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How to Play the Coming Gold Meltdown

Correction presents short-term trades and buying opportunity for long-term investors

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I have followed precious metals for a decade and have come to appreciate the volatility in mining stocks — both to the upside and the downside. Right now, I think we are still in the bull market that started in 2001, but almost every year, we have had a meaningful shakeout. I’m seeing the same signs from the sector that I have seen before every meaningful dip in the past decade, and the coming correction will be a dip to buy.

Mining stocks and exchange-traded funds (ETFs) are notably underperforming the metals themselves. This “equity fatigue” is not only evident in gold and silver stocks, but also in copper and other industrial metals mining stocks.

While there is nothing wrong with purchasing some put options on the Market Vectors Gold Miners ETF (NYSE: GDX) or shorting poorly run gold mining stocks in order to capitalize on a correction, I have learned from experience that investors sold on the merits of gold bullion can be quite irrational about their precious metals investment.

For example, a profitable short sale suggestion back in 2004 resulted in plenty of hate mail to sift through. I could not believe my eyes as I read (quoting by memory): “Why are you doing this if you think gold is going higher long term? How dare you?”

That said, this is my current thinking on the sector, and I hope I can help you make an informed investment decision that leads to profitable trade.

Mining Stocks - GLD:GDX SIL:SLV

Above is the relative performance of GDX against the SPDR Gold Trust (NYSE: GLD) in red. GDX made a high in early December, and GLD made a new all-time high on Thursday … something is fishy here.

It is even fishier in the wild world of silver mining stocks. Silver has indeed gone parabolic, but the silver miners have not followed suit in 2011. While the Global X Silver Miners ETF (NYSE: SIL) has made marginally new highs since hitting a high of $27.53 in early December — it is close to that level as I write — silver bullion has done much better.

Silver bullion has advanced 20% since that December high in silver mining stocks while the stocks are marching in place. This massive underperformance evidenced by the black line in the chart above, which represents the SIL to iShares Silver Trust (NYSE: SLV) ratio, is as bad as I have seen it over the years. (I am not counting 2008, as that was a different kind of decline, one brought on by the banking crisis).

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