At the outset let me note that it is “Annual Forecast” season.  I am always fascinated by “predictions”, especially those made regarding the financial markets and the economy.  Of course, the thing that fascinates me most about these types of predictions is that anybody actually listens to anybody else’s predictions. I am occasionally asked questions like “what do you think the stock market will do in the next year?”  My stock answer is pretty simple - “It beats me”.  Unless I am in a smart alecky mood in which case I switch to the even more succinct - “Fluctuate.”  That usually ends that line of conversation pretty quickly.

But what I really want to do in these situations is to pull the questioner aside and like a dear old friend give them some sage advice that I have learned over the years and which I have cleverly (if not with the best of grammar) fashioned into:

Jay’s Trading Maxim #7: “Predictions don’t mean diddly squat.”

For the record, this Maxim started out even more succinctly with a single four letter word in place of “diddly squat.”  But I am a family man and what not, plus in all candor it is actually more fun to say “diddly squat” than the original word (oh go ahead and try it, you’ll see what I mean).

All this being said, there are two acceptable “predictions” that can be made year in and year out regarding what we can expect in the year ahead:

1) “More inexplicably bad decisions from Washington” and;

2) “the Cubs will NOT win the World Series.” 

Write those two predictions in stone.  All others should be ignored.

Dealing with Gold Bugs

I have never considered myself a “gold bug” – you know, one of those people perpetually fixated on the yellow metal and all things surrounding it, and willing to talk about it ad nauseum.  I can assure you that these people do exist.  For the record, once they get started talking about gold it is certifiably (and isn’t that an appropriate choice of words) impossible to get them back off the topic.  Your only choices are to:

A) Wait for them to exhaust themselves (although I have yet to see this actually happen),

B) Suddenly look at your watch and shout, “Oh my goodness, look at the time" and then run off.  When executing this strategy remember – do not hesitate!  Make the announcement, then turn and run.  If you accidentally leave something behind (briefcase, cell phone, children, etc.) do NOT attempt to go back and retrieve them until you're sure the coast is clear. 

C) Feign a major illness.  However, in this situation do not be tempted to throw up on the gold bugs shoes.  While a tempting strategy, there is a better than even chance that the person will just keep talking and then you are still stuck standing there except now it smells like, well, you get the idea.

So, no I am not one of “those” people.  Nevertheless, I have always held a fascination for gold stocks.  I think this stems from the fact that they are extremely volatile and that in the right situation they offer a great deal of upside potential (albeit with attendant downside risk) – in a relatively short period of time.

Playing with Gold Stocks

Back in the mid-1980’s “I developed” something that was later dubbed by Nelson Freeburg of Formula Research as the “K-Ratio”, as a timing tool for gold stocks (in this case, the phrase “I developed” is more accurately defined as “one day for no real good reason I divided one number by another number, um, because I could” just to see what the ratio looked like over time.  Sure, I was pretty “cutting edge” back in the day).

Anyway, the K-Ratio is simply the Barron’s Financial Weekly Gold Mining Index divided by the price of gold bullion.  The history of the K-Ratio appears in Figure 1.

Figure 1 – K-Ratio (Barron’s Gold Mining Index divided by Gold Bullion) indicates gold stocks are historically "cheap" relative to gold bullion

In a nutshell, this ratio tells us whether gold stocks are “expensive” or “cheap” relative to the price of gold bullion.  Low readings mean gold stocks are "cheap", high readings mean that they are "expensive.  Up until recently any reading under 1.00 was invariably followed by a major advance in gold stoc*ks.  To wit:

1/11/1980 – Gold stocks doubled in 9 months.

4/14/2000 – Gold stocks continued to decline for 6 months, but had just about doubled by June of 2002 (a pretty good performance given that the NDX fell -64% during the same time).

10/3/2008 – The K-Ratio fell below 1.00 with the Barron’s index at 791.  3 weeks later the K-Ratio plunged to an all-time low (until recently) of 0.66 with the Barron’s index at just 470. By the end of 2010, the Barron’s index was up +105% from 10/3/2008 and up over +245% from the ultimate low.

But from there, things have gotten a bit “murky”.  The K-Ratio dropped back below 1.00 on 5/6/2011 and has stayed there pretty much ever since.  In fact, the K-Ratio hit a new all-time low of 57.6 on 12/7/2012.  Still the Barron’s index is presently roughly 30% below its level on 5/6/2011.

All of this could lead someone to state that “Jay, your K-Ratio doesn’t work too well anymore.”  To which I reply – well, OK, first, “Ouch”, but then I would add two other statements.

1) You may be right.

2) But the jury may still be out.

One dynamic that has changed is the availability of ticker GLD, an exchange-traded fund that tracks the price of gold bullion. Prior to the popular migration to this fund, when investors got bullish on gold their only real choices were to:

a) Buy actual physical gold (a bit cumbersome and needed to be stored somewhere)

b) Buy gold futures (potentially very profitable but involves that pesky “unlimited risk”)

c) Buy gold stocks

So the vast majority of bullish gold investors would stampede into gold stocks, which would then drive prices higher.  Now an investor who is bullish on gold is far more likely to simply buy shares of GLD to track the price of the metal directly, rather than to use gold stocks as a surrogate.  So gold stocks may be becoming the “forgotten sister”, hence the reason they have been meandering lower relative to gold bullion.

Gold and Gold Stocks Now

Figure 2 displays the weekly price action of ticker GLD (black bars that track gold the metal) and ticker GDX (red bars that track an index of gold stocks).  If you look at the black bars (GLD or gold) one can argue that gold has topped out, that gold is fluctuating in a trading range, or that gold is poised for another move to the upside.  It’s all in the eye of the beholder.

Figure 2 - Ticker GLD (Black bars - tracking gold bullion) and Ticker GDX (Red bars - tracking gold stocks)

Gold stocks as measured by GDX have lagged GLD pretty badly.  So if gold has topped out and starts to decline in a meaningful way things could get ugly for GDX.  Still, I look once more at the far right side of Figure 1 and remember that at no time during the past 37 years have gold stocks been cheaper relative to the price of gold.  So my goal is twofold:

1) Make some good money if gold stocks go up

2) Don’t get killed if gold stocks go down     

So let’s look at one way to play.

A Call Option on a Triple-Leveraged ETF (Ticker NUGT)

First let me remind you that what I will discuss next in NOT a recommendation.  In all candor, it might even be a good idea. What it represents is essentially one way to “play” a possible outcome without “betting the ranch.”  Ticker NUGT is a triple-leveraged ETF that is designed to emulate the daily performance of a given gold stock index times three.  Can you say “Volatile?”  Figure 3 displays the daily bar chart for NUGT with the MACD (18,37,9) indicator below.  Note that while NUGT has declined precipitously, MACD has been working sideways to higher (i.e., a potential bullish divergence) and NUGT often “pops” for at least a little while when the MACD histogram moves from negative to positive.

Figure 3 – Ticker NUGT (Direxion Daily Gold Miners Bull x 3)

Now the truth is that I have a slight phobia of triple-leveraged ETFs.  So let’s instead look at a call option on NUGT. 

Figure 4 displays a position holding 3 June 2013 NUGT 10 call options at a cost of $585.

Figure 4 – Long 3 NUGT June 2013 10 Calls

Be forewarned, it is quite possible that gold stocks could collapse and that these options could decline in price.  Still, the investment and the total dollar risk is only $585. In reality, if gold were to break hard and gold stocks collapse you could sell this option well in advance of June expiration without losing the full amount.

On the flip side, if gold stocks do “pop” at anytime in the next 5+ months and NUGT manages to retest its September 2012 high of $19.41, this position could generate a profit in excess of $2,300.

Summary

So let’s see if we can sum it all up:

A) Don’t put faith in predictions – look at reward-to-risk and probabilities and make up your own mind.

B) Nothing works forever.  If something you have trusted (for example, K-Ratio) starts to falter, see if you can figure out a reason why (advent of ticker GLD?) but don’t necessarily discard it, for it might surprise you at some point (if anything at all positive happens in gold, gold stocks are coming off of “dirt cheap” territory.)

C) Always look for opportunities to minimize your risk while maximizing your potential upside (not always possible granted, but a call option on something as volatile as a 2x or 3x ETF is a strategy you should at least ponder).

Well, I could go on and on about gold but I am afraid someone might throw up on my shoes……

Jay Kaeppel

Staff Writer and Trading Strategist

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