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Trading Lessons

Using Gold's Cyclical Model to Trade Junior Gold Stocks

Commodities / Gold & Silver Stocks Dec 01, 2009 - 02:38 PM GMT

By: Bob_Clark

Commodities

Best Financial Markets Analysis ArticleGold is cyclical. Can knowing this help us make logical trading decisions about low priced gold stocks known as Juniors? Do these wild, speculative stocks even care  what the price of gold is doing. Even if they do, why would I want to gamble on such a high risk investment? Lets take a look.  

Since gold has bolted to new highs, I am getting more questions about the gold ETF, gold stocks, their options and juniors in particular. Here are a few of the questions and issues.    


Gold is so expensive, so is the gold ETF, how do I protect such a big investment? 100 shares of  GLD costs $11,500 and I don't want to trade 3 share odd lots, any ideas? I don't have a lot to invest but I want to participate, should I buy options? Are gold futures the same as the gold ETF?

Are Juniors as risky as people claim?    

I am not a stock picker. My business focus is on strategic risk management. We use ETFs because of their diversity and liquidity. The GLD ETF is not diverse at all but it does trade on a stock exchange and is very liquid.

Here are a few of my thoughts. Many of the vehicles that we trade today were designed when the price of gold was much lower. When GLD was started, gold traded near the $400 dollar range. At that time a regular 100 oz gold futures contract was worth $40,000, now it is worth $115,000.

Trading two or three shares on an odd lot basis is do-able but full service brokers may charge extra. With large positions you should protect yourself, large draw downs on unprotected positions can be confidence shattering experiences, even when you are right long term. The last drop in GLD was nearly 35%!

Once you start trying to defend against draw downs, you find yourself in the arena with the Fat Boys. They are the ones with all the talent, money and technology. They  make the rules. Their computerized systems are designed to find and trigger stops. There is no B-league in the investment world, when you trade, it is against the best. They are often on the other side of each trade you make. They are the ones that sell you your options as well. It is beyond the scope of this article to get into all the pitfalls that lay before us when we place our bets. Yes bets, all investing is a form of gambling, the odds may be in our favor but they are still odds.   

I like the odds.  

The point of this is that buying a junior gold explorer at this time in the cycle may not be as risky as it first seems. In fact the risk may be lower than our other choices. If I am right about where we are currently in the gold cycle, (see my F.S.N article, Gold a cyclical recipe for disaster ) then there will be a lot of merger and acquisition activity taking place in the gold sector in the near future. At acquisition time, valuations will be partially determined by how many ounces the buyout target has. As the big fish swallow the smaller ones, they in turn will be hunting frantically for juniors to buy. Intending to increase their reserves relative to their market cap and make themselves more attractive. It won't be as important how mineable those reserves are, as long as they are cheap. Here's the thing, the bigger a gold company is, the higher value the market attaches to their reserves relative to their price. Some Juniors are trading at $15 to $20  per ounce based on proven reserves. Some of the bigger miners are trading at $300 plus. When they buy a junior, those acquired reserves increase to $300.  

There is a new ETF which just began trading. It is composed of junior precious metal companies. (symbol GDXJ) It does not have much history and is not useful for analysis. It does show however, that many small stocks have been bid up aggressively lately.

When it comes to junior gold sector, I would suggest going a different route than buying an ETF .

Instead do your homework. Find a stock that has proven reserves of more than 2 million ounces, which are in a safe country and is priced in the $20 an ounce range. For example, a company with 100 million shares outstanding priced at .40 cents, means the company is worth 40 million dollars. Divide the 40 million by the 2 million ounces they own and you get the dollar value ($20) of each proven ounce of gold in the ground. Find one that still has some kind of a believable story.  

What about the cycles?   

In the chart below I have compared the cycles in gold to a unremarkable, unnamed Junior. I have chosen it as a generic representation of  juniors in general. If anything this one is a major under performer. I only go back 10 years because most juniors weren't around more than that long.

We essentially get to see one 8 year cycle,(red line) which actually came in a Little early. This is not unusual in a late translation bull market in which you have a rapid 35% decline. We know the sum of all cycles larger than the 8 year cycle are up because of how late the 8 year cycle topped out. (see MY f.S.N. article Gold a recipe for disaster )

We do see commonality in their cycles. There are two things that stand out. One is the cycle low in 2005. Hardly noticeable in gold but very dominant in the junior. We note that it is of 4 years duration (orange lines), which is half of the 8 year cycle. Not unusual. We also see that the junior tends to lag gold by 5 months. Also notice that the junior made its cycle high in 2002 and then retraced back up toward it while gold ran to repeated new highs. That rally was over 1000% in 8 months, it went too far, too fast and investors wanted to cash in.   

What next?  

We have just made a 1 year low (red bar, brown dot) which is higher than the last 1 year low, so the sum of all cycles larger than the 1 year cycle are up. Last years low coincides with gold's 8 year cycle low.  Therefore I assume that we have the following situation. The 1 year is going hard up. The 4 year has bottomed and is going hard up and the eight year is going up as well. The rally should last another year at least before the 4 year cycle possibly tops out. There are many juniors with similar charts to this one. It shows me that cyclical modeling does work with small companies. 

  chart 

To conclude

If the gold market has made a major low and the big gold companies have as well, it follows that the money that will be thrown at the sector over the next three years will filter down to the little guys. The cyclical picture of most of the juniors I looked at is very promising. Many will go up 1,000% or more, all you can lose is 100%. Purchasing 100 shares or even 1,000 shares of a .25 cent junior won't break the bank. They are like options with no expiry date, plus there is no premium over intrinsic value. You don't have to worry about the Fat Boys gunning for your stop loss orders either.  

If you do choose to buy some juniors, pick ones that actually have some gold. Whether they will become buy out targets really doesn't matter. What matters?  Whether they have a plausible story and will anyone "buy that story". Anything with a pulse will have its five minutes of fame. Don't over invest in any one stock. Don't pay more than $1.00. Get gold in the ground for $20 or less. Don't bet the ranch. Spread the risk. If you get a windfall, take it.  

Compare your favorite junior to gold's cyclical model as I have done above. See how it stacks up. If it does not, find one that does. Then with your mind, visually extrapolate the evolving three year uptrend into the future by using past cycles as a guide. 

Used judiciously, Juniors are a good strategic risk right now.

Bob Clark is a professional trader with over twenty years experience, he also provides real time online trading instruction, publishes a daily email trading advisory and maintains a web blog at www.winningtradingtactics.blogspot.com  his email is linesbot@gmail.com.

© 2009 Copyright Bob Clark - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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