It's No Time to Ditch Gold

06/01/2012 9:45 am EST

Focus: COMMODITIES

Curtis Hesler

Editor, Professional Timing Service

The Midas metal hasn't been faring well lately, but that's no reason to think about walking away, writes Curtis Hesler of Professional Timing Service.

Something I read recently remarked on how amazing it is that folks can look at a clear sky and see a color other than blue. Such colorblindness is an essence you will find discussed in Charles Mackay’s 1841 classic work, Extraordinary Popular Delusions and the Madness of Crowds.

If you haven’t read this book, do so. If you have, read it again—at least the first three chapters. Reason sometimes gives way to emotion and illusion, but the result is never profitable, either emotionally or financially.

In recent memory, we saw the dot-com hysteria in the late 1990s and the deflation of the real-estate bubble. In every case, logic became twisted to an extreme and lofty prices ended up correcting in a precipitous fall.

However, sometimes—like the bear market of 1973 to 1982—an inverse process unfolds. Rather than becoming absurdly overpriced, an asset class can fall to the point that reason abandons those assets and rare buying opportunities avail themselves. Stocks were so out of favor in the late 1970s that leveraged takeovers targeted companies in order to raid their cash and retirement accounts for a profit.

Often due to the madness of the crowd, an asset class can become too cheap on one occasion and too expensive on another.  The current precious metals market is interesting in this light. First of all, there is going to be a classic buying mania in the precious metals sector, but not right away. Looking at bullion, gold is simply correcting. For all intents and purposes, the 55-week moving average is holding the downside.

Looking at a daily gold chart, classic technicians may argue that a bullish “head and shoulders” pattern is developing here, and I concur. There was also a trend break to the upside last month. Such trend breaks are often followed by a retracement back to the trend line to test, followed by a resumption of the new uptrend. Essentially, the bull market in bullion does not look threatened, and this correction will be completed soon.

The anomaly can be found in the mining shares. You would logically expect to see a direct relationship between the miners and the price of bullion. When bullion rises, the price of the miners should also.

However, much like when sanity left the stock market in the late 1970s—a time when P/E multiples were single digits and companies could be purchased for less than their cash accounts—mining stocks today have diverged way too far from the price of bullion. They are simply silly cheap in many cases.

Typically, the relationship between gold and the miners is followed by watching the gold/XAU ratio, which measures the price of bullion versus the price of the Philadelphia Gold and Silver Index.

In days past, before the great crash in 2008, the ratio would cycle between about 3.50 and 5.00. A reading of 5.00 evidenced that the mining stocks were bargains, and 3.50 signaled a typical sell. The ratio broke over 10.00 last month, challenging the readings we saw at the depth of the 2008 fiasco.

The message is still the same. The mining stocks are as cheap as they have ever been, yet gold is twice as expensive. The miners are making money, and the producers are beginning to quietly buy up competitors' properties at ridiculous prices, much like the leveraged buyout raiders were doing with corporations in the 70’s.

It might be a good time to think about supply. We are all familiar with the concept of peak oil, but it is time to consider the idea of peak gold.

Gold production is becoming more difficult as the availability of profitable grade ore diminishes. The most promising new ore discoveries are less common and are in areas that are increasingly inaccessible. This is not unlike finding new crude oil sources.

Goldcorp’s (GG) Red Lake mine is unusually high grade, and that value will be exploited profitably. However, finding gold is becoming more difficult, and global gold production is soon to peak. Bottom line: when you look back at 2012, you will wax nostalgic at the buying opportunities here.

Looking at the XAU can also be instructive. It closed at this writing at $164.89, rallying off the $160 support zone I pointed out in the last letter. There is positive divergence in both the RSI and MACD.

My opinion is that the worst is behind us. The kickoff level is just over $180. Once the XAU hits $181, look for the mining shares to begin a strong advance.

Our mining share positions are down, and that can, if we are not careful, cause us to get caught up in the extreme bearish madness that goes along with buying opportunities. The key is to cut through the emotions and the media hype. Bullion is doing just fine.

And although mining shares are currently in disfavor, they will recover once bullion launches into its next up leg. Once you see August gold break over $1,700 and July silver hit $33.40, the race will be on. As the XAU tries to catch up, the resulting rally in our mining stocks will be very dynamic.

There will be plenty of fundamental support for higher metals prices once the next rally is underway. European financial distress will be at the root of it—and perhaps some geopolitical saber rattling as well.

Nevertheless, the signs are evident that investors should be investing in precious metals if they are underinvested in this sector —and holding tight to their positions if fully invested. Whether or not gold reaches $5,000 or the XAU hits new highs, this is definitely not the time to sell.

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