SECTOR SCOPE by James Anderson October 11, 1999

A Narrow Window for Gold Stocks
The metal's price is way up, but don't count on that to last

Recently, there has been a lot that glitters when it comes to gold. In just the past few weeks, the price of bullion has rebounded from 20-year lows and caused many folks to speculate that the shiny stuff is back with a vengeance. Yet for all the good news and lofty expectations a few things about gold -- and the stocks of the companies that produce it -- just won't hold a shine.

You'd have to have been buried in a mineshaft to have missed gold's recent surge. After hitting a 20-year low of $252 an ounce last summer, gold awoke from its slumber on Sept. 27, when the heads of 15 European central banks pledged to limit their sales of gold on the open market as well as the amount they lease to hedgers. What ensued was a frenzy almost as spirited as the 49ers' crazed rush to California 150 years ago. In a matter of two days, the price of gold roared to a high of $325 an ounce.

Just as quickly, gold stocks and precious metal funds that had spent the year in the doldrums began to gleam. As recently as July, Placer Dome (PDG), one of the group's bigger players, was off as much as 20%; it's now up 26% for the year. Newmont Mining (NEM), another big name, was bust at mid-year, down 10%. It's now up nearly 40% since Jan. 1. Little wonder, then, that a group of 20 leading gold stocks, as measured by Morningstar, has posted a 49.1% gain so far in 1999. The gold boom raised funds like the Gabelli Gold Fund (GOLDX) and the Sogen Gold Fund (SGDDX) 20% just last week.

DON'T FORGET THE JEWELRY. There are a number of factors behind gold's sparkle. Start with the action by Europe's central banks. Add a touch of inflation-phobia spurred by rising prices of commodities such as oil. Mix in a tight labor market plus sporadic reports of big wage increases and suddenly pesky rumblings in the consumer price index. That awakens gold bugs the world over who believe the precious metal is the best hedge against inflation.

Don't forget that people still love to wear the stuff, too. Jewelry sales, after all, make up almost 80% of the worldwide market for gold. Thanks to Asia's recovering economies, gold demand in the second quarter was up nearly 16%, according to the World Gold Council.

Still, no amount of bangles and beads can cover the tarnish that blemishes the outlook for gold and the companies that mine it. Some gold company executives were cursing as much as others were cheering during the recent rise in the metal's price. That's because gold stocks these days often represent more than piles of ore and jackhammers. Quite often they include a big dose of derivatives, which are used to hedge declines in the price of gold. That way, a mining company doesn't have to shutter facilities and lay off workers just because of a temporary trough in demand. The downside is that when gold prices rise, the mining companies' hedges can lose money. "Among the big stocks, there's not a one that's a 100% pure play on the rising price of gold," says Leo. J. Larkin, an analyst with Standard & Poor's. "In some cases companies have sold forward four years worth of production, in others they've sold two."

Once mining executives cover their positions, it might be too late to really cash in on gold's resurrection. That's because a number of developments could tilt the delicate balance of supply and demand and make the recent rally an exceedingly brief one.

SCARIEST SPECTER. First off, gold isn't the only inflation play in town anymore. In fact, its position as the undisputed king of inflation hedges hasn't been tested since 1980, when the precious metal sold for an average price of $612.56 an ounce. That's partly because Nervous Nellies can now shelter their savings in U.S. inflation-indexed Treasuries. Uncle Sam not only promises bondholders that the investment will keep pace with the rise in consumer prices, but will pay bondholders a steady stream of income, an important extra given how shaky gold has been in the recent past.

The scariest specter haunting gold bugs, however, is the idea that central banks might finally be coming around to the notion that large reserves of gold aren't necessary. "Above-ground stocks of gold bullion have lost their raison d'etre," says Lehman Brothers analyst Peter J. Ward. "Most central bank holdings are left over from the Bretton Woods monetary system, which ended a long time ago, and many banks, including the U.S. Treasury, specifically held on to these gold reserves just in case of a return to the gold standard."

Already, a number of nations, including Canada, Belgium, the Netherlands, Switzerland, and England have begun shifting their holdings from gold to interest-bearing securities. In fact, Switzerland, with its reputation as the great gold haven, is bringing just over 1,300 tons to market above the European central bank agreement; England has made it known that it's cutting its reserves some 58%, starting with 400 tons of its own. That's an overhang great enough to take a big bite out of any increase in jewelry demand -- enough to keep prices mired at current levels or lower for some time to come.

Witness, too, how some of the European Community's smaller nations were willing to part with large holdings to meet national debt limits set for the European Community's common currency, the ecu. All told, the world's central banks hold about 34,000 tons of gold, a sobering figure considering recent trends. The other 25,000 tons that are held privately could start making its way to the auction block as well. "There's not much of an argument left behind gold as a store of value," says Ward. "We've had 20 years of positive inflation, and theoretically, gold should be trading near a 20-year high. Instead, it recently traded at a 20-year low."

BEST BETS. And the doomsday crowd that's hoarding the metal in anticipation of y2k disasters? Well, you can expect it to lump its supply atop the mass earmarked for market come next Jan. 2. In short, it looks as if gold shares pack more risk than reward.

If you're still feeling intrepid, or if you feel that the current euphoria might carry the gold group higher, you're probably best off angling for a mining stock with the least amount of its production tied up in hedges of different sorts. That way, with costs fixed and no futures contracts to worry over, the company you hold will be sure to see the benefits of higher gold prices hit the bottom line.

S&P's Larkin says your best bet is Homestake Mining (HM), an outfit that has only 16% of its annual production strapped to derivative strategies. A company like Barrick Gold (ABX), meanwhile, has been a lot more aggressive in the financial and commodity markets, covering as much as four years' worth of supply in hedges, he says. "Among the big gold firms -- Barrick, Newmont, and Placer Dome are the names portfolio managers will gravitate toward just out of familiarity," Larkin says. "Homestake is as close to a pure play as you're going to get," he adds.

An even better idea for a gold investment might be to buy a mutual fund that specializes in gold stocks. The Franklin Gold fund (FRGOX) is up 30.4% this year through Oct. 8. Although its annualized three year record looks pretty atrocious at a negative 9.4%, that's enough to make it tops among all gold funds. The Franklin fund focuses primarily on gold shares; as of mid-year its portfolio was 94% stock, 6% cash, with Barrick and Newmont as its top two holdings. The long-term results aren't awe-inspiring, but at least if you invest in a gold fund, you won't have to put all your nuggets in one pan.

James Anderson teaches journalism at the City University of New York

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