In less than three months, the gold price has catapulted up U.S. $194 to settle at U.S. $1,187 last Friday. In that time, the share prices of OceanaGold Corporation (ASX: OGC), Northern Star Resources Ltd (ASX: NST), Newcrest Mining Limited (ASX: NCM) and St. Barbara Ltd (ASX: SBM) have risen 85%, 84%, 69% and 68% respectively.
Is it too late to invest or will the rally continue? Gold does tend to trend in one direction for extended periods. Beginning in late 1999, the gold price rallied from U.S. $252 to U.S. $1,780.This led to both Newcrest Mining and Kingsgate Consolidated (ASX: KCN) shares rising over 700%. With apologies to the American singer-songwriter Prince, should we begin to invest like its 1999?
In my opinion, there are two possible scenarios at play in the current rally. Too much growth leads to inflation and rising interest rates. Gold has in the past been a leading indicator of rises in other commodity prices due to rising world growth. This scenario suggests that now would be the time to buy the big diversified miners including BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO).
However, too little growth and a Japanese-style period of deflation may be beckoning. In my opinion, deflation is far more likely. Former US Federal Reserve Chairman Ben Bernanke has admitted that the rationale behind all the quantitative easing to date is to counter deflation. Unfortunately, apart from propping up worldwide asset prices, there has been little success.
The good news is that gold thrives under both scenarios of inflation and deflation. Further, if deflation is more likely, it would be detrimental for all but the precious commodities, which would inevitably result in a falling Australian dollar. Thus, the right Australian gold shares would receive a boost from both the rising gold price and falling dollar.
Here are my two recommended gold shares.
1. Independence Group
The recent reporting season revealed that Independence Group (ASX: IGO) has effectively transformed itself into a quality gold stock, with its proportionate exposure to base metals declining.
The record profit result illustrated that all mines are profitable and have strong cash margins. However, it is the Tropicana gold mine that is generating the most excitement. This stems from an expected increase in production rates and the potential to achieve exploration success close to the existing operations.
Providing additional assurance was the company FY2013 year-end cash balance of $46 million and only $16 million of debt.
2. Newcrest Mining Ltd
Sometimes investors have to take a counter-intuitive view. Last October, I recommended Newcrest Mining at $10.20. This was despite a litany of troubles including a recent gold price decline, a mediocre profit result in the August reporting season and some disruptive boardroom departures. Such times of turmoil are often the best time to pick up such a quality stock.
Newcrest is now subject to ongoing speculation of a capital raising due to its debt levels. If you are a true believer in a sustained gold rally, the stock offers substantial leverage just because of this high gearing. A recent rally (now reversed by a falling iron ore price) in Fortescue Metals Group's (ASX: FMG) share price illustrated this point. Suddenly the company was deemed capable of paying down its debt by generating vast amounts of cash from an elevated iron ore price.
The more recent February profit release was in line with market consensus forecasts. Perhaps more importantly, it lacked nasty surprises and even offered some potential upside from dividends in coming years.
Foolish takeaway
Gold may well afford some protection during a period of either inflation or deflation.
My preferred exposure is via Independence Group and Newcrest Mining. Independence Group is the more conservative choice with lower debt levels and its newly revealed status as a quality gold stock.
