to- one, could go to something like ten-to-one for the major companies, and well beyond that for the mid-tier and junior miners.

The real question to ask ourselves is what the financial landscape would look like after the initial panic move into the precious metals, which could fuel a historic rise in the mining shares. If the move is parabolic and unsustained, then we would need to think of this as a trade only. However, much more likely in my opinion, is the financial establishment will be forced to implement gold back into the monetary system, and at a much higher value than present.

This implies that the margins on the mining shares would be significant for a long period of time, and the dividend payments
would be sought after by income seekers, pensions, insurance companies and many others. This would over time, place this investment class into a “utility” type of mentality but based on real money.

There is little doubt that regardless of the future outcome, the rise in the precious metals that lies ahead of us will be historic in nature, and as it is often stated; perhaps ninety percent of the move will be achieved in the last ten percent of the time, which implies that what lies ahead for precious metals will certainly go into the financial record books.

 

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