The world has just experienced the greatest destruction of wealth ever. Share prices around the world are down 50% on average. Many stocks are down a great deal more than that. For example, General Motors, long the backbone of American industry, has lost 90% of its value from a year ago. Some of the big American banks are gone completely, with shareholders losing everything.

After an experience like that, many people will be tempted to give up on investing. Or worse yet, they will wait on the sidelines until the popular media tells them how great things are in the investing world. Normally, the popular press being positive on any investment topic signals the top of the market.

But, the top of the market is precisely when many people come back into the markets.

It takes a great deal of courage to invest contrary to popular wisdom. Legendary investor Warren Buffet said, "Be fearful when others are greedy and be greedy when others are fearful". This is exactly how Buffet amassed his fortune. You buy when others are afraid, and you sell when others are greedy.

There are signs now that the financial markets have stabilized, that share prices are no longer going down. In fact, there has already been substantial recovery in some investments.

Of course, there is no assurance that this is the bottom of the market. However, it is clear that there is a great deal less risk today than there was a year ago. People are still frightened; resources are seen as the last place one would want to invest, especially the small companies.

That thinking makes this an ideal time to invest. It's like 2001, when nobody wanted anything to do with resources. Investor who came into the market at that time made fortunes. Prices now are as cheap as they were at the bottom of the last cycle, with many companies in a much stronger position.

Right now, many of the small exploration and development companies have piles of cash. Some of those companies are trading at prices that are less than the value of the cash. That means that in some cases, you can effectively buy cash at a discount, AND get a gold deposit for free.

I'm not going to add another long-winded explanation of what caused the financial crisis. However, it is very useful to understand in general terms what happened in order to be able to anticipate what is coming next.

Once the crisis set in, and stock prices started to fall, investors panicked and dumped stock on the markets, pushing prices down even faster. Forced selling of shares, for example, from margin calls, added further downward pressure. The final and most destructive stage in the selloff came as trillions of dollars worth of mutual funds and hedge funds faced calls for redemptions from their investors. To satisfy the redemptions, fund managers were forced to dump stock onto the markets at a time when there were few buyers.

Investors were cashing out of all classes of investments. The flight to safety saw an enormous shift of wealth into cash, with the US dollar being the most favored safe haven. US government treasury bills have become so popular that the interest rate now is effectively zero. For now, investors just want a safe place to park their wealth.

At this time there is an estimated $9 trillion around the world in cash (that is, T-bills, money market funds, bank deposits and the like). To put that into perspective, that value is equivalent to about three quarters of the total value of all American publicly traded companies.

As soon as there is a sense of stability coming back into the financial world, a great deal of that $9 trillion of cash will be looking for a return. Money will exit T-bills and go back to equities and it will go back to other countries and it will go back to commodities.

One of the first places that many investors will think of as they recover from the financial crisis will be the safe haven of gold.

Gold did a fine job of preserving wealth during the financial crisis. The gold price is actually higher now than it was at the start of last year.

Sure, gold took a hit at the height of the crisis. But, it was nowhere near as bad as nearly every other investment class. It then recovered quickly. Gold equities of course were also hit hard by the financial crisis and are just now beginning to recover.

We have seen this pattern twice in the past dozen years. After the Asian economic crisis in 1997, gold and the gold equities fell hard, along with other investments, but then rebounded well before other investments began to recover. (See the graph below)





That pattern appears to be repeating now: Bullion has come back from its lows of late last year. See the previous graph. The senior gold equities have also begun to recover. At present prices, the major and the mid-tier gold producers are trading at around 2-times net asset value (NAV), based on a $900 gold price. That means investors are valuing those companies at a huge premium to the value that the companies are expected to generate based on the current gold price. The premium reflects the belief that investors expect the gold price to rise.

So, investing in the large gold companies provides some leverage to moves in the gold price, but that leverage is largely offset by the premiums that one pays.

The small companies are riskier, but they provide much greater leverage to moves in the gold price, and for the most part trade at discounts to NAV (not premiums). So far, the values of the smaller companies have not followed the larger companies upwards. If the pattern from previous market cycles holds, then the gains will ultimately trickle down to the smaller companies in the gold sector.

Before we talk further about gold companies, let's look more closely at the gold market.

So much attention in the gold market is misdirected. Most people simply position themselves for a risein the gold market and then wait. People are disappointed that gold is down from the $1,000 level oflast March. However, gold was fulfilling the very purpose for which many investors held it. It provided a stable and liquid form of wealth in a time of crisis.

You can own gold as bullion or coins, or by way of exchange traded funds. In that way, you wouldbenefit from moves in the gold price. If you are waiting for a big move in gold, just remember, it was 1980, 29 years ago, when we last had a big run. There is no assurance that it will have another big move any time soon.

Some day, gold will have a big move and you want to be positioned. But, it would be great if your investments were doing something in the meantime. Therefore, you may want to consider investing in gold companies, especially companies that are growing and adding value independent of moves in the gold price.

First, let's look at why you want to own gold, and then we will look at the companies that offer the greatest potential for gains.

The gold price is likely to continue higher. But, on a similar path to the past 8 years: Trending higher, with spikes and pullbacks.

So many people look at one or maybe two aspects of the gold market. There are a great many factors operating on gold. We can see the cumulative effect of all of the variables by looking at the following gold price chart.



All of the factors that pushed gold higher for the past 8 years are still very much in place. In addition, the financial crisis has added to that upward momentum.

Here's why:

The meltdown in the financial markets scared the hell out of people. This crisis was particularly scary, because banks, which are supposed to be solid and reliable, were the most vulnerable.

Once again, investors saw gold hold its value in a time of crisis. As a result, there has been a huge inflow of wealth into the gold market. Exchange traded funds and similar investment vehicles are becoming increasingly popular as they make it easier for investors to own gold.

There has also been overwhelming demand for gold coins and bars, to the extent that a shortage of physical product has developed.

Investor demand for gold is likely to intensify. Think of all that cash now sitting in T-bills, earning no return. The investing world is aware that the dollar is likely to decline from the recent highs.

As investors gain comfort that the financial crisis is over, money will flow out of T-bills as quickly as it flowed in, and that will set the dollar once more on a downward path. Since the gold price is nominally set in dollar terms, a declining dollar will automatically see the gold price rise in dollar terms. The following graph depicts the trade weighted average of the US dollar against other major currencies.



The downward path for the dollar will be even steeper than it was over the past few years. The financial crisis has further intensified the factors that were pushing the dollar down: Look at the enormous cost of the bailout of the financial industry.

That money is effectively coming from the printing presses without adding a lot to the economy. Worldwide confidence in the American financial system has also been hurt, and that will keep many foreign investors away from investing in the US.
For some investors, gold will replace the dollar as a safe haven.

In short, the gold price will benefit from a falling dollar and from rising demand from investors.

Some people are puzzled as to why this intense level of buying by investors in the gold market has not resulted in larger gains in the gold price. The reason is that investor demand is only part of the picture for the gold market.

Physical demand for gold is dominated by the jewellery market. Jewellery demand in the developed world, especially in the United States, has fallen sharply with the recession, offsetting growth in jewellery demand in the emerging economies. As a result, physical demand has not grown nearly as strongly as it has in the past. Demand for gold jewellery is still strong in many parts of the world, and will rebound in the west as the recession passes.

The European Central Banks have agreed to not sell more than 500 tonnes (or, about 16 million ounces) of gold a year. For the past three years, they have sold less than the quota. Other Central Banks are buying, offsetting part of that selling. The Asian nations hold a very small portion of their reserves in gold. China, with $2 trillion, the largest foreign currency reserves of any nation, holds less than 1% in gold. There is speculation that China and other nations might increase their gold holdings.

A very important factor is the see-saw between the investor demand and the jewellery demand. Investors tend to buy as the price rises and sell as the price falls. Jewellery makers do the opposite.



Another important variable is mine production, which has been falling for several years now. Offsetting that decline in mine output, dehedging is slowing. That is, mining companies have sold forward some of their production, so a portion of the gold being mined is going to satisfy the forward sales rather than being sold into the market.

Thinking back to the charts showing the market reactions to two previous financial crises, we can see that bullion is now back above where it was a year ago. The major gold producers have begun to recover, but are still well behind where they were before the crisis, and well behind the level they climbed to after the previous crises.

Of even greater significance, the smaller gold companies were beaten down far more than gold and the larger companies, yet they have barely begun to recover.

The chart below shows the ratio of share prices of the juniors versus the majors. The junior companies rose faster than the majors for a couple of years, but then fell much harder than the larger companies last fall.



Why do we care about the smaller gold companies: the explorers and developers?

Quite simply, they represent the future of the gold industry.

Economists would tell you that when the price of a commodity increases, demand falls and production increases. That doesn't necessarily apply in the mining world. The gold price has more than tripled in the past 8 years, yet demand continues to rise. Supply, contrary to economic theory, is falling.

Gold production if declining even though mining companies are producing all they can. Simply put, economic theory does not stand up to geologic reality. New gold mines are not easy to come by.

For years, gold companies have grown through acquisitions. While Barrick and Newmont are each bigger than they were a few years ago, the industry is shrinking. Gold production is falling. Equally importantly, the overall reserves in the gold industry are declining.

The larger gold companies have grown through mergers, but those mergers have been dilutive: the amount of gold reserves per share has declined substantially over the past few years.



In spite of a five-times increase in spending on exploration by the gold industry, the rate of finding gold deposits has fallen far below the rate of mining gold. See the accompanying graph that depicts this increase.

Most gold production is now coming from mines that are more than 15 years old. The pace of mine closures will accelerate, putting further downward pressure on the level of gold production.



The chart above is quite interesting. It shows the trend in average gold grades for the whole industry. You can see the grade is falling steeply. The average gold grade is now barely above a level that would have been considered a geochemical anomaly, nowhere near being a mine, when I started my career in the mining industry.

Geologists have spent decades scouring the earth. The big, high grade gold deposits that are sticking out of the ground have been found and developed and largely mined out. New discoveries will be smaller, lower grade, more remote and deeper.

That is good news for the gold price. In the 1980's, for example, when the gold price increased, production ramped up. That new supply contributed to a decline in the gold price.

We have had a rising gold price for 8 years now. The industry has increased spending on finding new gold deposits by 5-fold, to the highest level ever. Yet, the industry can not find enough new deposits to even replace the gold being mined each year.

So what does this mean to an investor?

First, it is supportive of a further rise in the gold price.

Secondly, it means that the gold mining industry desperately needs new deposits. Shareholders of companies that find new deposits will be richly rewarded. And, since it is getting harder to find new deposits, those companies that have gold deposits hold extremely valuable assets. The value in those deposits is not being recognized now, but in due course, investors will realize that existing gold deposits are extremely valuable.

In summary:

The Gold price is likely to continue to trend higher. At some time in the future, it will have a big move.

The gold industry needs new deposits.

That leads us to consider the gold exploration and development companies. Those companies offer big upside potential from:

• A recovery from being oversold in the aftermath of the financial crisis.
  
  
• Developments that will add value to their gold deposits.
  
  
• Takeovers by larger companies.
  
  
• Exposure to a rising gold market.

Just remember that not all small gold companies are created equal. Be selective.