When to Buy Gold Stocks

“I think we’re going to have some of the worst inflation, with all the printing presses around the world running 24/7.”

That’s what leading contrarian investor David Dreman said in an interview two weeks ago.

Now, I know what you’re thinking, classic inflation hedges have fallen out of favor. Precious metals stocks have taken a beating over the past few weeks. And deflation, not inflation, is the fear du jour.

But if you recall, Dreman is a true contrarian and value investor. His success has come from sticking to investment trends through all the ups and downs.

For example, Dreman really made his mark in the early 80’s. At the time, stocks went nowhere for a decade. No one wanted anything to do with stocks except for Dreman who wrote a book making the case for buying stocks.

When the markets were really rolling 20 years later, he managed not to get caught up in the tech stock euphoria. At the height of the bubble Dreman lagged the S&P 500 by 34 percentage points. When the bubble burst in 2000 though, Dreman’s contrarian mentality and value-oriented focus led him to trounce the S&P 500 by 50 percentage points.

Then, once again, we had the chance to get together with Dreman a few months ago. It was a late Friday afternoon in February. The markets were falling week after week. They were slowly and painfully working their way to new decade lows. Dreman shut his office door, took about an hour to chat with us, and then recommended doing something “crazy” – buy bank stocks. Three months later most bank stocks had doubled or tripled in value.

As you can see, Dreman is a real contrarian. He doesn’t pay much attention to the short-term ups and downs of the markets. His success has come from identifying an opportunity and then waiting for it. That’s what it’s going to take to get prepared – and stay prepared – for the eventual inflation.

Now, it’s not our goal in the Prosperity Dispatch’s to state the obvious, get prepared, and merely wait for the opportunity whether it’s one, five, or 20 years away. Most of us don’t have the luxury of that kind of time horizon. Our goal is to figure how to best get prepared and find profits in the short-term and long-term.

With that focus on both the short-term and the long-term, it’s looking like a good time to start looking at gold stocks once again, for quite a few reasons.

Some Things Never Change

The market downturn has changed a lot of things. The bubble era has come to an end. The time when P/E ratios of 20 to 25 are “reasonable” is over. But the one thing which hasn’t changed is the impact of market psychology.

We’ve been over how the markets are highly cyclical before. Whether it’s the different stages of a bear market rally or how a new investment thesis takes hold and sectors fall in and out of favor every two or three months, market psychology is the main driver.

And whether you’re a long-term investor focused on the big picture or a short-term trader moving with the markets, these cycles are important. They allow short-term traders to profit on the daily or weekly swings. They also provide long-term focused investors the opportunity buy low and sell high.

That’s why now is the time to start looking at gold stocks. They’ve taken a beating over the past few months, are almost completely out of favor, and this could be an opportunity to starting buying back into gold.

Patience and Profits Go Hand in Hand

The price of gold has been on a volatile ride over the past few months. Gold stocks, as a leveraged bet on gold prices, have been even more volatile. A few months ago it looked like gold was on the verge of a big move higher.

Gold was knocking on the $1,000 an ounce door and, once again, it was turned away. But it doesn’t mean gold is done forever. In fact, the opportunity in gold has only become more compelling. The realistic consideration of a second stimulus, the long awaited launch of the Treasury’s PPIP, and the growing government deficits (of which money printing is the only politically feasible solution), will go a long way to proving this correction in gold will be temporary.

That’s why right now gold stocks are looking good once again. We’re entering the third and final stage of the correction in gold stocks.

We went through the first stage about a month ago. At the time gold was in all the headlines. When hedge fund manager John Paulson disclosed he was buying gold and gold stocks he made them “cool” again. Gold was hot and a “this will be the last opportunity to buy gold stocks” mentality was taking hold. As usual, the euphoria didn’t last.

Then we entered the second stage. This is the period when commentators start focusing on the long-term case for gold. They start making projections like “gold is going to take a while” and “if you’re going to buy gold, you better be in for the long term.” We looked at gold the same way, but we were doing it throughout the first stage and looked into how Paulson’s trades, although very profitable, usually take a couple of years to play out.

Now we’re in the third stage. When gold stocks are completely out of favor, deflation is overtaking inflation as the dominant fear, and Wall Street moves onto another hot sector. And it’s the third stage which is time to buy.

Of course, gauging market psychology is a tough thing to do. It’s not a firm science. But there is a way we can apply quantitative measures to it.

Another Case of Great Expectations

One of the most reliable indicators to help ensure you’re getting into gold stocks at a good time can be found in the relationship between gold and gold stocks.

The relationship is obvious. The higher gold prices go, the higher shares of gold miners should go. After all, their profits are highly leveraged to gold prices.

But there’s one more consideration. That’s the fact that stocks are valued over the long-term expected cash flows. It’s true for every sector – even gold.

As a result, the long-term expectations for the price of gold has much greater impact on gold stocks than the actual price for gold.

Just take a look at the chart below which tracks gold stocks relative to the price of gold (SPDR Gold Shares – GLD/Market Vectors Gold Miners – GDX):

During the mass deleveraging last fall, an ounce of gold fell 30% from its highs for the year to around $700 an ounce. Gold stocks fared much worse. The gold miners ETF fell 70% from its highs.

At the time, gold held up, but it was the expectations for gold which drove down gold stocks and held them down (granted, there were other factors, but it was primarily deflation fears).

Since then, the relationship between gold and gold stocks has become much more normal. And now we can use it to help us determine when to buy gold stocks.

Basically, you want to buy gold stocks when the ratio is high (which signals expectations for gold prices are low) and take some profits when the ratio is low (which signals expectations for gold prices are high).

If you take a glance back at the chart, you can see the ratio is on the rise and getting to recent high levels. The upturn in the ratio shows expectations are low and a time to buy is coming up (for more on the ratio, its long-run averages, follow this link for a full explanation).

Most importantly, the ratio helps steer us away from sectors that are too hot or they’re just a bit too crowded. The last three high points in the ratio (October, February, and April) all signaled good entry points for gold stocks.

A Disciplined Approach

Although there are no hard and fast rules for market timing and trying to get into a sector, these factors do show the importance of maintaining discipline when it comes to investing.

For instance, had you bought into gold stocks a month ago when Wall Street Journal and Bloomberg headlines were directed towards gold, you’d already be down about 20%. If you waited, however, and made a predetermined plan to buy at specific intervals you’d have plenty of cash on hand to start nibbling away at an out of favor sector.

All this just shows, once again, how dangerous it is to run with the herd in today’s volatile market.

The herd will come back to gold and other inflation hedges in the future. It’s only a matter of time. The likes of Dreman and Paulson are all getting prepared for it now and we will too. And by paying attention to the short-term and utilizing all the tools available, you can reduce risk and earn a better return over the long-term.

By Andrew Mickey

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