(This article appeared in the June 1997 issue of Jim Blanchard's Gold Newsletter.)

Life After Bre-X: Taking Advantage 
Of "Maximum Pessimism"

By Ray Knight

Editor's Note: This year's Gold Newsletter Seminar was a rousing success, with hundreds of investors looking for the best strategies and stocks to buy in the post-Bre-X market. They got just that. Bob Bishop, Adrian Day, Ian McAvity, Paul Montgomery, and Rick Rule joined Jim and myself to give our best picks and strategies in this dramatically different investing environment. To give you a taste of the topics covered and the valuable information imparted, we assigned local reporter Ray Knight to cover the event. - Brien Lundin

The 1997 Gold Newsletter Investment Seminar gave savvy gold investors an upclose, interactive chance to pick the brains of the industry's top analysts about what to do next in the Bre-X aftermath. James U. Blanchard III set the tone of the seminar with a quote from John Templeton: "Common sense will tell you that the only time you can get something for a small fraction of what it's worth is when other people are despondently selling. So, it has been a theory of mine -- the Theory of Maximum Pessimism - that if you want to succeed in selecting investments, look for points of maximum pessimism and look for value." The general outlook according to the analysts: From the debris of Bre-X, from the current lack of confidence and interest in gold and overconfidence in the stock market, there are nuggets of opportunity to be mined by the disciplined, sharp-eyed investor. With some variants, it seemed that the "Theory of Maximum Pessimism" resonated through the speakers' commentaries, underscoring a contrarian view of opportunity in the face of adversity. 

Table of Contents

Jim Blanchard: "A Balanced Hard Money Portfolio"
Ian McAvity: "A Chartist's View of Gold, Currencies, and Other Related Markets"
Paul Montgomery:  'Protecting Your Investment Portfolio With Gold: An Often Overlooked Strategy '
Bob Bishop:  "What Now? The New Reality of Today's Junior Resource Stock Market"
Adrian Day: "Which Gold Stocks Now?  My Favorites"
Paul Montgomery:  "A Tour of Precious Metals - What Makes Sense for Your Portfolio?"
Rick Rule: "Global Values in Resource Investments"


Jim Blanchard sees evidence of gold's surprising resilience in the fact that last year gold averaged $387.87 per ounce, up 1 percent over 1995, despite intense negative pressure. These pressures have created some extraordinary values, making gold severely undervalued. At the same time, the stock market is severely overheated -- Warren Buffet says almost all stocks are overvalued; John Templeton says the stock market could plunge as much as 40 percent. Blanchard believes the gold market is at its point of maximum pessimism, ripe for the courageous investor to seize advantage. However, he notes, "Timing has been very difficult. But as Templeton says, you have to have the courage to step up and buy value when [others] are buying heavily into a grossly overvalued market." 

"A word of caution: The next time stocks double and triple, it's not enough to pull money out of that one game. You need to take it totally out of the game and walk out of the room. It's too tempting; there are too many apparently good deals around. Take 30 percent of the money you made and just buy gold coins and put them away. It's very good discipline." 

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Looking at the big picture, Ian McAvity sees a "financial asset mania' that has been running since about 1982. "God only knows where the actual top [in the Dow] is, but when I hear that Wall Street has been changed into an everybody-wins game, I think we're pretty close to the end of the madness," McAvity said. 

Many people look at the stock market as a thermometer that measures the heat of the economy. "In point of fact, it's a barometer. It's looking ahead, feeling and sensing pressure changes. And in recent years, the economy and the stock market are quite unconnected." 

The notable explosion of debt since the 1980s is worrisome to McAvity. "Somebody, somewhere holds the other side and thinks that's an asset. This is the real strangulation effect of debt on the economy. On the one hand, people are borrowing money, but they're not investing to create things. They're basically creating paper and trading it." 

Taxes, capital flowing out of the GDP to the government, have soared. Under Bill Clinton, this tax extraction is reaching levels only seen previously under Jimmy Carter and Lyndon Johnson. "If anyone is telling you there is less government in your life, I would ask them to explain that one more time," McAvity said. 

In spite of the government's claim of "fiscal responsibility," 16 cents out of every tax dollar still goes to support the national debt. There are only three ways to get rid of debt, according to McAvity: 1) pay it off, 2) default on it with some form of a bankruptcy, 3) depreciate or inflate the currency. The big debate is whether Washington will ultimately resort to the sneaky strategy of inflating its debt away or will there be an "accident" that sets off some sort of default. 

The long term picture of interest rates shows a steady rise from World War II to a peak in 1981, followed by three significant drops, which have become the disinflation triggering the current financial asset mania. McAvity believes the bottom has been confirmed, and predicts a rise in interest rates. "In 1993, we saw an extreme that I still regard as a very significant turning point." It isn't fully resolved, but he thinks when it is, many people will caught by surprise. "Alan Greenspan is being pulled along by the market," said McAvity. "He is not leading the market, in spite of claims to the contrary." 

What does it mean in the bigger picture for commodity prices? The Economist All-Items Index shows general commodity prices continuing an upward trend, the current market correction notwithstanding. In recent years, gold has tended to peak out ahead of commodity prices, McAvity notes. Right now, gold is out of line with this relationship to commodity prices, and when it starts to correct, there's probably going to be a catch-up move coming in the gold price. He predicts that the price will accelerate if it gets above $425, and advises including gold bullion as a component of your portfolio. 

The short term performance of gold stocks has been disappointing, largely due to the Bre- X situation. McAvity argues the upside case for gold stocks, with a caveat - "There are some risk levels in there." 

The Market Vane Bullish Sentiment reveals the market psychology at play. At the top of the gold price, 77 percent of the survey said they were bullish. In February of this year, only 23 percent labeled themselves bulls. "That is the lowest number of bullish people since February 1985, when the gold price was $284." Since February there have been wild swings in the bullish sentiment, but McAvity believes the emotional bottom has been reached. 

Another bullish indicator for gold is the changing fortune of the dollar. In McAvity's opinion, the dollar is very near topping out, in spite of hype to the contrary from the government. The significance of this is that gold is typically a mirror reflection of the strength of the dollar. 

To illustrate the potential offered by mining stocks, McAvity revealed his recent discovery of an intimate, highly leveraged relationship between a stock and its underlying commodity, using Pan American Silver as an example. Charting the company's share price against the price of silver, McAvity and John Carder, of Topline Investment Graphics, discovered that the price of silver is essentially the cube root of Pan American's stock price. That means that the share has three times the volality of the metal price. The same relationship pattern seems to be shaping up in Silver Standard's shares, and should also apply for First Silver Reserve. "This is an extraordinary trading tool," observes McAvity. 

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As many forms of investment, especially stocks, seem to be at unusually high levels, it is appropriate to examine what role gold should play in your portfolio, according to Paul Montgomery, president and CEO of Jefferson Coin & Bullion. 

"Many investors are shifting away from aggressive strategies and into a wealth-preservation mode," says Montgomery, and he maintains that including "hard money" components in your portfolio is an important wealth preservation strategy. 

Montgomery cites five conditions which argue in favor of portfolio diversification into "alternative assets," such as gold: 

1) The stock market is at an unusually high level. 2) A market correction is a high probability. 3) Stocks and bonds are no longer mutual diversifiers. 4) There has been a movement to indexation. 5) Gold is at the low end of the historical price range. 

Montgomery points out that the traditional portfolio ratio of 70 percent stocks, 30 percent bonds is no longer valid. Stocks and bonds have not been moving inversely, while gold is negatively correlated with both stocks and bonds. When stocks and bonds go up, there is a 35 percent chance that gold will go down. Logically, then, when stocks and bonds come down, gold should go up. 

Investments in foreign countries, especially those in emerging markets considered risky, can be protected by gold as a backup in the event of a breakdown in the monetary and political system. 

"Gold is superior to paper assets in that it is not subject to government's promise to pay," says Montgomery. "In other words, bullion is nobody's liability. On the other hand, dollar bills and government securities are the liability of governments and are thus subject to the behavior of the government." 

Gold has high liquidity, more so than other "alternative assets." It is easily bought and sold on international markets, with narrow bid/offer spreads. According to investment industry research, to trade $10 million in gold takes about a minute. Stocks take about three or four minutes. Real estate and venture capital investments of that size, by comparison, could require on the order of 10 million minutes (about 19 years) to liquidate. 

Gold offers these benefits that other alternative assets lack: 

    - Reduces portfolio volatility and can enhance returns
    - Provides a buffer to exchange-rate volatility
    - Hedges more effectively
    -  Is more liquid than other "alternative assets" 

Diversifying with gold is an insurance policy with an investment component," Montgomery says. 

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After a period of grieving, the market has come to terms with the Bre-X debacle and shaken out all those who were inclined to be scared out of the market by the incident. That, according to Bob Bishop, means the stress is out of the market now. He finds it shocking that the market can take a punch of this magnitude and get back on its feet so quickly. "There's a resiliency that we can't begin to fathom built into the system, and it's a function of how much money is there," Bishop says. 

Another reason for the resilience in gold stocks is that the market has been so good to so many for so long that it can roll with the punches. Though many people were hurt by Bre-X, "The breadth of profits built into the system are such that it's not causing huge pain," says Bishop. "Most people are giving up profits, not losing money." 

There will always be some fraud. There will be much less chance of it in the future, Bishop believes. It won't change the market, just make it more selective. 

Another factor supporting the junior stock market is the quality of the projects out there. "The major companies are not finding the deposits. Period." Bishop notes. "If they're going to have new deposits, they've got to buy them. And they will be buying them from junior companies." 

Some junior company takeovers appear probable before year end. Arizona Star and Farallon are two likely targets. Manhattan also seems an obvious takeover candidate. "I think these are the kinds of transactions that will re-validate the junior mining sector," Bishop says. 

An important idea to remember, Bishop points out, is that many people made huge profits from Bre-X, even on the way down. It was not a totally losing proposition on all sides. Little is being said about it, but a key point that Bishop holds up to put Bre-X in perspective is this: "The reason you get to own stocks that go from 25 cents to $290 is that these are speculations." There are risks. There are no guarantees. Caveat emptor. 

Many of the people hurt by Bre-X were victims of their own greed. "They rode it up, and they rode it down," Bishop observes, "just because they didn't want to pay taxes." He advises investors to sell when good sense dictates it, and not let paying taxes be an inhibitor. 

What will be different as we go forward? Bishop thinks the market will be generally quiet for the summer. Money will be harder to come by in this quiet market, especially for those companies that don't have it now. The companies that didn't raise money when the financing window was wide open are now at the mercy of the market and can be good buys. 

The pace of news about new developments will slow as new layers of due diligence and comfort are built into the process to avoid a replay of Bre-X. This will also slow down the deal-making process. There will be fewer deals and fewer ways to make money, but this means less confusion in separating the good deals from the garbage. 

One lasting consequence of Bre-X is that much of the "new" money, the mutual fund "hot" money that got into it big, but late, will not return. 

What can the investor do to protect better against another Bre-X bath? "Get to know the people who run the companies," Bishop says. "Go to conferences like this and meet them, ask them questions." Another defensive measure is to sell more. "Always be taking money off the table." 

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Why gold?  It's cheap, both in absolute terms of its historical price and relative to other investments. The Dow is the most expensive it has ever been relative to gold. 

The same comparison applies to other markets, e.g., bonds or even cash. Also, the fundamentals of supply and demand for gold are positive and increasing. The explosion of gold production is over and new production for the next several years will be relatively flat. 

At the same time, demand is up sharply, for jewelry and electronics in particular, creating a primary deficit. The deficit has been so far met by central bank sales and forward selling by producers. 

These sources are at their limit and will not significantly increase. Flat production, growing demand, the end of central bank selling as a suppressive factor - these are ingredients for a rise in gold prices. 

How do you choose gold stocks? Traditional analysis methods are of very little help. Look at cash flow and in particular future cash flow, Day advises. Spend time looking at reserves, which determine cash flow. Examine the company's ability to exploit its reserves. Look at the tangibles: mines, production, reserves (amount and quality), potential of the deposit, cost of production, etc. Consider the intangibles: management, credibility of the company, promotion (how well the company tells its story), market liquidity, political risk, diversification, etc. 

Use the "hard" methods of analysis: market cap to production and market cap to reserves ratios. Factor in discounted net present value. Finally, apply a discount or premium to any negative soft factors (the intangibles). 

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Gold bullion is one of the cheapest ways to own gold. Ingots or bars are the cheapest, and a 100-ounce gold bar usually sells for about 2 percent over the spot price. 

The venerable South African Krugerrand is a relatively cheap way to hold gold in a coin form; it carries a relatively low premium and is simple to buy and sell. The Canadian Maple Leaf and Mexican pesos (in denominations of 10, 20, and 50 pesos) are good buys, as is the Australian Philharmonic. The American Gold Eagle and Silver Eagle are always popular, partly because of the romance attached to them. 

Bags of "junk silver," circulated American coins minted before 1964 with 90 percent silver content, with a total face value of $1,000, trade for about $3,500 at current prices. They are somewhat heavy and bulky, but represent a good "insurance" value, according to Montgomery. 

The single best gold investment in bullion is in old world coins - the Swiss Helvetia and British Sovereign are good examples. A prime benefit of buying old world coins is complete privacy; the IRS does not require sales to be reported, as is the case with stocks. In addition, these gold coins offer a double profit opportunity: from increases in the price of gold and from potential increases in the premiums over gold value as demand from collectors and investors grows. 

Numismatic or rare coins have been in a bear market for the last seven years because of the stock market boom. If equities take a sudden dive, as some analysts are warning, people who have not had an interest in rare coins will quickly rush in, which should drive prices up dramatically. The market is thin, and it takes relatively few people entering the market to have strong impact. 

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The natural resource business is more cyclical than most, according to Rick Rule. In the next ten years, this will be to the advantage of investors because, Rule believes, it is entering an up cycle. 

There has been a long period of depressed prices because of a plentiful supply of natural resource commodities at low prices. Demand began to rise, too. However, commodities are, by and large, not growth businesses. "Every day you pump a well, every day you mine a mine, the business gets smaller," says Rule. 

The resources developed in the '70s and '80s were finite; they're running out. In addition, the global economy is a lot bigger now than it was in the late 1970s, and growing rapidly. "The resource investor could make money in the next ten years based just on the depletion of earlier discoveries and increases in Western world demand." 

A byproduct of political liberalization around the world has been more freedom for people in Indonesia, China, Peru, Zaire, etc. As they gain freedom, they become more productive and want the same standard of living enjoyed by developed democratic societies. The increases in wealth in Africa, Latin America and Asia will lead to staggering new materials consumption demand. 

For the explorationist, a sidelight to this political liberalization is the opening of enormous new resource deposits behind formerly closed borders. Three-fourths of the world's surface that was closed to exploration is now open. "Areas that had never been explored by any means more efficient than a pick and a mule were suddenly accessible to [exploration] by modern methods, and it has led to some really truly spectacular discoveries." 

"The next ten years are going to be very exciting, both in the sense that we are running out of old supplies at a time that demand is increasing rapidly. Married with that, we have the ability to look for new supplies in places that we've been politically constrained from looking before. 

"High demand and the ability to meet that demand at a reasonable profit is an extraordinary opportunity, one that we haven't seen in the resource business for the last ten years."