Stagflation is back -- and that's good for gold A slowing economy and rising inflation are here. That's great for precious metals, though it hasn't helped gold and silver stocks yet. Their time will come. By Bill Fleckenstein 05/02/2005
Last week brought macro confirmation of what we've been seeing at the micro level: The economy is slowing down. That obvious fact came via 1) the news that durable-goods orders saw their biggest drop in two years and 2) the report on second-quarter gross domestic product (GDP), which weighed in at 3.1%, vs. expectations of 3.6%.
The GDP deflator (a measure of the economy's average price level), which I don't consider an accurate representation of inflation, at least got the direction right, as it printed at 3.2%, vs. expectations of 2.1%. Therefore, by the government's own calculations, inflation is now running at a higher rate than GDP. (If the true rate of inflation is running at 4% to 5%, that would whittle down real GDP to about 1% to 2% in real growth.)
This is a mild version of stagflation, though I don't know that if the headline numbers were 1.5% real GDP growth and 4.5% inflation growth, people would be consider that a "mild" version or not. Nevertheless, in my opinion, that's what we are dealing with.
The stag horns of a dilemma In my April 2004 column, "Game over for stocks and real estate," I wrote about inflation/stagflation being the best outcome I could see going forward. It's a theme I've talked about a fair bit since. I think we are clearly in a state of stagflation, though I don’t know how long it will persist.
There's obviously a good chance that, when the stock market really tanks and the real-estate market goes with it, and given all the debt that's piled up, we could experience the break to deflation that many people are expecting. That said, the Federal Reserve would fight deflationary symptoms tooth and nail by printing more money, so it's not clear how the dollar would survive that.
What the GDP and durable-goods data also point out is the fact that the Fed is trapped. With the economy slowing down, I'm sure they'd like to reduce their tightening, but inflation is too high. However, I don't believe the Fed cares very much about inflation. In my opinion, the Fed will be swayed by GDP weakness, not by inflationary pressures.
Meanwhile, it seems clear to me that the beneficiaries of these problems are the precious metals, though, given the crosscurrents in the metals arena, it's possible that people won't come to that conclusion just yet. (The precious metals will also benefit ultimately from the weakness in the currencies.)
Costs shaft the miners
As many folks know by now, Newmont Mining (NEM, news, msgs) missed its earnings number last week, due to the pressure of higher costs and some production problems. (I noticed that similar pressures occurred at Placer Dome (PDG, news, msgs) and suspect that other mining companies are experiencing the same pressures.)
What's now clear is that the gold stocks' weak performance since early March has been discounting higher costs, not a lower future gold price. (Perhaps, as a director of a mining company, Pan American Silver (PAAS, news, msgs), I should have smelled this problem coming. But I'm embarrassed to say that I did not.)
Folks' slavish devotion to the notion that the gold stocks are a prognosticator of the gold-bullion price was brought home last Thursday when a dealer told me that he saw customers selling the bullion the day before, simply because the Philadelphia Gold and Silver Index (XAU.X) was down. I don't know if that was happening on a small or large scale, but selling gold because the index is down -- because the mining companies are experiencing higher costs -- does not sound to me like a very successful approach to money management.
Headwinds before a harvest As for Newmont, the stock is now trading at the price it did when gold was roughly $350 an ounce. I find it rather perverse that the companies whose products are direct beneficiaries of stagflation/inflation are the ones manifestly being hurt by inflation, as their energy and attendant costs have screamed up much faster than metal prices. Concomitantly, the money spent by mining companies on exploration has not yet had enough time to bear fruit. (Parenthetically, I note that Newmont has been getting absolutely no credit for its financially successful investment in the Canadian Oil Sands Trust (COSWF, news, msgs). The trust has a working interest in energy resources being developed in the tar sands of Alberta.) Thus, for the moment, the miners are stocks without friends -- which is precisely the opportunity one looks for when one is a "contrarian." (For more on the trust, click here.)
Newmont's stock price now assumes it costs Newmont $250 to mine an ounce of gold. (Using the framework I've discussed in my daily column, divide Newmont’s market cap -- $16.68 billion -- by the company’s estimated 91 million ounces of gold in the ground and you get $183 per ounce. Subtract $183 from gold’s recent price, $433 an ounce, and you get $250.) If the company were to drive cash costs back to where they were two years ago, i.e., approximately $200, then, using the same methodology at today's gold price, Newmont should sell at $47, not around $36.
Looking at it this way, one can see that it has been costs that have hurt Newmont's stock price. But let me be clear: This is just my way of looking at metals stocks vs. bullion, and it may or may not be the right way to view the situation. And the logic has worked well in the past. Obviously, future production increases and a rising or falling gold price will affect the price of Newmont. It should also be noted that the company had a poor first quarter last year, and its stock price bottomed out in early May 2004.
A bullion-to-shares ratio Having said all of that, I haven't added to my Newmont position in a long time, and I'm not exactly sure when I will. As readers of my daily column know, whenever I have made a metals purchase in the last four months, it has been of bullion, not shares. My bullion position is now more than twice as large as my Newmont position. Not because I've sold Newmont (other than the sales I made at year-end), but simply because all my additions have been in gold itself.
I've discussed my reasons why. Gold is gold, and mining companies are the beneficiaries of higher gold prices. But mining companies are businesses, and there are lots of things that make this particular business difficult. That said, they will be dramatic beneficiaries of rising metals prices, and doubly so if we reach a moment in time when energy prices actually decline.
To summarize, it's unfortunate that Newmont got caught in this vise, but it did. I expect that gold will go much higher and that the company will reap the rewards. Should the right things set up, I will add to my Newmont position. But I may just buy more gold. Owning gold itself has less risk than owning a mining company, as well as being a better currency surrogate. That said, you can make a lot more money on the upside in a mining stock. As such, they are pretty good examples of risk and reward being closely tied together.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of CNBC on MSN Money. At the time of publication, Fleckenstein was long Newmont Mining and Pan American Silver.
Market Data 
Markets 
AI
