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This Indicator Says When to Sell Gold Stocks

Commodities / Gold & Silver Stocks Oct 22, 2010 - 04:02 AM GMT

By: Q1_Publishing

Commodities Best Financial Markets Analysis ArticleGold has taken a $50 hit this week and, if you’ve been watching gold stocks, it would seem like the gold bull run is over forever.
Although gold is being historically an extremely volatile asset class and it’s down a mere 4% from its recent all-time highs, now that the herd is running from gold stocks is a good time to consider whether it’s time to take profits too.

Considering that, it’s important to understand that gold (and most mining stocks in general) move inversely to traditional valuation measures. And we can use that unique feature to determine when to  start taking profits in the gold sector.

There’s nothing like a steady run in gold prices to send gold stocks soaring – the more out of favor the better. But as more and more investors see the glitter of gold, they’re bound to miss out on the bull market altogether because gold stocks move exactly opposite of what the stocks they’ve been buying for 30 years do. Let me explain.

The Upside Down World of Gold and Commodity Stocks

Ratio analysis is among the most basic metrics of security analysis. Traditional measures like yield, earnings, cash flows, and growth relative to share price are among the most common.

Disciplined investors have looked to buy low and sell high will normally jump at the chance for stocks with double-digit yields and single-digit P/E ratios when all else is equal. And a nearly three decade bull market has rewarded them for that.

When it comes to gold stocks, however, the profitable reinforcement of that strategy is exactly the wrong thing to do. Gold stocks should be viewed exactly opposite.

The best time to buy gold stocks is when P/E ratios are high and the best time to sell is when P/E ratios are low.

Think about it. When gold prices are low a gold miner’s earnings are almost non-existent. The boom and bust nature of the industry pushes most mining companies into the red during tough times while profits explode during good times.

Barrick Gold shares provide the perfect example:

As you can see, Barrick Gold has moved exactly opposite the way most stocks in other sectors would relative to its P/E ratio.

The best time to buy Barrick and most gold stocks is when the P/E ratio is actually very high.

History Will Signal When the Top Is In

With that in mind, it doesn’t take long to see how much higher gold stocks can go and when to start looking to sell.

Looking at P/E ratios for most stocks and gold stocks, we can see a strong correlation over the long run.

As a result, we can expect the exact opposite of normal to signify when it’s time to start unloading gold stocks.

If history is our guide, we know historical bottoms in long-run bear markets are marked by low P/E ratios. A “rock bottom” P/E ratio has historically ranged from between six and eight for the entire market.

Since gold stocks essentially move exactly opposite to the entire market in terms of P/E ratios, it’d be safe to assume when gold stocks are sporting P/E ratios of six to eight would be a good time to start selling.

This implies gold stocks have a lot more room to run. The largest ones could easily double or triple again from this point (the P/E on the Market Vectors Gold Miners ETF – GDX – is 23) if gold prices remain at $1300. They also could easily quadruple or run even more as earnings rapidly increase with every uptick in gold prices.

In the end, its times like these when investors flee a hot sector we have to remember that most investors who tend to walk away too early when they’re up and stay too long when they’re down.

There are a lot of unique factors set to drive gold prices higher, but from a purely ratio analysis perspective, history says it’s still too early to sell at this point in the gold bull market.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Disclosure: Author currently holds a long position in Silvercorp Metals (SVM), physical silver, and no position in any of the other companies mentioned.

Q1 Publishing is committed to providing investors with well-researched, level-headed, no-nonsense, analysis and investment advice that will allow you to secure enduring wealth and independence.

© 2010 Copyright Q1 Publishing - 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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