Gaineswood Market Transformation (May 2012)

7/31/2019 Gaineswood Market Transformation (May 2012)

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CreditMarketTransitions:AnHistoricalTemplate(May2012)

Contents

Overview ............................................................................................................................. 1

The Great Transition to Lower Corporate Profitability ..................................................... 4

Gold & Gold Mining Equities: The Precursor Stage ....................................................... 12

The Adjustment Period: Rejecting the Null Hypothesis .................................................... 19

The Aftermath: Returning to a New Normal.................................................................... 35Conclusion ........................................................................................................................ 37

Disclaimer......................................................................................................................... 37

Overview

There is an old saying among economists: the cure for high prices is high prices. What they

mean is that if the price of something used in the economy is too high, then this elicits acorrective response. Either people will rush to compete and supply more of it, or buyers will

substitute other things for it, reducing demand. This maxim is also a forecasting tool. What it

tells us now is that corporate profit margins are probably peaking. This would at best place a

ceiling on stock prices for many years ahead, or cause a decline.

Gaineswoods model of long-term trends in corporate profit margins would be in equilibrium if

S&P 500 inflation-adjusted per share earnings drifted from the present Wall Street consensus

forecast of over $100 to less than $75 over the next decade. If inflation continued at its present

rate, the nominal outcome would be flat earnings. Note that in the 1980s, which were relatively

good economic conditions, real earnings for the S&P 500 fell 30% from the 1979 peak by 1987,

and increased rapidly after the stock market crashed that year.

Corporate profits are now more than two standard deviations above a multi-decade mean,

specifically higher than about 99% of other observations. Because of the extreme divergence,

our degree of confidence in forecasting a drop in margins is high. We reviewed nearly a century

of data, and found two earlier periods when this was also the case: the 1930s and the 1970s.


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In revisiting this data, we found there was one thing that was common to these two eras and

the present time, which did not occur in other times. These periods began with low gold prices,

and concluded with a gold price that went shockingly higher. In both past instances, the price of

either bullion or companies that produce it corrected some after these eras were over, since

they overshot. But even after this, the dollar and other currencies were permanently devalued

or you could say gold was revalued by a lot.

Gold is therefore the one exception to the cure for high prices adage. Why? Because the

cumulative supply of gold mined since the beginning of mankind is rather constant. Currencies

and credit expand often rapidly thus stretching their number of units relative to ounces of

gold, setting the stage for periods when gold catches up. One corrective response to this

situation can be reduced supply of credit and currency (deflation, austerity, and default), which

reduces the volume of these tokens of value to their old ratio relative to gold bullion. Another is

a rise in the gold price that pushes the aggregate value of the yellow metal to its former level

relative to currency and credit. Its just like the cure for high prices example, but due to golds

inability to be synthetically manufactured, its price is the thing that adjusts, not its volume.

We note that gold can be fabricated in the futures market, and these paper ounces couldchannel demand into derivative liabilities. This creates the potential for a short squeeze later in

the cycle. The Hunt brothers established a derivative asset this way in the 1980s by being long

silver futures. They attempted to squeeze the physical market by demanding physical delivery,

but were foiled by regulators in 1980. Regulators have been investigating a large short position

in silver futures by J.P. Morgan for several years, but to date no action has been taken. The

bank claims this is a hedge, but it may simply be a derivative liability. Excitement over the

potential for a squeeze was probably the main cause for the silver price to spike to $50/ounce in

April 2011.

Some believe in conspiracy theories that the Fed or the BIS are acting behind the scenes to

suppress the price of gold during the entirety of the present adjustment cycle. Suppose weconcede they may have a point. Then the significance of our research would be that it

establishes a linkage between corporate profits and gold. Maybe a small and arcane gold

market can be suppressed, but a financial ecosystem containing reflexive relationships would

overwhelm interventionists, just as the London Gold Pool failed spectacularly. To this list one

might add the gold standard itself, for governments could no longer suppress the price in the

early 1930s or the early 1970s, no matter how proficient they were at printing money.

For those interested in long-term ratio analysis of gold relative to the money supply and Fed

balance sheet accounts, see The Case Against the Fed(Rothbard, Mises Institute 1994) and

updated calculations in Endless Money(Baker, Wiley 2009), or many internet sources. These

typically place the value of bullion at over $10,000/ounce assuming gold were to only to provide

20% backing of credit dollars.

Apparent in reviewing the data is that gold mining equities are sensitive indicators in their own

right, because they incorporate not only the gold price in their valuation, but also the cost of

economically sensitive materials and other inputs.1 They can provide intelligence on where we

1For nearly all of our charts we have used the Barrons Gold Mining Index, which was started in 1938, initially with

two companies in the composite: Alaska Juneau Mining and Homestake. We credit Mark Lundeen for providing data


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might be in these peculiar cycles marked by abnormal readings in corporate profitability or the

price of gold, or both. For this reason, gold mining equities can enter prolonged periods when

they are not well correlated with the stock market, or are even negatively correlated. But they

can just as easily enter into years when their correlation is high. These phase changes are good

markers as well as the actual movement in gold mining equities or of bullion.

If we are correct about our thesis that the 1930s and the 1970s provide a template for the

present, then we believe that gold and gold miners would soon begin to appreciate again,

ending a severe correction that began over a year ago. However, if this decline matched the

most severe downturns of these previous eras, potentially another 45% to 50% of downside risk

remains. (Note they are down over 40% through mid-May, and the greatest stumble of the

template eras was 69%). Once the upturn commences, we think the miners will outperform

bullion handily. The upside is unknowable, but in the 1970s the total move for gold and its

miners was about 20x (depending how you measure it). Based upon what we think we know of

monetary and credit conditions in the present era, we would rate it a coin toss as to whether

the present era logs less or more of a gain than the 1970s.

that incorporates price research of these two stocks going back to 1920, thus permitting us to make a full cycle

analysis of the 1930s economic adjustment period and its precursor time. Generally charts in this essay index the

Dow Industrials and the mining stocks at a common starting value of 1 in 1920. Recall that funding of World War I

had caused inflation to be strongly in the double digits each year from 1917 through 1920, so there is a little

distortion from using 1920 as a jumping off point. Hyperinflation would surge in Europe, especially in the Weimar

from 1921-1923, but in the U.S. deflation started in 1921. This long indexation permits the reader to glean insights

into the valuation of gold miners during normal economic times in between the crisis periods of the 1930s, 1970s,

and the present. For example, inflation expectations remained high in the 1980s, and the Barrons Gold Mining Index

vacillated between 50x and 100x its 1920 value, whereas the Dow ascended from 9x to 24x during the 1980s. This

difference has been completely worked off at the present time, but because of unknowable issues surrounding the

choice of 1920 as a starting point for indexation, no one can precisely say whether equivalence having been reached

proves the miners are fairly priced presently. We would rather use DCF analyses of cash flows as a reference for that,

which indicates there are substantial discounts to be realized through buying productive, profitable mines, even

assuming lower gold prices than in the spot market today.


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TheGreatTransitiontoLowerCorporateProfitability

Many Wall Street analysts and strategists maintain that stocks are attractive now based upon

valuation. Valuation in turn is a function of underlying corporate profit. Most observers think

profits will grow in line with recent upward trends. We find that corporate profit margins are in

the upper 99% of historical observations of our present era. Moreover, going back to 1920 wehave identified other times when this was the case and noted the outcome for stocks and also

for gold mining and bullion. The common deduction is that the foundation for the stock

markets current heights could erode surprisingly and persistently. In this section, we show

three periods where corporate profit margins had expanded to levels similar to the 99% reading

today, and what the outcome was.

The theory that the price of a commodity would rise and fall to induce the right amount of

production also applies to corporate profits. When companies are extraordinarily profitable,

there is a powerful incentive for competitors to seek a bigger piece of the profit pie. They may

do it by hiring away key talent, which might bid up the cost of labor. New products could be

devised that would tempt customers to change brand loyalty, often prompting a marketing war

that would erode profitability. Competitors could deploy new business models that would

disrupt mature businesses. Or, they could do it the old fashioned way by expanding capacity

or cutting prices.

Managements dont always slit their own throats. When money and credit is flowing, demand

for their products or services can outstrip supply, fostering wider margins. Somehow corporate

profit margins expand to high points, a process that can take years. But then it similarly takes

years to unwind, and we dub these usually decade-long periods transition eras.

It is not easy to assemble historic data that extends back into the interwar era of nearly a

century ago. What we have done is to use profit data from the S&P 500 as far back as the

1920s, and compare that to gross domestic product as a proxy for sales. Therefore dontconclude the ratio calculated is exactly the same as corporate profit margins, but it should be

somewhat proportionate. (In some of our charts we have utilized Federal Reserve corporate

profit data).

Period #1: The 1930s

The first period when high corporate profitability was corrected back to a mean value was the

Great Depression. In the graph below, one can see that at the start in 1929 profits were more

than two standard deviations above the average of the following two decades. Interestingly,

profitability actually fell as the United States came out of the Depression, because of wartime

rationing and price controls.


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Source: Bloomberg/S&P and St. Louis Fed, Gaineswood

Another fascinating aspect of the period is that before the Fed committed the Mistake of 1937

by raising reserve requirements, corporate profit margins had returned within hailing distance

of the late 1920s. But unemployment remained irritatingly high, and the stock market could not

regain all its froth. Unlike earlier decades or the postwar years, Roosevelt jawboned and strictly

regulated pricing, especially for labor. For instance, Jack Magid, a New Jersey tailor, was jailed

for pressing a suit for 35 cents when the NRA had fixed the price at 40 cents. Price controls

would not be seen again until the next anomalous era in our study, the 1970s.


Below we present the next similar transition period, the 1970s, which also saw a permanent

resetting of the gold price through the breaking apart of Bretton Woods, and a parallel erosion

of corporate profit margins as measured through the same set of statistics:

0.00

0.05

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1929

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1932

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Ratio:S&PProfitto

GDP

Profit Margin ProxyPrewar Era

Profit Margin Indicator +/- 2 Std Deviations


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Source: Bloomberg/S&P and St. Louis Fed, Gaineswood

Nixon placed wage and price controls on American businessmen to fight off the effects of too

many dollars and too much credit having been extended relative to the worlds gold supply

during the baby boom era after World War II. Ultimately that fight would be futile. After an

initial shock associated with the oil embargo of 1973, there was a tepid economic recovery.

Similar to the 1930s, this would be cut short by an aftershock, which happened in 1979

coincident with the Iranian hostage crisis.

Before the 1970s, economists were confident most economic questions had been settled. But

soon Keynesians had to share the limelight with Milton Friedmans monetarists. Even then they

could not easily resolve the breakdown of the inflation and unemployment tradeoff (PhillipsCurve). The infamous misery index was conceived just as the well-meaning President Carter

gave up and declared malaise was a permanent condition.

The decade of the 1970s was not good for stocks, despite inflation of nominal earnings, because

cost-push inflation and supply constraints eroded margins. We entered the era with profitability

at over two standard deviations above the norm, and exited in the opposite condition, over two

standard deviations below it. The stock market had the nifty fifty in the late 1960s and early

1970s: companies like Xerox, Polaroid, Avon, or IBM. These were juggernauts with new

paradigms impervious to competition. But they would crumble as Japanese imports, Wal-Mart,

and mid-sized computers and minicomputers stole their markets away.

Period #3: The Present Era (2008-Onwards)

The present era has its own competitive steamrollers, Apple being the epitome. But there are

Facebook, Google, Visa, Disney, Nike, Goldman Sachs, and others. Companies today make use

of inexpensive Chinese labor, Indian software engineers, or Taiwanese semiconductors but

maintain command of their American and Eurozone distribution systems. They arbitrage third

0.00

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1966

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Ratio:S&PProfitto

GDP

Profit Margin ProxyVietnam-Malaise Era

Profit Margin Indicator +/- 2 Std Deviations


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world costs against their ability to set pricing at developed world levels. Never have these cheap

imports been available in such quantity relative to total economic output, and the spread

between costs and revenues may have achieved a generational maximum of wideness.

Source: Schiller, Yale University

S&P earnings have been on a tear. The late 1990s experienced rapid earnings growth, similar to

the 1960s, but on steroids. The 2008 meltdown creates an air pocket that was quickly filled, for

the 10-year calculation plotted in the above chart compares earnings of the current year to the

same time 10-years ago, and 2009 saw earnings collapse.

Now in 2012 it doesnt matter much what your forecast is, for if you think the S&P earnings will

flatten out at $105 a share or rise to $120 per share, the 10-year growth rate only varies fromalmost 11% up to a bit over 12%. Both are hugely positive, being unmatched by an order of

magnitude compared to over fifty years of data on the chart. Similarly, you might argue that 10

years ago marked a recession, so the denominator might be artificially depressed for 2012.

However, if we normalize the denominator then the 10-year earnings growth would soften to

just below 9%, which is still an outlier.

Perhaps globalization of input costs has caused the surge, but Fed policy may have spiked the

punchbowl, to borrow a phrase from former Chairman William McChesney Martin. Make no

mistake: the Greenspan and Bernanke eras have been inflationary for corporate profits as well

as the prices of stocks and bonds, and 2009 was a very brief hiatus.

Equity risk premium models are popular for determining if stocks are attractive relative to other

investments. We believe they have a flaw which becomes relevant only when corporate profit

margins are high as they are today. Essentially they are two-dimensional. They take a snapshot

of the valuation of assets today and make a conclusion, without reflecting any statistical wisdom

of what inputs are going into the model. In Gaineswoods investment process of looking at

individual companies, we think of this phenomenon as bad GARP.

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10YrAnnualizedChange(%)

S&P 500 Real 10-Yr EPS Growth

10-Year Real EPS Growth


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Think about it. What is GARP (growth at a reasonable price)? There are two components. One

is growth. Most portfolio managers tell you a stock has earnings growth by observing earnings

over the last five years or so. It must be proven by this rear-view mirror test. How is a

reasonable price defined? Usually by looking at a price-earnings ratio, which typically uses next

years earnings as its input. Heres the weakness. If a company has proven its earnings should

grow and analysts have not learned there is something on the horizon to derail this, then it

almost never would see its price-earnings multiple compress. So if such a stock gets cheap or

reasonably priced, it means some of its shareholders have put selling pressure on the stock,

but expectations for the majority of holders (and especially the analyst community) have yet to

be reset lower. So you might think you are paying a reasonable price of, say, 13x earnings, but

once earnings weaken, you will find out you paid maybe 20x earnings.

For the market as a whole, we think of this as the Lake Wobegon effect. At the mythical

community of Lake Wobegon, all the children were above average. There are so many good

companies in the S&P 500 that its aggregate profitability cannot be attributable to Apple or

Nike. Nope. They are all pretty much well managed, have extraordinary growth, and have the

financial flexibility to think about raising dividends or buying back stock, at least looking at the

data for the index as a whole.

Equity risk premium models generally utilize inputs that reflect analyst expectations, and weve

just shown you that with profitability so high now, weve lost the sensitivity of measuring GARP

properly. Presently the S&P 500 looks inexpensive or reasonably priced, and earnings

projections are consistent with rear-view mirror extrapolations, which are as robust as ever over

50 years. So there must have been sellers who have put pressure on the market without

factoring in what analysts think is reasonable today. If statistics revert to mean values, we may

have paid up dearly for future earnings that wont materialize or would be lackluster at best.

Source: St. Louis Fed, Gaineswood

0%

2%

4%

6%

8%

10%

12%

Jan-53 Jan-63 Jan-73 Jan-83 Jan-93 Jan-03 Jan-13

Ratio:CorpProfittoGNP

Profit Margin ProxyBaby Boom to Present

+/- 2 Std Deviations


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Not to state the obvious, but the graph above of present times differs from the two for the

previous transition eras, because the present era has just begun. So the surge of profitability

that christens what we have observed is the start of another anomalous era appears at the end

and not the beginning of the charts time frame. Also notable is the greater sweep of time

chosen to depict the present era. Without doing so, in isolation the past five years would look

normal, like we had always been in a new era of permanently higher profitability.

Such a conclusion was once drawn in 1929 by famous stock market commentators such as

economist Irving Fisher who, upon observing reasonable price-earnings multiples at the time,

said, Stock prices have reached what looks like a permanently high plateau. The S&P 500

index closed at a value of 26 at the end of June 1929, and then-current earnings were about

$1.50 per hypothetical index share. Enthusiasm was reinforced by rapidly growing innovators

like RCA that exhibited market leadership. Forty years later at the start of the next decade of

adjustment, analysts would write glowing recommendations to buy one-decision stocks in the

Nifty-Fifty when valuations as well as earnings were stretched. T. Rowe Price would start its

New Era fund in 1969. In todays Wobegon market, all companies are nifty, and companies

like Apple and Facebook are the niftiest.

Phenomenal profitability would have arisen for cyclical reasons, but it may have been preserved

for longer than usual by super-accommodative monetary policy. In the graph below, through a

regression we fitted the expected value of corporate profit that corresponds to a level of GDP.

Prior to the Greenspan-Bernanke heavy hand in setting interest rates and printing money,

expansion of the economy from year-to-year would produce a moderate increase in profit,

depicted below the red trend line. The function steps up as soon as the new Fed policies are

enacted to save the economy.

4Q 2001

Q4 2008

Q4 2011

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40.0

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0.0 20.0 40.0 60.0 80.0 100.0 120.0

CorporateProfit(1947=1)

GDP (1947=1)

Regression: Corporate Profit & GDP

Postwar Period (1947-2011)

Corporate Profit Predicted Corporate Profit


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This brings us to yet another similarity of the present era with the 1930s and the 1970s. In our

time, perhaps the most important driver of the capital investment, savings, the budget deficit,

and retirement income the interest rate is regulated by price controls. The maintenance of

interest rates at zero percent may be a many times greater distortion than Nixons wage and

price controls, which were easily circumvented by changing job titles, developing new and

improved consumer products, or substituting new oil for old oil. Imagine if something asimportant as interest rates say gasoline was decreed to be free until 2014 at the earliest.

Poor Mr. Jack Magids distortion of the price of steaming a suit by a nickel seems picayune.

Note that in the mid-1930s, it was possible to temporarily maintain high profitability in the

midst of an economic disaster, so the unusual profit margins recorded thanks to the stimulus of

Bernanke and Greenspan may not be as incongruous with bad times as we think ought to be the

case. Imagine if a newly appointed Fed chairman spurns quantitative easing, as rightly must

occur someday. Would not another Mistake of 1937 be in the making?

To put the price control on interest rates into perspective, the chart below depicts how the 10-

year U.S. Treasury bond yield is approaching its 60-year lower boundary of 95% of observations:


The precursor stage of eras of financial adjustment starts with corporate profits being about two

standard deviations above a very long term average. Our observation of the 1930s and 1970s

revealed that corporate profit margins weaken, and usually overshoot to be two standard

deviations below the mean.

In this essay, we will break down the progress of stocks, gold, and gold miners as we move

through three distinct stages within long periods of financial adjustment, making the case that

the present is following in the footsteps of these two earlier periods. The next section describes

what we call the precursor stage of these eras, a period of years when gold miners awaken from

a multi-decade slumber to warn us of the events that transpire once the adjustment begins to

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Jan-53 Jan-63 Jan-73 Jan-83 Jan-93 Jan-03

In

terestRate(%)

10-Year Bond Yield

+/- 2 Standard Deviations


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take place. Later we will cover the other two stages, the adjustment period, which can last a

decade or longer, and the aftermath.


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Gold&GoldMiningEquities:ThePrecursorStage

The last section established a fundamental basis for a long corporate earnings cycle. In the past,

part of the cure for high prices in this case high profitability was the action of the capital

markets to stop allocating capital to businesses for expansion. This launched two infamous

periods when stock prices performed poorly for an extended time, the 1930s and the 1970s.The present adjustment era may drag on longer than these did, because intervention has put

economic transition on hold. No one ever wants to believe that there could be too much capital

available, so there are few who advocate for less. The present era is unique since for the first

time authorities have possessed powerful tools to accommodate the equity and debt markets

with bulk production of money out of thin air.

Truly horrendous episodes of printing paper tokens exchangeable for gold or silver recurred in

bursts during the two centuries leading up to the establishment of the Federal Reserve System

in 1913. These were difficult moments, so bankers worked to establish a central bank that

would emulate those of Europe. Compared to clearing house operations used to stem bank

runs that occurred after too much credit had been extended, the new Fed had more expansive

power.

Modern finance traces its origin to the establishment of the Fed, and its foundation is the logic

of having an elastic supply of funding in order to permit business expansion and avoid crises.

But since 1913 the character of capital profoundly changed, and the crises became prolonged

affairs such as the eras we have identified in our analysis of corporate profit cycles. We have

witnessed a steady expansion of capital, and with it devaluation of the dollars purchasing

power by about 98%.

As a repository of value that expands only very gradually, gold ounces historically thought of as

base money cant be more or less, just the same. Gold may have been outlawed or fixed by

government in price, but this could not alter its attributes ideal for use as money (durability,portability, divisibility, rarity, anonymity, recognizability, inability to be counterfeited, and most

importantly its innate appeal as an element). Therefore, whether or not you side with Warren

Buffett in thinking gold is a barbarous relic, the hard cold fact is that it remains a barometer of

financial cycles, and it generally increases in value in fits and staggers proportionate to the

supply of money. Somebody holds it. Perhaps 75% to 80% is in private hands, and the central

banks and treasuries that own the rest are buying gold in size for the first time in many decades.

China may be establishing gold reserves, a daunting task since its currency has been fiat based

since it dropped the silver standard in 1935. During the Second Sino-Japanese War (1937-1945),

the Empire of Japan plundered gold and other wealth from China, Korea, and other Asian

neighbors, so there is a void to be filled. A fascinating account of this pillaging is documented by

Sterling and Peggy Seagrave in Gold Warriors: Americas Secret Recovery of Yamashitas Gold(Bowstring 2005).

Changeover in the investment climate from normal expansion to eras of extreme adjustment

such as the 1930s or 1970s was completely unanticipated by investors. Probably because of

this, our study of gold bullion and gold equities shows that perhaps one of the easiest tradable

pattern recognition opportunities for investors is the period of time prior to one of these eras,

which we call the precursor stage.


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What happened in these adjustment eras, in short, is that after decades of dormancy, shares of

miners started to rise for several years. Their advance was inexplicable because the price of

gold was fixed (1920s and 1960s) or trading in a sideways pattern in a market where it is allowed

to float (late 1990s). The movement of the miners offered a signal that the price of gold was

also about to rise and usher in an adjustment era when the supply of capital to the economy

(business, government, or both) gets constrained. In the 1930s and 1970s, this lead to lower

profit margins for companies and a persistently unhealthy stock market. Lets take a look at

each of the three precursors to a gold revaluation, starting with the 1920s.

Period #1: Precursor to the 1930s

Source: Barrons, Mark Lundeen, Gaineswood

Above we see how gold miners (really Homestake and Alaska Juneau) cycled from being

somewhat correlated with stocks to having negative correlation during the period prior to the

severe devaluation of the U.S. dollar in 1934.

The interplay with corporate earnings and long-term interest rates is evident in the graph below.

Notice how once corporate earnings weakened, gold mining stocks got a boost.

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Correlation

StockIndicies(1920=1)

Gold Miners & Dow IndustrialsPre-1934 Devaluation

Gold Miners Dow Jones Industrials Correlation


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Basically, as in the 1950s/1960s and the 1980s, gold stocks were in hibernation during the bull

market of the 1920s. Recall that during the 1920s the price of gold was mandated by

government to be $20.67 per ounce. As a miner, all you could do to grow earnings was manage

your costs or increase volumes, something that was quite difficult to do in the 1920s under price

controls for your product. The rise in the miners must have been difficult if not impossible to

explain with fundamental data. But they began to appreciate beginning in 1927, a process that

picked up steam by 1932, two years before Roosevelt devalued the dollar. Gold mining stocks

were invulnerable to the 1929 onslaught, and continued to appreciate despite the severe equity

bear market of the early depression years.

Period #2: Precursor to the 1970s

The next period in our study that anticipates the topping of corporate profitability and the

revaluation of gold is depicted below. The graph covers the 1950s through the first break in the

fixing of the gold price in dollars. This occurred in March 1968 when the London Gold Pool, a

secret endeavor of the U.S. and its major trading partners, collapsed because it could no longer

suppress the gold price at $35/ounce.

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S&PEarnings/Gold1920=1

S&P Earnings & Gold MiningPre-1934 Devaluation

Earnings Gold Miners LT Interest Rates


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The 1940s (not shown) and the 1950s were uneventful, and gold stocks failed to work off much

of their overvaluation left from the 1930s. The stock market entered the Go-Go years in the

mid-1960s, ultimately reaching an important secular top in February 1966, followed by a

double top in 1969, and finally a triple top in 1972. (Note these moments are hard to

discern on the graph because the action in the gold mining shares overwhelms that of the Dow

Industrials, a phenomenon that would continue into the 1970s).

When the secular top for the Dow (especially as measured on an inflation-adjusted basis) was

achieved in 1966, gold miners awakened from a period of hibernation, just as they had in the

late 1920s. Probably most thought this sectors own private bubble party was to end

convincingly by 1969 on cue with the second peak in the Dow Industrials, when gold bullionreestablished its $35/ounce value. Certainly the nearly 60% plunge in the Barrons Gold Mining

Index (BGMI) from March 1969 to January 1970 seemed to confirm this. However, the setback

would set the stage for the real fireworks, a roughly 14-fold advance in the following decade.

The year 1971 was quite eventful. Like today, central banks were swapping out dollars for gold

in their central bank reserves. The demands on the U.S. Treasury became unbearable, so Nixon

cancelled gold redemptions in April 1971 and slapped wide-ranging wage and price controls on

the economy by August of the same year. The elimination of the convertibility of dollars for

gold in 1971 may be the defining economic moment of our lifetime, for which we may just be

feeling the primary ramifications. Nixons actions call to mind the eighteenth century perils of

the assignat or John Laws break with gold. With the new economic order established by him soinadequately understood, gold merely crawled into the low $40s/ounce range by December.

Meanwhile, mining stocks imploded, suffering a heartbreaking setback of 35% from April

through December, culminating the 60%, two and a half year-long clipping we just mentioned.

Making matters worse for those measured by performance relative to conventional equity

indices, the Dow steadfastly held its ground near its old high. In our opinion, the 60% decline for

the miners may have been logical to those living at that time, because no one could envision

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Jan-69

Jan-70

Correlation

StockIndices(192

0=1)

Gold Miners & Dow IndustrialsBaby Boom to Gold Pool Failure (1950-1969)

Gold Miners Dow Jones Industrials Correlation


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16

how these companies could make much money at $35/ounce. But in hindsight many years

later, this steep correction seems completely irrational. The selloff happening in 2011-2012 may

have similar characteristics, but we think it better fits with dips that occur in the middle of the

customary 10+ year periods when corporate profit margins erode and gold revalues relative to

the dollar.


Inflation made its debut in the 1970s in response to Nixons closing the gold window, because it

meant that loan volume could expand unchecked and the price of tangible assets would be

exuberantly bid up. Tangible assets attracted global capital flows more than equities, because

inflation-adjusted profits for the S&P 500 were listless, as seen in the chart above. The huge

rally in gold mining stocks that took place in the late 1960s coincides with the weakening of realearnings for the S&P 500 during the first three years of the chart above. In the next two years

real earnings descended sharply, and along with this was the 60% retracement spoken of earlier.

Period #3: Precursor to the Present (2008-Onwards)

We believe the present time shares a lot in common with the 1930s and the 1970s. Below we

display the data on gold mining stocks leading up to the 2008 meltdown.

0.0

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1970

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1976

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1981

1982

1983

1984

InterestRate

S&PEarnings

S&P Earnings & LT Interest Rate

Earnings Real Earnings (2012$) LT Interest Rate


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17


In the graph above, once again we see the familiar pattern of gold mining equities being in a

deep slumber during decades of normal economic expansion. Of note is that in this chart,

twenty years before the present era begins, they start out at well over 100 times their 1920

value. At that point, the Dow Industrials had only gone up about 9-fold. (Note: Both the DJIA

and the BGMI are indexed to start in 1920 at a value of 1).

While the decade of the 1980s was good for stocks, it was the feel-good 1990s that saw the

greatest and most consistent appreciation of stocks for any decade of the last century. The Dow

Industrials roughly quadrupled in 10 years, whereas the 1950s had achieved only a triple.

Positive psychology was primed by the birth of the internet in 1992. Microsoft and Intel had

wrested control of the technology sector from IBM, while enterprise software firms and Cisco

routers made it all work together and drive productivity. Banks gobbled up other banks, and the

government finished its cleanup of the savings and loan crisis.

There were plenty of good investment opportunities in the economy at large, but few in gold

mining due to margin pressure from a falling gold price and cost inflation. Nevertheless,

commercialization of large scale low grade heap leaching technology in the Carlin trend in

Nevada was a major advance. This enabled industry leader Newmont to experience dramatic

production growth from 1986 to 1989, and sustain a high level of output afterwards. However,

its per share earnings would be only slightly lower in 1990 than a decade before, despite its

realized gold price falling from $615 an ounce to about $385 per ounce.

(1.0)

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Correlation

Indices(1920=

1)

Gold Miners & Dow IndustrialsVolcker Rate Hike to Lehman Meltdown (1980-2007)

Gold Miners Dow Industrials Correlation


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Gold prices started an uptrend in the middle of 2002, about two years after the miners had hit

bottom. Both the miners and gold continued to advance through March 2008, presaging the

credit crisis by half a decade or more. This loosely fits the pattern established in the late 1920s

and the late 1960s, which telegraphed a secular peaking of the stock market and corporate

profit margins. As in those cases, the awakening of the gold mining stocks, if noticed, was a

powerful early warning to major economic structural change that would shock the financial

system and society at large.

Our next section covers what we call the transitional eras, when gold prices rise dramatically

and corporate profit margins erode substantially, a persistent trend that equally lasts about a

decade. In hindsight what happened in the 1930s and 1970s is obvious. But we will focus onhow investors dealt with these changes. What we find may surprise you. It seems they

steadfastly deny the change is occurring. This attitude successfully held back the tide in the

financial markets for a year or two periodically during these long transition periods. However,

eventually those who choose to lean against the wind become overwhelmed by the necessity to

remove capital from the overly profitable corporate sector and its associated stocks and bonds,

and to restore gold value in historical proportion to the pool of invested dollars and other

currencies.

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Correlation

Index(1920=1

)

Gold Miners & Bullion

Gold Miners Gold Correlation


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TheAdjustmentPeriod:RejectingtheNullHypothesis

In the statistical analysis of experiments, the burden of proof is that your concept of whatever it

is you are testing is sufficiently different from the status quo. For example, a new drug must

affect a meaningful number of patients andproduce a measurable effect in a sampled

population for one to conclude it is better than the null hypothesis of taking a placebo.

We believe the investment community and for that matter the population overall gets quite

accustomed to normal conditions of economic expansion that take place when the financial

system is not in transition periods like the 1930s and 1970s. Then, once in an adjustment

period, it takes a great deal of evidence before anyone feels confident in rejecting the null

hypothesis that conditions wont revert back to normal relatively soon. For this reason, when

gold and gold miners rise going in to establish a prolonged period of economic adjustment, it is

regarded as an oddity.

By the end of a decade or so, corporate profit margins erode substantially and gold prices

ascend beyond what was thought possible going into the long transition, give or take some

gyrations in between. Towards the end of this transition period the phenomenon has been

explained ad nauseum and the harsh conditions of the transition become accepted as the new

normal. A depression can be named Great, America can suffer from malaise, but names

such as these would not have been conjured up just a few years into the process of adjustment. 2

We mentioned that the precursor to these adjustment periods may be among the most easily

recognizable patterns useful for forecasting and trading. Once the adjustment period begins,

gold mining shares have displayed superior investment characteristics. In the 1930s and 1970s,

returns for gold miners exceeded the Dow, and correlation was often low or negative. However,

our read of the data is that the easy part of achieving good investment results with this sector

comes in advance of the transition period having started, because disbelief is near total.

Essentially you are both a value and a growth investor, who is buying in at an early discoverydiscount. Here in 2012, we are perhaps 4-5 years beyond that point.

In our study, we define the transition starting point at about the time the dollar surprises the

world by taking a large reduction in value relative to gold bullion, and when corporate

profitability peaks. From that point forward, the process begins when investor convictions

change. We observe that they gyrate tremendously between accepting the null hypothesis that

the world will return to the old normal or that it would go through a marked transition into a

new set of market clearing prices. Those who might be prescient enough to identify the new

trend can be foiled by a year or two of market action that harkens back to the old normal. A

sizeable and prolonged retracement of the move into a transition, which eventually saw equities

rally strongly and gold miners decline, happened in the 1930s. It happened three times in the

1970s, like a tug-of-war contest. It has happened four times already in the present era!

Here is a table that summarizes the action in gold, gold miners, commodities, and corporate

profits during each of the transition eras:

2Note: We cant go back and sample opinions of market participants to draw the conclusions we do about the

psychology of market participants. Our conclusions are based upon the movement of securities prices, which tell the

story of where capital was flowing.


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Transition

Era

Commodities Gold Gold Miners Major Mining Stock

Corrections

Corp Profit

1930s Collapsed

initially, rose

from lowlevel post

revaluation

Government-

set price raised

from$20.67/oz to

$35/oz in

February 1934

Anticipated 1934

turning point from

May 1925 bottom.Peaked in March

1939.

14x increase to top

35% Mar-36 to Oct-37 1929 > 2 SD from

average

1932-34 average1937 near 2 SD >

average

1944-1946 near < 2

SD from average

1970s Explosive

upside from

beginning to

end

Government-

set price of $35

abandoned in

April 1971

20x increase

overall

Slow rise in 60s

accelerated in

1965, made over

17x advance by

1980.

61% May-68 to Jan 70

35% May-71 to Dec-71

68% Aug 74 to Aug-76

1966 > 2 SD from

average

1971-81 average

1982 2 SD from

average. 4Q08 wasaverage.

Many think of the 1930s as a period of extreme turmoil and volatility. Being only about twodecades after the formation of the Federal Reserve, the set of prices necessary to make the

market clear in the 1930s had not varied too much from normal times. Clearly the 1970s and

the present times exhibit a greater range in the value of gold and the miners. We think an even

wider range of outcomes is possible now. Investors should develop some imagination of how

different prices could be for stocks, bonds, gold, and gold miners. Knowing such vision is never

perfect, they should also develop some tolerance for misjudging the swings.


Lets look a little closer at the 1930s. What we see is that after the huge move up for mining

stocks prior to the 1934 revaluation in the U.S. of gold (and against other global currencies

during the early-to-mid 1930s), gold mining stocks generally did well up until the outbreak of

World War II. However, there was a 35% correction from March 1936 to October 1937. This

happened during the second half of a bull market in equities when industrial production

recovered sharply from the depths of the depression.


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Source: Barrons, Mark Lundeen, Schiller / Yale University

Despite persistently high unemployment and an undercurrent of financial system instability, the

stock market had rallied from its bottom in 1932, and people thought the recession was over.

Seeking to cool things off and establish a firm foundation for the banking system, the Fed

doubled reserve requirements in 1937. This caused commodities prices to tank (except gold,

which was fixed at $35), and the stock market started a nosedive that only saw a modest

recovery occur in 1938, followed by meandering for another two years. It appears the bulk of

the outperformance of gold mining shares occurred prior to 1934, because by then they had

nearly doubled off their 1920 value while the Dow had given back all of its increase over the

same time span. But through their apex in 1939, the gold miners had appreciated 445% from

1920, far in excess of the 40% profit in the Dow (excluding dividends).

Even going on through the end of 1942, well after credit markets had cleared, the gold miners

would be 149% above their 1920 level, compared to just a 10% gain for the Dow. This is quite

surprising, because as a business proposition they had become quite shaky again. World War II

totally remade the gold mining landscape. The government continued to cap gold prices, but

since it printed up a storm to pay for the war effort, costs inflated. The Treasury cut back on its

aggressive gold purchases of the 1930s, and it began to ration supplies of rubber, steel, andother vital commodities so critical to getting ore out of the ground.

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InterestRate(%)

S&PEarnings/GoldMiners

Index

S&P Earnings & Gold MinersPost-1934 Revaluation

S&P Earnings Gold Miners LT Interest Rate


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The correlation between action in the mining sector and the Dow was negative during the gold

miner price decline phases, and not very strong otherwise. However, when correlation became

stronger (roughly 40% to 60%), it signaled either a bottom or a top in the gold miners (spring

1936 top, summer 1937 bottom, summer 1939 top).

All told, the 1930s were a transition period for the economy. It saw the gold price unexpectedly

reset from $20.67 to $35, an elevated price that would be smashed apart to the upside a few

decades later. The gold miners suffered a major setback that lasted 18 months in the middle of

the decade. However, a financial aftershock was felt in 1937 that would seal the sectors

reputation as a low or negatively correlated asset that could appreciate, especially when there

was pressure on corporate profit and stock prices. The setback of the 1936-1937 period mightbe a parallel to the present post 2008 meltdown time, when earnings have recovered strongly

and gold stocks stopped participating in the equity rally in the late stage of the move up.


Turning to the 1970s, we see another slightly different template. An apex of American

technological achievement was the landing of astronauts on the moon in July 1969, which

occurred pretty much right at the secular peak of the stock market and also for real earnings per

share of the S&P 500. During this adjustment period, the Dow Industrials appeared to be

constrained by a glass ceiling fixed at 1,000, which it approached or exceeded many times: in

1966, 1969, 1972, 1976, and 1980-1981.

Inflation-adjusted profits seen in 1966 would only be marginally matched or surpassed

occasionally during the 1970s. The S&P 500 had essentially the same peak inflation-adjusted

earnings in 1966, 1974, and 1977. In 1979 oil producers experienced a profit windfall, elevating

real earnings of the S&P 500 a mere 15% over what they had been in 1966. By 1987, well into a

robust economic recovery and prior to the stock market crash of that year, real earnings for the

(1.0)

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Correlation

StockIndices(1920

=1)

Gold Miners & Dow IndustrialsPost-1934 Devaluation



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S&P 500 were 23% lower than they had been in 1966! Once knocked down from their perch at

two standard deviations over average, S&P 500 profit margins hovered at the center of the

channel of profitability discussed at the beginning of this essay through 1979. By the early

1980s, profitability would reside two standard deviations below its two decade norm. (Two

graphical depictions, one of earnings and other of margins, are presented in earlier sections of

this essay).


The chart above shows how the gold mining stocks reacted during the economic transition of

the 1970s. While it is important to see the entire transition era in one sweeping view, the

magnitude of the changes during the 1970s requires splitting the era in two.

The first half we present below, with an ending point of August 1976. In that month gold bullion

and the gold mining stocks bottomed out simultaneously. Gold then was $104/ounce, nearly

20% below where it peaked in mid-1973 and 40% under its April 1974 top.

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Correlation

StockIndices(1920=1)

Gold Miners & Dow IndustrialsMoon Landing to Malaise+ (1969-1984)



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We already mentioned how the miners gave back 60% of their roughly three-fold advance from

1965-1968 that presaged the collapse of the London gold pool in 1968 and how irrational it was.

Like the three mystic apes who see no evil, hear no evil, speak no evil, once again in the early

1970s gold mining investors steadfastly refused to recognize what was happening right under

their nose in the bullion market. The casting off of the U.S. dollar from its anchoring at

$35/ounce by 1971 (its free market price was $39.10) would be greeted by a yawn. The gold

price would climb almost 70% from the 1971 free market value to January 1973, a point where

the Barrons Gold Mining Index would not have advanced at all.

Compared to the eight fold increase to come for gold miners through the peak in 1980, this

price action in the first three years of the 1970s seems unbelievable. A parallel may be in themaking today, where the gold price has ascended mightily, but gold miners have by and large

ignored the massive move up by bullion. Well share more insight on this in a series of charts

later.

Finally in 1973 and early 1974 the gold mining stocks could not wallow in the mud while gold

made a another baby step along its march to a 20-fold increase, this time from just over

$100/ounce to about $150/ounce. 1973 was the first year Americans waited in lines to get

gasoline, driving home the point that there was an imbalance in the global monetary order.

Nixons severing the dollars linkage with gold may have been an esoteric point to most

Americans, but when oil followed suit the monetary origin of the crisis became painfully real.

Spiro Agnew, the nations Vice President, would exit the scene in 1973 after being charged with

accepting bribes, presaging Nixons demise.

Throughout 1973 and 1974 the stock market eroded gradually after having touched 1,000 in

1972. Then, like the Titanic, it took on water and headed for the bottom in August and

September of 1974. During 1973 the gold miners had grabbed the bullish baton from the Dow,

nearly quadrupling through the first two months of 1974. They would ultimately hit a high in

August 1974. This was the month when the Dow submerged definitively, and unfortunately it

(1.0)

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80


Correlation

StockIndices(1920

=1)

Gold Miners & Dow IndustrialsEarly 1970s Gold Cycle (1970-1976)



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beckoned from the deep and soon pulled the gold miners down there with it. Mr. Dow Jones

might have well changed his name to Davy.

The Dow would bottom in October 1974 at the start of the Watergate trial, two months after

Nixon had resigned. This would start yet another period of delusion counter to the primary

trend that favored gold in its best decade ever, since the Dow would rally back to over 1,000 by

the second half of 1976, but the gold miners would suffer their biggest collapse ever, a 68%

free-fall that ceased in August 1976. Concurrently, gold bullion fell 30%. Strangely, the

restoration in confidence for the stock market and the correction in gold witnessed two major

bearish milestones. Saigon would fall to the Vietcong in April 1975 and New York City would

brush with bankruptcy later in October. Correlation between the Dow and the gold miners was

negative once the stock market got a head of steam, an interesting flip side to its having also

been negative when gold stocks made their huge advance in 1973 during the equity bear

market.

This correction in the miners and the rally of the Dow was a countermove back to the old

normal. Large as it was, it set the stage for an even more pronounced repricing of stocks, bonds,

oil, and especially gold and the gold miners by the end of the decade. By 1979, President Carterand most Americans concluded America had descended into what he described as malaise.

Gold miners would climb 554% from their August 1976 bottom, making the dreadful 68%

decrease in the 1974-1976 period seem small by comparison.

The late 1970s finally saw the economic adjustments of that decade reach completion. While

gold miners surged 554% in their final leg up of that decade, gold bullion would go from

$104/ounce to almost $700/ounce using weekly closes, or an intraday high of $850/ounce. We

would exit these years at a climactic peak marked in 1980 by the Iranian hostage crisis and the

attempt by the Hunt brothers to corner the silver market. The speculative juices were so

exaggerated that the Barrons Gold Miners Index would be nearly 140 times as valuable as it

was in 1920, while gold would only have advanced by a factor of about 33 and the DowIndustrials would register about a 9-fold gain over that same 60 year span.

Precisely sticking to the decade, gold bullion handily outperformed the miners, but in reality the

full cycle saw no differential in appreciation because bullion was handicapped by being under a

price control during the late 1960s, when the miners got a head start on beginning the dramatic

advance.

The chart below starts with the simultaneous bottom seen for both gold and the miners in

August 1976, a point when we believe the two assets had worked off their differences. Our

proof of this theory is that from 1976 through the peak in 1980 the two achieved an equal gain.

If we are right, then the lagging behind seen in the present time wherein the miners have not

shared about two-thirds of bullions ascent since the 1980 peak might be restored. Note that

well after the long adjustment period of the 1970s was over, gold miners and gold would

maintain a permanently higher plateau. But by then malaise was gone and there would be

morning in America, at least through the next normal period.


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Period #3: The Present

Our thesis in this section has been that in the middle of the eras of the 1930s and the 1970s, we

were well into an adjustment period for corporate earnings and for gold. We further claim that

at these midpoints, investors foolishly accept the null hypothesis, that the world has not really

changed much and in fact will revert to its old normal. During these countermoves, gold

mining stocks have declined anywhere from 30% to nearly 70%, which certainly is a large move.

However, we observe there were much more powerful forces at work during these decades of

adjustment. The main trend is that corporate profit margins to go back to their mean or eventwo standard deviations below this in the fullness of time. It may simply be coincidence that

gold and gold miners feed on this erosion of corporate profitability. But it is far more plausible

that capital is compelled to flow to the logical alternative to credit.

Capital flees the equity and debt instruments of corporations in order to rationalize their undue

expansion. If the price of gold and its miners is low relative to the aggregate pool of debt and

equity in circulation, which is the case by definition after long periods of dormancy or big

corrections, then flows into it and out of conventional corporate securities have a powerful

effect.

The value of all publicly traded stocks in the world was over $50 trillion at the end of March

2012, and the value of all traded bonds was about $100 trillion. This compares to perhaps $10

trillion for gold bullion (which allows for about $2 trillion of gold unaccounted for in official

statistics), and only $350 billion for all precious metals miners.

When money flows out of gold into the public securities markets, not much impact is felt. When

it moves the other direction, the price is greatly affected. Think of how a large reservoir of

water behaves once someone opens a sluice gate on a dam. The outflow is raw energy, and the

(1.0)

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Aug-76 Aug-77 Aug-78 Aug-79 Aug-80 Aug-81 Aug-82 Aug-83

Correlation

StockIndices(1920

=1)

Gold Miners & Dow IndustrialsMalaise & Recovery (1976-1984)



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funneling effect hydraulically magnifies price movement in gold, and especially for the miners,

which are only a miniscule safety valve that can slightly increase the capacity of the lesser vessel

of wealth.

In the 1930s we saw that the gold price was fixed, being raised once by only about 70%. With

the deflation of that era, gold miners benefitted on both the cost and revenue parts of the

income statement, and the stocks did better than the bullion. In the 1970s, we saw both bullion

and miners do well, but with a staggered performance wherein the stocks raced ahead prior to

the 1971 devaluation because the gold price was still fixed. In the present, the value of bullion

has been the star, with gold miners left at the altar, as the chart below dramatically attests.

Source: Bloomberg

The present cycle has been odd indeed. Gold mining stocks are down over 13% (through May

15) since their last cyclical peak, which was in September of 1980, while gold bullion is 2.3x

more dear. In contrast, from that peak the S&P 500 has multiplied by almost 11-fold, and debt

in the U.S. has grown by about 11x as well. So it is very clear that the financial water behind

the dam has swelled immensely, while gold and gold stocks have not changed much. If there

will be an aftershock in our present period of adjustment as we foresee, it could open the sluice

gate, and the force of the capital flowing into bullion and mining stocks could be a sight to

behold. If we are correct that the template of the 1930s and the 1970s applies to the present

time, then gold stocks are likely to make a massive move up, well in excess of bullion. Althoughmany commentators are currently offering explanations as to why precious metals miners

should almost perpetually underperform the yellow metal, we observe that in the 1970s

investors went through similar phases when bullion beat stocks only to see that situation

powerfully reverse.

While it is interesting to make a comparison from the prior peak, of more fundamental value is

what has happened to these three indices since the dollar became purely fiat based, i.e. not

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

1971

1973

1975

1977

1980

1982

1984

1986

1988

1990

1993

1995

1997

1999

2001

2003

2006

2008

2010

Index=100in1971

S&P 500, Gold Miners, & Gold Bullion(1971=100)

S&P 500 Gold Miners (XAU) Gold


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exchangeable for gold internationally, which takes you back to the far left of our graph above.

You can see that gold began to part ways with stocks quite dramatically in late 2006, which

marks the peak of the leveraging of the financial system that fueled the denouement of a

multigenerational boom in real estate.

This behavior poses a question that has been dogging the goldbug community for about five

years, because there appears to be no fundamental reason for gold to appreciate mightily andfor gold mining stocks to trade as if they are no different than IBM, Coca-Cola, Pfizer, or

ExxonMobil. To be fair, gold mining stocks did extremely well from the internet bubble peak

through the 2008 meltdown, so one might expect some underperformance relative to bullion.

Particularly strange has been the behavior in the last six months, where a slight hesitation in

golds ascent has clobbered the already lackluster gold stocks.

One reason offered by observers for this difference in performance is that the profitability of

extracting gold has not expanded as much as one would have thought from the strengthened

gold price. The two charts that follow show a key cost driver (particularly in West Africa): oil.

Source: Bloomberg

Here we can see that even though oil has been one of the best performing commodities that

affect the cost of gold mining, in the time period since gold began to take off and leave the

mining stocks in the lurch, gold and oil have traced out about the same appreciation over time,

with the meltdown a temporary interlude.

So might oils progress prior to 2006 account explain the anomaly?

0

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160

0

500

1,000

1,500

2,000


Oil($/Barrel)

Gold:$/Ounce

Gold & Oil Prices

Gold Brent Crude Oil


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Source: Bloomberg

Perhaps. But it is doubtful that oils rise relative to gold way back in 1999 would still be on

everyones minds. The industrys cash margin has tripled in the last four years (see chart

below), so another theory is that companies have been investing too much of this windfall into

the ground. Maybe.

Source: ABN AMRO, Gaineswood estimates

Finally, those who would accept as logical that mining stocks would decline since 1980 while

bullion would be up substantially point out that governments can be hostile to companies that

extract precious metals in their country. Recently Argentina imposed capital controls and

nationalized its largest oil company, YPF. Peru blocked a silver project in the province of Puno.

A civil war nearly broke out in the Ivory Coast, disrupting neighbors. Mali recently raised its

royalty, but that placed it near that of other countries. While these are all obstacles, we would

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note that governments and companies have become more sophisticated and have begun to

draft regional mining codes such as the Union Economique et Monitaire Ouest Africaine

(UEMOA). UEMOA has been promoted through the 15-member Economic Community of West

African States (ECOWAS), which sets standards for state participation, royalties, and taxes. Such

pacts have been helpful in reducing sweetheart deals, corruption, and in presenting a unified

stance when negotiating with Chinese mining interests.

Gaineswood invests in long-term growth, so we actually want management to expand, provided

the return on capital is high. We monitor the internal rates of return of major projects, and the

ones that are getting funded usually do have high returns even with a $1,250/ounce gold price,

which is about the 3-year average through 2011.

With the decline in gold miners relative to bullion, now we are finding many established small-

to-mid tier producers are trading at 25% to 50% discounts to corporate wide valuations that

discount cash flows at 5% or more. In theory if you paid par for the present value of a gold

project calculated with a 5% interest rate, you would earn a 5% return that is backed by a hard

asset. If you buy in during a big correction as is the case in early 2012, your compounded rate of

return should be far higher, presuming our template is correct and we have done our homeworkon project cash flows.

However, since you are buying a stock and not making a loan, there is the risk of cash flows

drying up under a lower gold price scenario or unrecovered cost inflation. The market seems to

be discounting margins dreadful enough to put a serious crimp on maintaining industry

production levels, much less funding exploration and development. But if our template from

the 1930s and 1970s is correct, then these projects would generate significantly higher earnings

if the gold price takes a quantum leap up and at the same time corporate earnings weaken.

Well return to the conundrum of the present times a little bit later. In the meantime, lets

review what has been happening during the present era, and how the templates of the 1930s

and 1970s may be setting a precedent.

Source: Barrons, Mark Lundeen, Schiller, Yale University

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What about corporate earnings and the economy? In the chart above the performance of the

gold miners is shown to be similar to the early stages of the 1970s period of adjustment. Recall

in the 1970s there was an initial move up in the miners prior to the big 1974 bear market, which

also saw the miners eventually succumb. Similar to that is the meltdown in 2008, which we

think marks the start of the present era of financial adjustment. In late 2008, S&P earnings were

nearly wiped out (using Schillers data), and the collapse in gold stocks edged out the previous

record correction of 68% set from August 1974 to August 1976 by a point. Among chaotic

kickoffs that started transition eras, we believe the 2008 meltdown has earned a spot aside

1929 and 1974.

The 1970s are also providing a better template for today than the 1930s, because of the

seesawing of gold miners in the middle of the adjustment era is a shared element with the

present situation. We think the 2011-2012 sell-off is continuing to follow the template of the

middle of both adjustment periods. Back in the mid-1970s, corporate earnings recovered from

the 1974 debacle as did the Dow Industrials. But the return to the old normal caused capital

to abandon the gold miners in favor of the equity markets other sectors. Similarly this is what

has happened in the 2011-2012 period, when corporate earnings looked good and seemed to be

accelerating, perhaps due to unusual seasonal adjustments.

In March and April sporadic employment and other reports suggested that we may be in danger

of entering a recession. This episode has not yet concluded, but we think when it does, the

twist could be that gold miners bottom out before the Dow does. Our reasoning is that this time

miners led on the way down, and the Dow will need a long time to digest what we think will be

serving after serving of unpalatable quarterly earnings reports.

If we are anywhere near correct about corporate profits being stretched at a multi-decade high

above two standard deviations of observations, this would suggest the surge in the Dow and the

collapse of the miners in late 2011 to early 2012 is a recalcitrant countermove. We think it most

closely resembles 1936-1937 and 1974-1976 among the seven deep corrections in mining stocksof those two transition eras. Like these two, corporate earnings were in a strong uptrend, luring

capital out of gold and back into corporate securities. Recall that in the mid-1930s, profit

margins nearly returned to two standard deviations above average. Inflation pushed corporate

profit margins close to their upper boundary in 1974 as well. But it was the last hurrah for visits

to the stratosphere of corporate profitability until 2005, save for an unsatisfying oil-inebriated

fling in 1979.

We believe that the credit markets have not cleared adequately. The cure, which is higher

interest rates or forced debasement of all global currencies, has been indefinitely deferred by

quantitative easing. Without clearing, intense pressures have rebuilt at shorter intervals

between interventions (it took just one month to burn through $1 trillion from the ECB).

Sovereigns and banks have access to new money from central bank purchases of notes and

bonds when the funding window is opened, but the minute funds are consumed, the system has

a very limited capability to organically service debts. The political shift from austerity to growth

may further destabilize the sovereign debt market.

Europe may turn out to be more important to market psychology than has been the case

through early 2012. The shrugging off of the unexpected scare of late 2011 indicates


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complacency may be stoked by rising corporate earnings, a factor that for now is having the

upper hand. However, growth in earnings is clearly decelerating. Europe might graduate from

being a mere psychological influence to become a fundamental cause of weaker earnings.

To date, what has preserved earnings in so challenging an environment? For one, the U.S. dollar

has lost one-third of its value from the 2000 peak, despite its recent rally. About 35% of

corporate profit comes from abroad, and these earnings have surged from the translation

benefit. We dont see this happening again without setting off a trade war. Spain, Portugal,

Greece, Italy, and now the United Kingdom are in recession. China claims merely to have slower

economic growth, but enviously its high single digit GDP expansion has remained faster than

almost every other nations on the planet. However, some dont believe the statistics. In China

real things like electric power growth slowed to less than one percent in April, and oil demand

purportedly was flat and perhaps negative in that month. Europe is a big customer of Chinese

exports.

Asia has been regarded as an engine of earnings growth, but it might become a drag on

corporate profitability. The Federal Reserve has exported inflation to countries that have trade

imbalances with us, because more than a few important developing nations peg their currencyto the dollar. This means that their authorities print local currency that they provide within their

borders in exchange for dollars, which they keep to invest as exchange reserves. Credit growth

remains high in China, which may explain why retail sales climbed 14% in April when output

measured by electricity or oil barely changed. Wages in China and other developing nations

have risen, which might negatively impact margins. For example, earnings at Wal-Mart, a major

importer of Asian goods, have fallen slightly short of analyst expectations in the last two

quarters, and projections for the coming year have been shaved by a few percent.

There are also hazards approaching that could shove U.S. corporate earnings down the stairs,

such as tax increases looming in 2013, the cost of implementing healthcare reform, the effect of

state and local austerity programs, or enacting a U.S. debt ceiling.

We dont want to overstate what is only a slight change so far. But you have to ask, why should

there be any slowing at all, and what is it about this point in the recovery that contributed to the

change in tone that started late in 2011, and which has resurfaced just half a year later? Each

period, the 1930s, the 1970s, and the present era, have their own rhythm. No one can predict

which ball players will score runs or in which specific innings they will do so, but we might have

a better than even shot at figuring out what team will prevail over time by using our template.

While there is a certain amount of randomness in the short-term, through solid statistical

analysis we may not be completely blind to forces at play now compared to the 1930s and the

1970s. If we have the template right for the present (and there is no guarantee that we do), we

could be nearing another inflection point where gold miners and gold resume their uptrend and

have low or even negative correlation with the stock market. The path of corporate profits,

credit markets, and then by extension gold miners might be known in general terms over the

balance of the adjustment era, especially once the present countertrend has exhausted itself. If

we are right, fundamental news from Europe and from corporations will begin to cast a larger

shadow over the U.S. stock market, which appears somewhat detached from downturns on the

bourses of Europe, Japan, and developing nations like China and Brazil.


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The chart below shows how correlation between the Dow and gold miners has dropped to no

greater than 50% since about a year ago. While unpleasant to gold mining shareholders, it could

indicate that gold has begun to break free from the risk on risk off trading pattern just as

was the case in 1973 and 1978-1979 just before the sector catapulted upward (see charts similar

to the one below presented in the beginning of this section).


One risk is that like in the 1970s we see gold miners extend their loss to match the greatest

corrections on record. But once that has happened, what then are the odds that the fragile

state of affairs cannot be preserved longer?

Another risk is that the template more closely matches the 1930s. However, then gold prices

were kept under wraps and held constant, with the economy bearing the brunt of adjustment

through the mechanism of default. The 1970s coincided with shortages of oil and other key

commodities, as well as a banking system that had the ability to take on additional leverage.

Finally, the present era is decidedly different, and that presents unknown risks. Commodities

may have already had a bull market cycle, and their descent could be a part of weakening

nominal corporate earnings. The 1970s saw corporate earnings rise in nominal terms, but in

real terms they only went sideways in serpentine fashion. Our best guess is that unless tens of

trillions of dollars and Euros are printed, the present cycle will see earnings and commodity

prices move sideways cyclically in nominal terms, somewhat like the 1930s, but not as bad since

there is a predilection to print Euros, dollars, Yuan, and other currencies. A major difference is

gold bullion is no longer pegged. So, it can float upward, which is what happened in nominal

terms in the 1970s and in one mandated step in the 1930s. In the 1970s, shares of gold miners

followed in grand fashion, which we believe is the probable outcome once the countermove in

the present era runs its course. It could happen in spades considering the underperformance of

mining shares and the hefty discounts to project net present values.

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If you extrapolate the large declines in the Barrons Gold Mining index seen in the 1970s to the

present period, then the correction that began in April 2011 might take the shares of gold

miners down another 45% to 50% from where they were in mid-May 2012. But if they

bottomed here, they would have declined by over 40%, which would exceed three out of the

seven major corrections that happened in the 1930s, the 1970s, and in 2008. In other words, as

far as corrections go, the present one already ranks up there among the worst.

When the dust settles, the 1970s may keep their title of producing the wildest ride for gold and

the miners ever. During that episode, recall that the gold price advanced 20-fold from 1971 and

the miners went up by 15-fold (starting from 1965). The present era, although seemingly

formed by fantastic speculative bubbles, has had gold and its miners only jump 7-fold. Even

the staid 1930s which had the government capping the gold price increase to 69

Gaineswood Market Transformation (May 2012)

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