He simply wanted an advisory that compared what you pay (the stock price) to what you get (the gold in the ground).

It turned out, what he was looking for didn't exist. So in 1994, he started his own letter, Gold Stock Analyst. His idea was right on... His top 10 list has averaged 30% a year since he started his letter!

John discovered an extremely high correlation between the price of gold and the performance of the major gold stocks. And he devised a simple – but very effective – method for determining whether gold stocks are cheap or expensive.

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The relationship is simple to understand, too... When the price of gold is less than about $400 an ounce, gold stocks are nearly worthless, because it costs more to mine the gold than it's worth. But for every dollar the price of gold rises above the cost of production, gold stocks go up in value even more.

This is actually the reason you own gold stocks... They can go from worthless to outrageous values. They give you great leverage to the price of gold.

For example, let's say it costs Newmont Mining (NEM) – the world's second-largest gold producer – $400 to mine one ounce of gold. When gold is above $900 an ounce, like it is now, Newmont is incredibly valuable... You're talking roughly 100 million ounces of gold reserves with a potential profit of more than $500 per ounce. (That's $50 billion in potential profits in the ground!)

But when gold is below $400, as it was not that long ago, Newmont isn't worth anything. Okay, it's worth a few bucks, for hope. That's it.

The thing is, since the beginning of 2005, the price of gold has more than doubled from just over $400 an ounce. But the price of Newmont Mining is only up about 20%. Other major gold companies, like Barrick (ABX), have doubled in line with the price of gold.

But gold stocks are supposed to do better than this... The reason people buy gold stocks is for leverage to the price of gold. Meanwhile, these two big stocks are plodding along, at pace with or even slower than the rise in gold's price.

According to the January issue of John's letter, Barrick was trading at a stock market value of $253 per ounce of proven and probable gold reserves. And Newmont was trading at $233 per ounce. These are very cheap prices...

According to John's model, at these values, Barrick and Newmont are trading as if the price of gold were $650-$700 per ounce.

I talked to John on the phone about this last week. He told me, "Whenever the majors get to be double-digit percentages away from the line, they typically move back in line soon after."

Take a look...

There are two ways the majors can get back in line... Either gold stocks can soar in value, or the price of gold can fall. (Or we could see a little of both.)

The chart tells the story. (I took it from John's free issue on line. It covers from 2001 to early 2007 and I extrapolated it out to the present.) The bottom value on the chart is simply the price of gold. And the left axis is the market value per ounce of gold of the major gold companies.

Gold stocks are trading at a double-digit percentage discount to where they should be. The price of gold has soared. It's literally off the charts from John's 2007 version. But gold stocks haven't done what they should.

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I expect this relationship will return to "normal." It either means gold will crash by $200 an ounce... or the major gold stocks will roar higher. Take your pick... but the bottom line is gold stocks are cheap relative to the price of gold.

Good investing,

Steve

P.S. I've read John Doody's letter for years... I think it's a great resource for gold investors. Read more about it here.