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Gold bugs, who have chanted "wait till next year" since the metal fell off its $800-an-ounce pedestal some 23 years ago, finally had something to cheer about this year. In 2002, gold stocks were back on top, albeit against very weak competition.

While most market indices show double-digit losses for 2002, the Philadelphia Stock Exchange Gold and Silver Index (XAU), at 75.39 on Dec. 12, is up 39.6% for the year to date. A weakening dollar and worries about geopolitical unrest have fueled the latest rally in recent days.

Gold investors must ask whether the run-up has been the result of improving fundamentals or whether it's simply a flight to safety. Phrased differently: After this year's rally, will gold mining and producing companies resume their long downward trend? Some see reasons for optimism.

"Gold will always hold attraction to speculators, but that's proving to have diminishing bang," said David Mallalieu, an analyst with Scotia Capital. On the other hand, "Investing in gold through the mining and production business currently presents a great opportunity," with the biggest players owning strong balance sheets and the smaller ones looking ripe for acquisition.

Free Parking

A look at the this year's XAU chart vs. the

S&P 500

index shows that gold stocks did indeed rally while the broader market continued to fade, leading some to argue the gain is destined to be short-lived.

The flight-to-safety phenomenon has occurred numerous times, most notably during the stock market crash of 1987. That year, the XAU index shot from 75 to 160, but the gain didn't last; the stock market stabilized, and the XAU sank below 90 by the beginning of 1988.

Could Not Travel Both
XAU vs. S&P 500

The XAU enjoyed a sustained bull market from 1993 to 1996 as the index rose from 65 to 150. Gold shares were supported at the time by the economic recession of the early 1990s, a threat of inflation with interest rates in the high single digits, heightened demand from the manufacturing sector, and improved margins due to industry consolidation. Gold itself remained stubbornly below $400, however, as many governments, most notably Britain and Mexico, decided to pare their reserves, providing a huge supply.

The Coming Tidal Wave

The XAU's move over the past two years, from a December 2000 low of 42, appears to be mostly the result of asset allocation. As investors sought refuge from sinking technology shares, they have plowed money into perceived tangible safe havens such as precious metals and real estate. As a result, gold prices have rallied 39% to $333 over the past year. But the jump was from extremely depressed levels, the lowest in over a decade.

Now, with the stocks stabilizing, inflation nearly nonexistent and manufacturing demand slack, some worry that there are precious few reasons left for a sustained rally. John Bridges, an analyst with J.P. Morgan, notes: "Nearly 80% of gold goes into jewelry, with the other 20% for investment. I don't see a rise in demand for jewelry, and there is only so far the investment piece of the equation can take us."

Indeed, the XAU already has tumbled some 15% since its May high. Four of the nine stocks that make up the index have slipped into the negative territory for the year, including

Phelps Dodge

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, at $30.20, and

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Barrick Gold


, at $14.02 -- both down about 5% for the year.

But a few names still sport big gains:


(AU) - Get AngloGold Ashanti Ltd. Report

added $2.30 Thursday, to $32.67, giving it an 80% gain year to date.

Newmont Mining

(NEM) - Get Newmont Corporation Report

stands at $28.11 and is up 56% for the year, while

Meridian Gold


is at $16.98, up 76% for the year.

Business and Pleasure

It's important to distinguish the business of gold, its mining and production, from speculation in the raw commodity. An industry analyst provided a primer on the former. "It's a three-stage process: $250 an ounce to find, $150 to mine and, depending on your efficiencies, anywhere from $100 to $350 to produce; that cost slides as the quality degrades from high to low."

Given a typical mine's life cycle of 18 years, he figures the cost basis averages $225 per ounce (amortizing the discovery and production costs). That means that established companies such as Newmont, already drawing from established mines, can stay profitable as long as gold is above $300 an ounce.

Golden Years
Tracking London gold since 1975

Source: Kitco

Though gold's $800-an-ounce glory days aren't coming back soon, industry analysts point to some constructive fundamentals that could stabilize earnings at gold mining and producing companies. In his November report, Leo Larkin, an analyst with Standard & Poor's, noted that low gold prices over several years have resulted in diminished production. This, coupled with an agreement in September by central banks, including the Bank of England and the Bank of Switzerland, to limit sales to 2,000 tons through 2004, should create a favorable supply/demand equation. He also thinks that consolidation will continue to lead to improved margins.

Barry Allan of Research Capital cites Barrick's recent purchase of HomeStake Mining and Newmont's "concerted effort to reduce debt" as resons for optimism.

"The large players are on solid financial ground, well-hedged and poised to take market share," Allan said. Still, he concedes, "earnings growth will remain in the midsingle digits" and may do worse if there is no economic recovery.

Another industry analyst, who requested anonymity, thinks a floor is in place for gold stocks. "The large players have become sophisticated to hedging techniques," he said. "As gold crosses $350, they'll lock in 3%-6% earnings growth over the next few years."