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The Risk & Opportunity in Precious Metals Stocks

By Dave Blais

Despite the recent bounce back in the precious metals sector in the past several days, I am electing to remain in an all-cash position, on the sidelines. As readers of my blog know, I sold all my gold and silver stocks before Christmas.

The reason for my stance is that I see the potential for significant risk ahead in the precious metals sector, especially the shares. Also, I have an idiosyncratic black-or-white point of view on investing in the precious metals shares — I believe they are an “all or nothing” affair.

That’s because my experience is a when the precious metals stocks are on the rise, they can provide outstanding profits. But on the flip side, when they are weak for an extended period, they can also deliver outstanding losses. In the last part of 2011, I was seeing signs that the sector may rise in the near term — but all those signs have since reversed.

In fact, I believe the risk that I see ahead is potentially great enough that it is prudent for me to stay in cash until the situation clarifies. Because I believe the potential risk in the precious metals market is high, I do not mind missing out on some potential upside in the meantime. If the risk I see fully expresses itself, then I see tremendous opportunity by getting back into precious metals stocks at what may be much lower prices down the road.

The potential risk

To review, here is what I see:

Gold (and silver) has been extremely weak in what is more often than not its strong season (November, December, January).  Despite the rebound in gold in recent days, for almost three trading weeks gold has remained below its 50-day, 150-day and 200-day moving averages — it is only in the last couple of days that gold has popped above its 200-day moving average.  Gold also remains below a three-year support line (the straight green line in chart below).  This previous support line can now be expected to act as resistance. The action in gold is poor — period.

To see gold (and silver) so exceptionally weak in what is usually a period of strength, I believe, is a potential warning that should not be ignored. To see such weakness in summer would be expected, as summer tends to be historically a weak period for the precious metals — but it is not to be expected in a period of seasonal strength.

Unless gold can quickly repair the technical damage it has experienced, gold is potentially opening the door to a much larger drop. By breaking below a three-year support line from 2009, gold increases the odds of being drawn to the lower boundaries of its current trading channel, which lie roughly at the $1400 area, then the $1300 area, followed by the $1200 area:

Of more concern, the HUI gold mining index may be replicating a very similar chart pattern that was present before the 2008 crash. The HUI has not yet definitively broken down from this pattern as shown in the chart below. (Several days ago it did break down, but it reversed the breakdown).

In the chart above, it can be seen that prior to the 2008 crash, the HUI gold mining index was supported by a key three-year trendline (orange line). Back then, just before this trendline broke, the HUI formed a “head and shoulder” type top that broke down, signalling the start of a devastating decline. An almost identical chart pattern exists today.

If a similar definitive breakdown occurs in the HUI now, I believe it could result in a possibly sizable decline for the gold (and silver) stocks in the near term.  Whether or not the decline would be as great as 2008 is not knowable in advance. And just because a chart pattern is similar does not mean will necessarily resolve the same way.

Nonetheless, the risk is the situation could turn into a real doozy to the downside, if a breakdown in the HUI occurs. The cause of such a decline would likely be an escalation of the debt crisis in Europe, causing another large wave of de-leveraging across the globe.

Given the potentially profound risk that I perceive, I prefer to stand aside and see how the situation resolves. On the downside, a definitive break of the HUI below the 495 level, I consider to be the trigger for a potentially bigger decline.  On the upside, a clear break above the 620 upper-level resistance in the HUI, in my opinion, would largely negate the risk to the downside, and give a potential “all-clear” signal to re-enter the market for gold and silver shares.

There is always more than one way to look at a chart. Below is an alternate view of the long-term chart of the HUI. This alternate chart shows a slightly different chart pattern replicating. If this alternate view is correct, a breakdown may have already occurred.

The purpose of showing this alternate chart is to explore possibilities. In any case, the message from both charts, I believe, is one of caution.

The HUI gold mining index isn’t the only chart looking dodgy. The Dow Jones Industrial Average is also looking a bit tenuous. Despite the positive action of the past few weeks, there is a potential “head and shoulders” top forming there as well:

In sum, the there are noticeable “echoes” from 2008 evident in the charts here and now. If these echoes resolve similarly in the weeks ahead, it could signal the start of a severe decline in the gold (and silver) stocks — and possibly other markets as well.

The opportunity, if such a decline in the gold and silver stocks actually occurs — could be life-changing for those who are prepared for it, and who patiently prepare to seize the opportunity such a decline would present.

In the 2008 smash, many quality gold and silver stocks were crushed beyond reasonable valuations. Those who were prepared by having a large cash position could have made a small fortune by buying near the bottom.

As an example, Novagold Resources fell from about $8 in the spring to well under $1 in the fall. (The actual low was below 50 cents, but few investors were actually able to catch the rock-bottom lows).

Once the bottom was in, Novagold over the next year rose to around $6, for a gain of more than 6 times. Had an astute investor bought Novagold near the lows, they could have turned a $50,000 investment to more than $300,000 in just a year. Two years from the 2008 low, Novagold rose to $14, which would have turned that same $50,000 into $700,000.

Novagold was one of the more extreme examples of the severe undervaluation that took place in the precious metals stocks in the 2008 smash, but it is by no means a unique example. Pull up the charts of almost any gold stock, and a similar story will be told. While I am not anticipating the same degree of mega washout as occurred in 2008 if the HUI breaks down, I am expecting that a another remarkable buying opportunity may present itself.

In 2008, what caused the precious metals stocks (and other stocks around the world) to fall below reasonable valuations was the extreme, rapid de-leveraging that occurred triggered by the failure of Lehman Brothers. This rapid de-leveraging caused individuals, hedge funds and others who used leverage or margin into forced selling. This forced selling caused more forced selling, and so on. In some ways, the 2008 episode could be described as a giant global margin call.

What if the gold stocks don’t break down, and reverse higher?

In standing aside here, I accept the possibility that the risks evident in the charts may not come to pass.  Indeed, many analysts believe that the precious metals sector has bottomed here and is poised to move strongly higher in the days and weeks ahead. That could very well happen.

If the market does not break down, and instead bolts higher, I will wait until the HUI gold mining index definitively clears key overhead resistance at the 620 level, before re-entering. In breaking above 620, the HUI will likely be signalling the next big leg higher is likely in the cards.

The bottom line for me is that I believe the precious metals shares are at an absolutely critical juncture — and I have positioned myself to preserve my capital while waiting to take advantage of whichever way the precious metals shares ultimately break — higher or lower.

Dave Blais is a full-time investor who specializes in quality gold and silver stocks. He writes on his blog, Epiphanies on Gold and Silver.

Disclaimers: Neither Dave Blais or Keith Schaefer are investments advisors; no part of this article should be considered personalized investment advice. As always, investors should consult with a licensed financial planner for help on their particular investment situations.

by +Keith Schaefer



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