How to Play the Coming Gold Meltdown

by Ivan Martchev | March 29, 2011 1:55 pm

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[1] (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[2]) 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[3]) 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[4]) 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[5]) 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).

I suppose that the Federal Reserve is (partially) to blame for the current surge in commodity prices. There is a coordinated G-7 intervention to keep the Japanese yen from surging in order to help the decimated Japanese export-driven economy. The yen had been surging as the Japanese were repatriating foreign funds to help pay for the damage at home.

This is in effect also suppressing the U.S. dollar and is relevant for precious metals investors as they have long been viewed as anti-dollar investments. I am not sure how long this yen intervention will persist, but it may be postponing the coming correction in gold.

If you think a correction is coming as I do, you need to be careful, especially with small-cap mining stocks. If you have large gains, take some off the table as the declines in small-cap mining stocks look like a crash almost every time. Many do come back and make fresh all-time highs, but it certainly is an experience that most holders of such stocks can do without.

The Market Vectors Junior Gold Miners ETF (NYSE: GDXJ[6]), which tracks small-cap mining stocks, has somewhat liquid options and some at-the-money June puts might come in handy here (or the relevant spread trade that aims to capitalize on the fact that the ETF has serious trouble staying above $40).

Long-term investing is about strategy; this is still a bull market in gold bullion and mining stocks and ETFs with years to run. Short-term trading is about tactics; you could have made a lot of money shorting gold stocks over the years with the proper timing.

As the great Chinese general Sun Tzu said many centuries ago, “Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.” Invest accordingly.

  1. exchange-traded funds:
  2. GDX:
  3. GLD:
  4. SIL:
  5. SLV:
  6. GDXJ:

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