The performance of junior resource stocks since 2008 is closely correlated to that of aluminum, lead and zinc. That makes sense, because base metals are very sensitive to existing economic conditions and to the market's expectation of future economic growth. When economic prospects are negative the market naturally becomes risk averse and the appetite for high risk juniors decreases.
But since the S&P 500 TSX Venture Index (which I have used as a proxy for the junior sector in the chart below) includes precious and base metals stocks (as well as some non-resource stocks), its performance should also be affected by gold and silver prices, which have performed much better than base metals. Yet we don't see nearly as strong a correlation between junior equities and gold as we see with base metals. That could be because the weighting of juniors exposed to precious metals - gold in particular - is too small a component of the index, or it could be something else. I believe it's something else.
Source: Bloomberg L.P.
The overriding control of the TSX Venture Composite Index seems to be forward looking risk aversion while gold and silver prices are fueled by the anticipation of inflation related to North American and European debt problems and economic woes. While gold and silver speculators focused almost exclusively on the possible monetary fallout, junior stock speculators have become more risk averse on the basis of the general economic outlook and possibly the outlook for future metal demand.
Source: Bloomberg L.P.
Gold is a monetary asset. Silver, as much as its speculators wish it weren't so, is an industrial metal impersonating a monetary asset. The US Federal Reserve Bank's response to the 2008 credit crisis, and other central bank responses to the European debt crisis that followed shortly thereafter, created a fear of monetary inflation and a global rush to hard assets - especially gold.
The good news is that the fear of inflation is misplaced. Yes, it is true that reserve banks have engaged in quantitative easing and have thus caused monetary inflation, but gold speculators are ignoring the fact that debt crises are themselves deflationary in nature - bank asset write-downs require banks to recapitalize, and that is a deflationary process. In the US, the Federal Reserve's quantitative easing has only mitigated the deflationary risk, not laid the foundation for massive inflation.
The average monetary inflation rate of the US dollar from 1900 to present is 6.5%. Were it not for QE1, the monetary inflation rate of the US dollar following the 2008 credit crisis would have been very close to 0%, and could easily have crossed over into deflation. As a result of QE1 the monetary inflation rate was held at around 8%, which is high, but not catastrophically high. After QE1 ended, the US dollar inflation rate fell to almost 2%, and remained around 3% until the introduction of QE2, which pushed it back over 7% again. But 7% is hardly high enough to warrant the current gold price.
The fear of monetary inflation is far greater than the actual threat of monetary inflation and as a result the gold price has become almost as over priced in 2011 as it was by the end of 1979. While base metals and junior resource stocks are trapped in an economically induced bear market, gold is trapped in a fear induced bubble. Silver tries to keep up with gold, but in the long run it will find it hard to resist its true (industrial) nature.
Paul van Eeden is president of Cranberry Capital Inc., a private Canadian investment holding company. He is well known as an investor and for his macro economic research on monetary inflation and the gold price. He is a regular speaker at numerous investment conferences in Canada, the United States, Europe and Dubai. He has also been a regular guest on business television programs such as Bloomberg and Canada's Business News Network, as well as CNN in Europe and the Middle East. He present a keynote today during the San Francisco Hard Assets Investment Conference.