Sunday, October 5, 2008

The next play - gold stocks

Once we get the end of this intermediate bear market leg down that's causing everything except U.S. Treasuries and cash to go down, we will have a "recovery" bounce in just about everything. Currently, I have all my money in cash, gold and market shorts (shorting Bank of America (BAC), KB Homes (KBH), S&P 500, and commerical real estate via the SRS ETF).

I expect to cover my shorts (which are actually put options) before October is over and potentially as early as this week if the market has another big panic move down. Once I do that, I am going to use the proceeds to go long the gold mining sector.

I believe blue chip miners will go up 50-70% in a 6-7 month time frame once the general stock market intermediate term bottom occurs. Catching the exact bottom is impossible except through luck, and I'm not very lucky, but I only need to catch 70% of this coming move to make a bundle.

There are some charts and fundamentals that justify my belief in a coming big rally in the gold stocks. The first is that a deflationary environment actually benefits gold miners because the "real" price of gold generally rises, even if it's nominal price remains flat or even slightly declines. In other words, the schizophrenic nature of gold becomes exposed. Though gold is a commodity and an inflation hedge, it is also the oldest form of money, and cash is king in a deflationary environment. If you think of gold as money instead of as a commodity, think about what a boon deflation is for gold miners. Other commodities (like energy) and labor costs go down in a deflationary environment, so the cost of digging money out of the ground decreases and money becomes the world's most valuable investment during a deflation.

To get a proxy sense of the "real" price of gold, we can use a ratio chart that divides the price of gold by the price of a basket of commodities (the $CCI).

Notice the breakout to new highs, which I believe is the beginning of a powerful new leg up in this ratio, increasing miner profitability. Next, I want to show you a ratio chart of the price of a gold mining index (the $HUI or gold bugs' index of un-hedged miners) divided by the price of gold. When the chart is going up, gold miners are considered to be more highly valued than gold and vise versa.

As you can see, gold miners strongly outperformed gold itself in the first 3 years of the gold stock bull market, but have lagged the price of gold for the last 4 years. This situation is about to reverse. I have given my estimate of Elliott wave count for this chart, which must be a pretty clean chart for me to even attempt it. Bottom line if you're not into Elliott theory, the "correction" for miners relative to the price of gold is nearly over (i.e. the "C" wave is almost done) and the next leg up should be powerful and roughly 2-3 years. Looking at a gold mining index chart, such as the GDX/$GDM, it is clear that we are undergoing a major (rather than a minor) correction that I believe will complete before the end of November. Since I don't know exactly when the bottom is in, I am going to buy gold stocks once general stocks (i.e. S&P 500)are done tanking, as a severe stock market decline (which we are in now) often takes everything with it.

Below is a chart I found on (a great gold site), which shows how Homestake Mining, a major gold miner at the time, did during the greatest deflationary bear market of the last 100 years.

A few things are clear here. First, gold stocks did go down during the initial panic in 1929 and second, the most spectacular gains occurred after the final stock market bottom in 1932. However, the chart doesn't have a log scale and a trader could have bought Homestake in late 1930 for a roughly 30% gain over a few months, in early 1931 for a roughly 75% gain over six months, and then in mid-1932 for a 300% gain in 1 year. Because this will be the "first" leg up in the next wave of the gold stock bull market, we don't know exactly how big the move will be, but such is trading. If you're not into trading, you can simply buy the GDX, GG or AUY this fall and hold for 3 years to make lots of money while everyone around you is losing their shirt. Me, I'm going to lever up and go for the gold, selling at what I think is the end of this leg up so I can switch to shorting the market again next spring.

I plan to play this coming leg up by buying 2010 LEAP call options on a few blue chip miners including Goldcorp (GG) and Yamana Gold (AUY), as well as a smaller gold company called Royal Gold (RGLD). For those not as familar with the sector, I would recommend GDX, an ETF that holds a basket of mining companies (LEAP options can be purchased to leverage gains and risk and the basket eliminates the risk of picking the wrong company in the sector).

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