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Kaeppel's Corner: Gold Stocks Look Cheap, but........

By Jay Kaeppel, Optionetics.com | Wed March 21, 2012 7:00AM PT

 

As I type my gut keeps telling me that gold stocks are dirt cheap (don’t you wish sometimes that your gut would just keep its big mouth shut?).  Actually, in this case, my gut sort of has a point.  Let’s first consider the bullish case for gold stocks.  Then let’s consider some caveats.  Then we can discuss what to do with some (reasonable) intelligence.

 

The Bullish Case

Take a look at ticker XAU in Figure 1 and consider the salient points listed below.

 

Figure 1 – XAU: Overbought and forming a bottom?

As you can see in Figure 1:

a) Ticker XAU (which tracks gold and silver stock) is presently attempting to form a triple bottom in the 171-173 range.    

b) The 3-day RSI just bounced up out of deeply oversold territory (which has previously presaged a number of previous short-term buying opportunities).

c) For what it is worth, XAU formed a “key reversal” (a sharply lower lower intraday followed by a higher close) to the upside on 3/20 (for the record, it has been my experience that key reversals are extremely important.  Well, except of course for when they end up not meaning a thing.  Tricky business, no?).

Next let’s consider gold stocks versus gold bullion.  Figure 2 displays the ratio between Barron’s Gold Mining Index and the price of gold bullion since 1975.  I first discovered this ratio sometime in the mid 1980’s when as a young, ambitious “market analyst” I one day thought, “I wonder what happens if I divide this number by that number?” (We market analysts types are always doing really sophisticated stuff like this).  Nelson Freeburg, the editor of Formula Research eventually dubbed this ratio the K-Ratio.

In any event, the theory is that when the ratio is low, then gold stocks are “cheap” relative to gold bullion and thus should be expected to advance.  Conversely, when the ratio is high, then gold stocks are “expensive” relative to gold bullion and should be expected to decline.  With the exception of the Cubs never winning anything, this has (until recently – more to follow) been one of the most reliable trends I know of.    

Figure 2 – K-Ratio suggesting that gold stocks are “cheap”

As you can see in Figure 2, by historical standards gold stocks are presently dirt cheap compared to gold bullion. Historically, low K-Ratio readings have been mostly followed by higher prices for gold stocks.  But there is a caveat that I will mention in a moment under the Section ominously titled “The Not So Bullish Case.”

Still in all, there does appear to be reason to take a fresh look at gold stocks.

 

The Not So Bullish Case

Alright, so now we have seen the “good news.”  Now a few points need to be made to dampen our enthusiasm for gold stocks just a bit.

Concern #1: Does the K-Ratio still “work”?

Now that I have just touted the magnificence of the K-Ratio (low readings mean “buy”, high readings mean “sell”), I must reluctantly now ask the question “is this ratio still relevant?”  In Figure 3 you can see that the K-Ratio (the blue line) plunged to a record low during the panic of 2008.  This triggered a fantastic buying opportunity for gold stocks (the red line).  In fact, gold stocks almost tripled in value from low to high over the next 12-14 months.  Since then however, low K-Ratio readings have not been followed by the same robust strength in gold stocks.

Figure 3 – K-Ratio readings not as useful in last 6-12 months

On the right hand side of Figure 3 you can see that the K-Ratio (blue) has been at a relatively low level for some time now, but gold stocks (red) have simply continued to drift lower.  So either, a) we are setting up for the next big run in gold stocks, or b) the K-Ratio is no longer quite as useful. 

(As an aside, my concern regarding the usefulness of the K-Ratio going forward is this: in the past when people got bullish on gold their only choice was to buy actual physical gold or gold futures contracts.  Since most people are averse to these two things what would happen is that people would buy gold mining stocks as an alternative.  However, there is now an ETF (ticker GLD) that tracks the price of gold bullion, the metal itself.  As a result, there may no longer be the cause and effect of low K-Ratio being followed by people piling into gold stocks.  Instead they might just buy GLD, which thus reduces the demand that might propel gold stocks higher.  Not a bad theory at least as far as theories go, eh?).

Concern #2: Bearish Seasonal Period

History suggests that one might be better off waiting until the month of May before piling heavily into gold stocks.  Figure 4 displays the “Tale of Two Months”.  The results in Figure 4 measure the growth of $1,000 invested in Fidelity Select Gold fund (ticker FSAGX) during the months of April and May respectively, since 1989.

Figure 4 – Seasonal Monthly Trends (FSAGX during April versus May)

As you can see in Figure 4, there is no guarantee that gold stocks will decline in April nor that they will rally in May.  Still, if you had to choose you might note that since 1989 gold stocks have essentially doubled during the month of May and have declined -37% during the month of April.    

 

What to Do Now

Two things we know for sure:

1) Gold stocks are oversold and relatively cheap compared to gold bullion.

2) There are some obvious caveats to the bullish case in place.

Attempting to pick a bottom in the price of anything is fraught with peril.  As one who has succumbed to the urge in the past I can tell you there are two important things to keep in mind when attempting to pick a bottom:

1) Minimize your risk – assume you are going to be wrong and risk some minimally acceptable dollar amount that you are willing to “take a shot” with.

2) Don’t beat yourself up too badly if you do in fact turn out to be wrong (since, Murphy’s Law being what it is – that is the most likely outcome). 

With all of this in mind, for a person who simply cannot fight the urge to pick a bottom right here and right now in gold stocks, consider the following position (OK, perhaps first consider seeking professional help regarding your OCD tendencies – come to think of it, it seems to me that it should be “CDO” since that is alphabetical order – but I digress).

Buy 2 Jun 49 GDX calls

Sell 3 June 55 GDX calls

Buy 2 June 61 GDX calls

 

Figure 5 – Out-of-the-Money Butterfly spread in GDX

Figure 6 – Out-of-the-Money Butterfly spread in GDX

This position entails roughly $400 of risk and enjoys unlimited profit potential between now and June option expiration.

 

Summary

 I think I’ve pretty much already said everything I have to say on the topic of picking a bottom in gold stocks. 

So have a nice day.


Jay Kaeppel
Staff Writer and Author of “Seasonal Stock Market Trends”

Optionetics.com ~ Your Options Education Site

 

NOTES:

Interested in covered call writing? Log onto www.MoneySteps.com for a free trial.  Course videos by Tom Gentile and Monday/Wednesday/Thursday Case Study updates by Jay Kaeppel.

 


Recent articles by Jay Kaeppel, Optionetics.com


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July 15, 2013  -  Kaeppel's Corner: Beware the Market BLIP (Bernanke Linguistics Induced Panic)
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July 02, 2013  -  Kaeppel's Corner: Of Gold Stocks, Falling Safes, and Moths to Flames
June 24, 2013  -  Kaeppel's Corner: How To Enjoy Market Summer Boredom


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