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Buy GDX Whenever it is Below 35 Dollars per Share--and Ignore Your Brother in Law
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There has been a great deal of commentary about whether or not gold mining shares should be bought at this time: whether they are oversold; whether their eight-year bull market has ended; how the collapse of the bubble in crude oil and agricultural commodities will impact precious metals; what the U.S. dollar may or may not do; and so on.
It is important not to lose sight of the big picture, which can be most easily appreciated by comparing the relative valuations of the price of gold versus GDX. GDX is a popular fund of gold mining shares which had its debut in May 2006. As with many exchange-traded funds, it was introduced several trading days following that year's peak for the precious metals sector.
Since then, there have been two deep annual lows for GDX: 31.82 on June 13, 2006, and 32.76 on August 16, 2007.
On August 11, 2008, GDX fell to an intraday bottom of 33.86. This level is therefore just a few percent above the lowest points from each of the past two years.
What is often forgotten is that the price of gold has increased substantially over the same period of time. Spot gold bottomed at $542.50 per troy ounce on June 14, 2006, and it recorded a higher low of $651.75 on August 16, 2007.
The profits of gold mining companies correlate closely with their net profit per ounce of gold. While costs for gold producers have increased due to higher wages, energy prices, and everything else, the spread between the cost per ounce and the price per ounce is still noticeably higher today than it was in August 2007. It is quite substantially above where it had been in June 2006--and yet gold mining shares have barely changed in their absolute valuations.
This represents an excellent buying opportunity for funds such as GDX, regardless of what else may be happening in the global financial markets.
Even if gold were to retreat all the way back to $700 per ounce as a part of a general commodity plunge, which is probably an overly pessimistic forecast, gold mining shares would still represent very good value as long as GDX is below 35 dollars per share.
GDX had reached a peak of 56.74 on March 17, 2008. When compared with this zenith, its recent low of 33.86 represents a pullback of slightly more than 40%. Historically, whenever gold mining shares have retreated by 40% or more, buying them has always turned out to be a profitable proposition when compared with their valuations one or two years later.
The recent slide in gold mining shares has had a very positive impact: it has knocked out most of the hot-money players, momentum traders, and what I call the brother-in-law investors. The fewer the number of amateurs who are participating in any plan of action, the greater its potential to be quite profitable. Any extremely popular trade, on the other hand, is almost certain to fail.
Brother-in-law investors are people who got tired of hearing how much their loudmouth brother in law was (allegedly) making in gold mining shares, and therefore decided to jump in when gold moved above $1000 per ounce. They couldn't help themselves; after all, they kept hearing every hour on the hour on cable TV shows back in March why they had to be in precious metals "right now, or else they'd be left at the station and miss the train completely."
These folks have been on one very overcrowded, poorly ventilated train ever since, and the ride has been even more unpleasant than a long-delayed Northeast Corridor journey on Amtrak (with which I am well familiar, having been born and raised in Baltimore and living in New York City for the past couple of decades). Recently, these hapless investors have been bailing out in droves, vowing to never listen to their brothers in law again.
This does not mean that you should be careless, and jump in after each rebound in this sector. There's a big difference between buying GDX at 34, and buying it at 38.50 (which was its peak from Thursday, August 21, 2008). In order to be successful as an investor, you must be highly price sensitive and absolutely disciplined.
As a simple rule of thumb, I am purchasing GDX whenever it goes below 35 dollars per share. The lower that it moves below that mark, the more that I intend to invest in the sector. On August 11 and August 15, I covered a modest short position in GDX and switched to a net long position of 5% of my total net worth. I plan to increase this holding, possibly by a substantial multiple, over the next several weeks.
Instead of jumping in whenever the mood strikes me, I have placed a ladder of good-until-cancelled buy orders at many different prices below 35. That way, I can be out to lunch or on vacation (holiday), and my orders will still be filled at my desired prices in my desired quantities.
The greatest threat to the prices of gold mining shares over the next few months is probably not a drop in the price of gold, which will likely have only a moderate impact. If global stock markets suddenly plummet, which is probably more likely than not, many amateur investors will rush to call their brokers.
When people panic, they don't calmly say, "Sell those securities which have recently crossed below their respective 200-day moving averages, but keep my gold mining shares." They scream, "Get out of everything now!" In other words, emotional investors act first and ask questions later. This could have a significant negative short-term impact on gold mining shares and their funds such as GDX.
Should such a general equity collapse spill over into gold mining shares, I will simply buy more of my favorite funds including GDX as the orders in my ladder are automatically triggered.
For those who prefer closed-end funds to exchange-traded funds, ASA is a good alternative to GDX. It is somewhat less liquid, which shouldn't matter unless you are trying to accumulate a position of several million dollars or more.
Of course, if you have (legal) insider information about individual companies, or you prefer your favorite individual gold mining shares, then buy more of them whenever GDX is below 35.
Buying gold mining shares is not recommended as a "get rich quick" scheme. The strategy I have outlined above will likely not produce windfall profits, or in fact any profits at all, in the short run. The best way to make money over the next two months is probably to sell short or any general equity fund. However, over the next year or two, substantial gains and possibly even a doubling from the ultimate bottom is a reasonable projection for gold mining shares and their funds such as GDX.
Steven Jon Kaplan
August 24, 2008
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Steve has been quoted in MarketWatch, Reuters, Dow Jones, Jiji (Japan), Barron's, and other financial media, and has been featured on MarketWatch's cable TV programming.
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