Mostly: Classical

[amarksp]

Hussman on Gold shares:
http://www.hussmanfunds.com/wmc/wmc050502.htm
Precious metals stocks appear increasingly attractive

One of the areas in which we've observed price weakness recently has been among precious metals stocks. Indeed, weakness in this group has been the main source of the modest -3.36% decline in the Strategic Total Return Fund since its most recent high on November 22, 2004. Though a periodic sideways lack of progress is neither unexpected nor of concern, it's a little bit tedious – particularly when it emerges as a result of a single group. Why not just sell the gold stocks and be rid of them?

The short answer is that there's a good possibility that precious metals shares may produce stellar returns over the coming year. Last week, I added modestly to our precious metals positions in the Strategic Total Return Fund, to just short of 20% of net assets. In the Strategic Growth Fund, I increased our exposure to nearly 5% of net assets, which I view as a sufficient overweight relative to the market for a diversified stock fund.

Probably the simplest way to emphasize conditions in the precious metals shares is to examine a simple valuation indicator that is, surprisingly, nearly as useful as much more sophisticated indicators: the ratio of the spot price of gold to the Philadelphia XAU Index. On Friday, spot gold closed at 434.39, while the XAU closed at 83.51. That put the Gold/XAU ratio at 5.20.

To put some historical context on this measure, since 1974, the Gold/XAU ratio has been greater than 5.0 about 15% of the time. When the ratio has been this high, the XAU has followed with annualized gains of 89.6%, on average – a figure that remains high even if the data is split into multiple samples. When the ratio has been greater than 4.0, the XAU has followed with average annualized gains of 27.4% (though the finer profile of returns has been sensitive to other conditions such as interest rates, economic trends, and inflation). In contrast, when the ratio has been less than 3.0 (meaning that the gold stocks are very elevated relative to the actual metal), the XAU has declined at an annualized rate of -36.6%, on average.

Importantly, the return/risk profile for precious metals shares is strengthened further if the economy is experiencing weakness. For example, when the Gold/XAU ratio has been greater than 5.0 and the ISM Purchasing Managers Index has been less than 50 (indicating a contracting U.S. manufacturing sector), gold shares have appreciated at an average annualized rate of 125.6%. In contrast, when the Gold/XAU ratio has been less than 3.0 and the Purchasing Managers Index has been greater than 50, precious metals shares have plunged at an average annualized rate of -49.9%.

Given increasing evidence of a potential economic slowdown, there's a good likelihood that precious metals may remain in a very favorable set of conditions for perhaps a year or more, first by reason of unusually favorable valuation measures, and subsequently by the combination of moderately favorable valuation measures combined with economic weakness.

Unfortunately, against the favorable profile of expected returns, it's important to emphasize that precious metals are among the most volatile industry groups in the market. For that reason, any given expectation for potential returns has to be tempered by risk considerations. It would be one thing to have an expected return potential of say, 50% for the S&P 500, which in context of typical market volatility, might warrant a leveraged investment position. It's another thing entirely to have that expected return potential in an industry with several times the volatility as the general market.

As usual, the size of our investment position is aligned not simply with the expected return, but with the expected return per unit of risk. In that context, I am very comfortable with a 20% exposure to precious metals shares in the Strategic Total Return Fund, and about 5% in Strategic Growth. If we observe some combination of better valuation and/or economic weakness, those exposures might increase by a few percent.

That said, these comments are intended only to articulate part of my thought process in establishing our moderate positions in precious metals shares, and should absolutely not be used as investment advice, or as any suggestion that investors should establish additional or aggressive investment positions in precious metals elsewhere.