The Contrarian's Strategy: Buy Gold

03/22/2013 7:45 am EST

Focus: COMMODITIES

Adrian Day

Chairman and CEO, Adrian Day Asset Management

The global easy money environment-as well as several contrarian factors-indicates a possible rally in gold, writes Adrian Day of The Global Analyst.

Gold's steady decline from early October to a six-month low has many analysts wondering aloud if the long bull market is over. We don't think so.

One can't be sure how much lower or for how much longer gold will fall, but we are closer to the bottom than the top, for both gold and gold shares. The fundamentals remain positive, while valuation indicators are near long-term lows.

There has been a cascade of factors over the past five months driving gold down from what was arguably an exaggerated high, including improving US economic reports, a strong global stock market, and an increasing focus on a future end to Federal Reserve stimulus. Hedge funds were exiting gold at the end of the year, including news that George Soros had cut his gold holdings in half.

But while the US economy has been improving, one can hardly call it robust. And while stocks have experienced a strong run, the fact that retail investors have started to pour money into equity funds-for the first time since mid-2008-should give a contrarian pause as to how long this rally may last.

Though "some members" of the FOMC think bond buying should end, the Fed has made clear that the "very accommodative" monetary policy would continue, even after the economy had improved.

With the new government in Japan embarking on a new easy money course, and the new Governor of the Bank of England suggesting that more stimulus is needed, easy money is global, and it is difficult to imagine policy here or overseas tightening any time soon. Monetary policy remains very supportive of gold.

Meanwhile, for a contrarian, the fact that hedge funds have sharply reduced their gold holdings is a positive sign. Another contrarian indicator is the rapid increase in the short selling of gold. According to Standard Chartered, there are 168 tons of gold sold short, well over the five-year average of 100 tons. What has been sold short has to be bought back eventually.

Lastly, various indicators have reached new extremes-including the oscillator indicator-back to extremes last seen at the beginning of 2009, suggesting a near-term reversal.

This is a painful period for holders of gold stocks. From the all-time high (September 2011) to today's level, the decline in gold has been 19%. We have seen much sharper declines before in this bull market-23% in 2006 and 29% in 2008. Both times, gold snapped back sharply, exceeding old highs within a year.

The stocks had sharper declines, but more dramatic recoveries. Following the stock decline in 2005, the XAU rose over 159% over the next year. From the 2008 lows, it jumped over 100%.

Many of the junior stocks moved even more. Indeed, most of our current buys would be among the juniors, which represent better value now. Our best buys include Vista Gold (VGZ) and Almaden Resources (AAU), as well as core holdings Franco-Nevada (FNV) and Virginia Mines (VGQ).

On a multi-year basis, our returns in gold have been quite satisfactory, notwithstanding the volatility. We want to be buying now, and look forward to good returns from these levels over the coming months and year.

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