In Tuesday’s Daily Reckoning, I explained why I thought gold wasn’t a ‘pet rock’, as one prominent Wall Street Journal columnist disparagingly refereed to it. I showed you a long term price chart that exhibited the same characteristics gold displayed back in 2002, when the last bull market got underway.
I’m confident that the next few years will be very bullish for gold and gold stocks. But that doesn’t mean you won’t experience corrections that make you question whether the bull market is for real.
I think we’re now at the start of such a correction in the gold market. Corrections are a natural part of market behaviour. It’s a way of restoring balance to a market that gets out of whack.
In recent weeks, gold has rallied strongly. Gold stocks have been relentlessly strong for the past few months. It’s now time for these stocks to pause for breath.
Investors usually respond to such corrections in one of two ways. They assume prices are close to a top. They see the pullback as a vindication of this view, and expect prices to keep falling.
Others see a buying opportunity. They use the correction to add to, or take new, positions in the market.
I see a buying opportunity too. In the next few weeks or months, I think you’re going to get a chance to buy into gold stocks at what could prove to still be an early stage of this bull market.
Because I see this as an outstanding opportunity to take a long term position, I’ve put together a special report on gold. In it, I outline what I think are the five outstanding gold stocks in the Aussie market, revealing where I think you should buy in the coming correction.
If you’re interested, keep an eye on your inbox tomorrow.
Of course, I could be wrong about gold. Maybe this is the top. No one knows the future.
But how do you protect against such ignorance?
I advocate the use of stop-loss levels. This is where you nominate a price at which you get out if the stock price falls below it. I know that sounds strange to many people. A falling stock price means it’s getting cheaper, right? So you should just buy some more!
I used to think that too. But it’s dead wrong. Sure, you’ll get it right sometimes by buying like this. But it’s a low probability play.
More often than not, a falling share price is a sign that something isn’t quite right. It’s an indication of weaker than expected earnings, or issues with management.
So how do I distinguish between a correction (when you should buy) and a share price fall (when you should sell)?
It all comes down to the chart. Let me give you an example…
The chart below is of Excelsior Gold [ASX:EXG]. It’s a stock I looked at when I was analysing the sector, but it didn’t really stack up. There were better quality options around.
Still, the rally at the start of the year was promising. If you bought in late 2015, the ride from just over 5 cents up to 15 cents was a highly enjoyable one.
A correction after such a strong run is to be expected. In fact, it is not unusual to see a stock price retrace up to half of the gain. So a move back to 10 cents was a normal correction.
[Click to enlarge]
However, after such a correction, you ideally want to see buying support come in, and you want to see the stock move higher. But in this case, EXG struggled to get back over 10 cents.
Then, in May, when other, better quality gold stocks were moving higher, EXG broke down to a new low. This was a sign to get out. It told you the stock was no longer correcting and consolidating for another move higher. Rather, it signalled that the trend had turned and the price was going lower.
And that is exactly what happened.
So the trick is to set your stop-loss level just below a natural and healthy correction point. If the stock falls below that level, you know something is up, and that it’s time to get out.
If you’re wrong, the damage won’t be too bad. But if you’re right, big gains await.
You can also use stock prices to help you in other ways. For example, in late November/early December last year, gold priced in Aussie dollars plunged to the lowest point in a year. You can see it in the chart below. That’s a bearish sign; many traders and investors sold out on that decline.
[Click to enlarge]
But the price action of the gold stocks didn’t support such a move. I explained this at the time in a note to subscribers of Crisis & Opportunity:
‘While the sharp fall in the Aussie dollar gold price is a concern, Aussie gold stocks remain well supported. After a very strong share price run over the past few months, most Aussie gold stocks are in a standard correction/consolidation phase.
‘From a technical or charting perspective, the price action is normal. That is, there are no signs of panic selling or share price breakdowns. This is a positive.’
As a result of this, I didn’t recommend selling gold or gold stocks at the time. Gold stocks were not confirming the breakdown in the gold price. My point is that you have to use as many different things as you can to work out this centrally planned and heavily manipulated market.
In my Crisis & Opportunity advisory, I use a combination of fundamental and technical (charting) analysis to get an edge. The results speak for themselves. My six-stock gold portfolio is up over 100%, and I expect much bigger gains to come as this bull market builds.
But first, the correction. That looks like it got underway this week. It could be short and sharp; or it could play out over a few months.
No one knows right now. But as I said earlier, if you’re interested in finding out more — about which gold stocks to buy and at what price in the coming correction — keep an eye on your inbox tomorrow.
For The Daily Reckoning