Choosing Gold Shares or Gold Bullion as Credit Crunch Hits

Aussie markets look to take their cue from Europe and the US today.  Sellers are selling. Buyers are spooked. And wouldn't you know it, the credit crunch and the American housing bubble are again the culprits.

Despite a raft of local data on actual earnings from actual Australian companies, the local market is slavishly following the US lead. Hmmn. Is the Australian market a one-trick resource pony?

Back to the scene of the initial rout in global stock prices, New York. In the eagerly awaited minutes from its most recent meeting, the Federal Reserve said the US housing slowdown, "could well prove to be both deeper and more prolonged than had seemed likely earlier this year". You think?

"Seemed likely," to whom? The Fed and most of the financial industry would like to treat the problem in the credit markets as a bad loan problem to be medicated with more money. Papering things over with new credit has always worked in the past, so why not again?

The public senses the rot in the system, though. Maybe that's because a good portion of the public-in America at least-owns a piece of the rot, namely a house with a big honkin' mortgage and a fallen market price. In any event, consumer confidence in America took a dive.

More importantly, investors don't seem confident that the market's credit woes are behind us. This is good news and bad news. The bad news is that all stocks get sold off when investors move to cash. The good news is that a good business is still a good business, even with a falling stock price. This kind of market rewards selective stock pickers rather than index followers.

What about gold? Gold shares and gold stocks are not acting in concert. The shares corrected far more than the bullion price during the recent sell off. We asked our friend David Evans in Perth what to make of the diverging fortunes of gold-related investments.

Dave replied:

“The old conundrum of gold shares or gold bars.

“The problem with gold bars is that if you own them yourself you have to keep them safe (which usually means keeping very quiet about them). Banks won't accept them in their safe-deposit boxes (commercial rivalry -- banks make paper money, and gold is their most serious rival). If you buy gold but someone else stores it, you have a trust problem -- if gold becomes very valuable, how can you be sure that they will give you back your gold if you want it? Do they even own your gold, or have they sold the same gold to several different people?

“The problem with shares is that they are shares in companies, with all the usual dangers of companies -- they can go broke or suffer for all sorts of unrelated reasons and are subject to the familiar range of malfeasances. The advantage of shares is that they are secure: the stock exchange keeps track of your shares in a company, and the company owns the rights to gold in the ground.

“Gold shares are a way to own gold while it is still in the ground. The price of this gold, if you do the math, is usually $30 - $200 per ounce (versus $800 per ounce when in gold bars). There are generally higher prices for companies with better mining operations, but since most investors are unaware of this way of pricing, bargains and anomalies exist. The gold typically costs another $300 - $600 to dig up, and again some companies are much cheaper than others. (This is where a subscription to goldnerds comes in very useful).

“If the price of gold rises a lot, gold shares have greater leverage and will tend to go up more than gold bars (the cost of mining the gold stays constant, but the price of the mined gold goes up). When the general public gets involved and everyone just wants gold, gold bars tend to appreciate faster. This was the experience in the 1970s, when the price of gold went from US$40 per ounce to US$800 per ounce. For the first few years gold shares went up faster than gold bars (and weathered a severe worldwide share slump in 1974 very well), but in the last couple of years the gold bars did better and the gold stocks stopped going up.

“The obvious strategy is to own gold shares now, and when every man and his dog is clamouring for gold, sell your gold shares and buy gold bars to enjoy the last part of the ride.

“Of course, I'm not a licensed financial adviser, so I can't give you any financial advice. I am however a gold buff and gold investor, and the above are my thoughts and strategy and the reasoning behind what I do.”

Sounds right to us. Shares early in a gold bull market. Bullion late.

Dan Denning
The Daily Reckoning Australia

Which do you prefer, gold shares or gold bars? Leave a comment below.

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