FRANK HOLMES: Great to be here, Jon.

RESOURCE INVESTOR: Well, the U.S. dollar is trading at record lows against the euro, and it seems like every bit of economic news coming out spells doom for the U.S. economy. Spot gold prices have gained 20% this year, even though we’ve seen some profit-taking here recently. After closing out last year at about 31% higher, we’re now very close to the much-anticipated 1,000 ounce gold level.

Now how did we get here, and just how much further can we go?

FRANK HOLMES: How much further can we go? Well, in the longer term, I believe that gold will probably go to $2,000 or higher, and there are several reasons for that. It’s not just one. But all the other commodities have gone through their inflation-adjusted prices of 1980 except for gold and silver.

And silver always piggy-backs on the price of gold, so gold is much more of a monetary asset, and it’s money around the world. And with that, we’re seeing group-think out of central bankers out of Europe that are basically putting supply in the system. Eventually, they’ll be gone, and then gold will go to its natural levels.

RESOURCE INVESTOR: Now, do you see any short-term correction on the horizon?

FRANK HOLMES: Well, we use a series of quantitative models, and we look at the stress between oil price movement and gold and the dollar. And then we look at the dollar versus the yen versus the euro. And there are correlations, such as the price of oil and gold moving the same direction 90% of the time. And the dollar and gold move opposite 70% of the time. So it’s never 100%. And then we have a correlation between the yen and the euro and the dollar, and recently the yen has been on a tear, and the euro’s been strong, but really, the yen's been strong on a relative basis.

The year-ends for Japan (fiscal year-end for companies) are at the end of March, which are coming up, it's basically our December and we get a lot of disclosure. We’ve not heard much negative news in the subprime in Japanese banks. So odds favour that if there’s any type of news that comes negative out of Japan that that currency would all of a sudden go through a correction, the dollar would rally, gold correct, and then you get on with this wonderful bull market in gold.

RESOURCE INVESTOR: Yeah, indeed. Now, the Federal Reserve has cut benchmark interest rates from 5.25% to 3% since September and confidence in the dollar has never been lower. Now, is there a point where interest rate cuts no longer support higher gold prices, meaning is there a point where worsening economic problems could bring gold back down?

FRANK HOLMES: Well, that’s always a great question. I think the more important part is that gold always performs whenever you get big deflation or big inflation. And the concern in the whole cycle for us has been deflation. Yes, there’s inflation showing up in various products, and with the dollar weakened, it basically imports inflation to the U.S. And there’s food inflation, etcetera.

However, I really have the concern that the biggest asset that investors have is real estate, and that’s very deflationary presently, and that’s much more to get your arms around because of what took place in the depression that lasted for over a decade, and Japan went through over a decade of deflation.

Inflation’s really easy to curtail. Cut back money supply, spike up interest rates, and immediately the economy slows down, and so does inflation. So I think the real concern is trying to manage it. And the talking heads are (saying) "inflation, inflation," but really, deep down in the belly of bankers is the worry of deflation.

Gold always performs well in either or.

RESOURCE INVESTOR: Yes. Now, I’m going to move on to the age-old debate, gold versus gold shares. What are your thoughts on this? Do you like futures, gold ETFs or mining equities?

FRANK HOLMES: Well, that’s another great question. There's been papers written back in the ‘80s out of Wharton, by a professor at Wharton, University (of Pennsylvania), and then Ibbotson has recently written reports, and we’ve done some of our own research. And basically, there are periods when bullion overperforms stocks, and stocks overperform bullion.

We are at a stage right now that bullion has been outperforming gold shares, and there’s been two compelling reasons for that. One has been the cost structure. The grades of many of these old mines are low and the costs have been rising. When you take a look at the income statement, 10% to 40% of the costs of operating these gold mines is energy. And with oil prices rising faster than the price of gold last year, then naturally, you can see a cash flow compression and you’re not getting those returns. So I think that that’s one factor, energy costs. There’s no "show me the money."

The other factor has been if you look at per share basis, the reserves per share and the production of gold per share, it’s actually been declining because so many companies have been doing financings, and they’ve been diluting the shareholders faster than they’ve been able to find reserves per share or increase the production per share.

And that’s having a big impact on the valuations for these (companies). But there’s a point where this will all pretty well, I believe, show down, and you'll start seeing the mining shares become more attractive for leverage.

The math says you should have a 10% weighting to gold and that’s about roughly the average you should have. Five percent into bullion, 5% into gold shares, and you rebalance. So in years that bullion’s going to be better than the gold shares, you rebalance it by the gold shares. The years that gold shares are better, you rebalance it by bullion. And then you still always try to maintain 10% of your overall portfolio of having this gold exposure.

RESOURCE INVESTOR: Sure. Sure. So do you believe gold shares are due for a catch-up to bullion right now?

FRANK HOLMES: I do. They’ll both correct. Gold’s correcting; the shares will correct. And then I think on the next leg, we’re going to get an overperformance of gold shares.

The other factor that hurt last year, Jon, has been the liquidity crisis. That is, the best performing shares are gold shares, so what do people do? They always sell their best performers to basically deal with their margin calls - hedge funds, etcetera that use gold shares they’ve been steady dumpers. So not only have you had a margin compression, you’ve had to do it as a source of liquidity.

RESOURCE INVESTOR: Sure. Sure.

FRANK HOLMES: The last thing I want to point out to you, it’s very important for your listeners and readers, is the big sea change that's taking place in the last couple years - the acceptance of commodities as an asset class. And we saw Calpers recently commit another $500 million towards commodities.

Well, what’s really fascinating is like anti-buying gold shares by some of these pension fund groups, they don’t want to own Newmont [NYSE:NEM] because they don’t like the union, because it’s a fireman’s union of some city or whatever, but they’ll turn around and buy bullion.

To me, it’s the most intellectual disconnect ever, so you’ve seen more money from these pension fund groups flowing directly into the commodities rather than any of the mining shares.

RESOURCE INVESTOR: Yeah. Now, during these times of sky-high gold prices, do you prefer producers, developers or explorers? Our readers would love to hear a few of your favourites.

FRANK HOLMES: What your readers should capture is the danger of these gold ETFs - equity ETFs – there is a gold equity ETF. And you’re seeing money flow into that faster than you’re seeing it into gold funds. And with that, you’re seeing that basically all the shares in those gold ETFs are getting where all the liquidity is, but if you’re outside of that world, then there’s hardly any buying.

So a lot of the junior stocks have not had any fresh money come to them, only those that are in the ETFs. That is going to affect capital formation for raising money for a new venture, and some hedge funds have basically ... I remember in November, one particular fund blew out $80 million worth of junior gold stocks in a day.

Not only was it a bad down day, it was just a bad day for juniors because they were underperforming. We saw the juniors last year underperform by 20% versus the overall gold equities. And my concern is that this formation of capital, unless there’s some big discovery, significant, big, multi-billion dollar big discoveries, that you’re not going to get money going into the exploration plays.

But what’s positive (that’s the negative part ... now let me talk to you about ... it’s a threat) let me talk to you about the opportunities. As the bifurcation gets greater between those that are producers, big cap versus mid cap, mid cap versus small cap, you’re going to get the Pac-Man. The big cap’s going to buy the mid cap. So my price to book is at a high level, then I’m going to buy a mid cap because it’s cheaper and safer to buy another company than it is to explore or develop resources. That mid cap is going to run out and buy junior, and the junior’s going to buy a developer.

Exploration? That’s high risk. I think that’s going to have a difficult time unless its flow-through money. But I think if you’ve got lots of reserves per share, and you have more than a couple of grams of gold per ton, and it’s not deep underground, then you all of a sudden show up on the radar screen to be acquired.

RESOURCE INVESTOR: Sure, sure. Well, unfortunately, we’re going to have to leave it there, Frank. Thanks for talking with me today.

FRANK HOLMES: Great.

RESOURCE INVESTOR: It’s always a pleasure speaking with you. Once again, we were speaking with Frank Holmes, CEO of US Global Investors on Resource Investor Podcasts."