Since the start of the credit crisis in August 2007, the XAU Gold & Silver Index of mostly large-cap mining stocks has tumbled 27%. In October alone – the worst month for investors in global stocks since August 1998 – the XAU Index has tanked 20%.

Gold bullion, however, has gained a cumulative 26% since the outbreak of credit panic in August 2007 while in a crash month in October gold has declined only 2%.

What ever happened to gold stocks protecting portfolios amid a market crash? Why have gold stocks disconnected from gold bullion lately?

On occasion, gold and gold stocks can deviate from each other. This is why it remains fundamental to hold physical gold (bars, coins, certificates) AND the gold mining stocks as part of a precious metals strategy.

Historically, this has occurred during extreme market circumstances like back in late 1979 when gold stocks collapsed and gold bullion was gaining traction ahead of $850 an ounce by January 1980.

The same phenomenon has occurred over the last 12 months with gold stocks absolutely mauled while physical gold has rallied.

Divergence in the precious metals sector can occur, and when it does it’s usually quite painful for those holding gold stocks.

In 2008, the XAU Index has plummeted 42% to a 3.5 year low with gold stocks now trading at a seven year high compared to the physical metal judging by the gold-to-XAU Index ratio. This implies gold stocks are absurdly cheap compared to the metal.

Gold stocks have failed badly this year, despite the fact mine production will be flat in 2008, demand is booming among nervous investors and European private banks have to wait almost three weeks to fill orders for clients – there’s barely any net supply of gold.

This is the time to hold both gold and the gold stocks, including silver.

The ongoing shift from a world obsessed with rising inflation has peaked since July. The major focus now is accelerated deflation, or an environment of rapidly declining asset values. This is the first time since the 1930s that prices worldwide are simultaneously falling together – stocks, bonds (non-government), real estate, hedge funds and other financial assets.

In the scramble for liquidity investors have thrown out the gold stocks in this panic, and since last Wednesday, have even started to sell Treasury bonds to meet liquidity provisions or margin calls.
In a deflation, gold should hold its value but anything traded on the stock market is unlikely to rise in value as the Wall Street tidal wave sinks all ships.

Eventually, the world will reflate again. Budget deficit targets in Europe will be smashed, the United States will expand credit like a monster and in time inflation will make a big comeback – far more serious than what has occurred until recently.

I expect gold stocks to probably double from these bombed-out levels over the next 12-36 months. Prices are extremely low. I feel the pain as a gold-bug but remain steadfast because the dollar and other currencies are simply poor long-term stores of value. The cost of this bail-out, now global, will be enormous and will continue to rise. Be patient with gold and the gold stocks. Salvation is coming.