By David Sterman
As 2012 came to a close, investors increasingly questioned the wisdom of owning gold or gold-related stocks and funds. After all, a commodity known as an inflation hedge is of dubious value when inflation is nonexistent. And for investors who still expected the Federal Reserve's aggressive stimulus efforts to eventually fuel inflation, patience was starting to wear thin.
What began as a steady exodus out of gold in the winter morphed into something a lot more dramatic this spring. In the past few months, gold has endured a pair of scary plunges that has pushed even its most ardent supporters to the sidelines. Gold prices now sit at their lowest levels in nearly three years.
But does the Fed's recent announcement that it will begin to wind down its massive quantitative easing (QE) program change the picture for gold? After all, part of gold's weakness had stemmed from rising expectations that the Fed would soon wind down the QE program. Now that rumor has become fact, has the gold sell-off ended?
One possible scenario for a gold price rebound: The Fed's retreat from QE means that we're moving into the next phase of a grand government financing experiment that has no precedent. Will the coming months represent a quiet phase for the stock and bond markets as investors take the Fed's changing policies in stride? Or should we brace ourselves for greater volatility and economic uncertainty?
If that happens, gold could quite easily move back into vogue, as it is a favored investment whenever there is broad confusion about the market and the economy, as was the case in 2009, 2010 and 2011. Gold finished the past trading week at $1,292 per ounce, and any move back above $1,320 could be a sign that gold bulls are returning. So keep an eye on current gold prices, because if the selling phase has indeed passed, then the stage may be set for the next bull market in gold.
Investors have many ways to invest in gold. Let's look at three very different options, each with their own risk and reward profile.
1. Barrick Gold (NYSE:ABX)
This is the world's largest gold miner, with proven and probable reserves of around 140 million ounces of gold (along with a lot of copper and silver). Not only has Barrick been affected by falling gold prices and the diminished profit spreads that that implies for producers, but the company has been beset by its own major mining problems in the Dominican Republic and Chile. Notably, both of those problems are being resolved, and output should return to normal later this year.
Even if you don't expect gold prices to rebound from here, shares of Barrick Gold now appear oversold as they are still suffering from the perception of the problems noted above. Analysts at UBS, for example, think shares are worth $24.50, or nearly 50% above current levels. If gold prices rebound in coming quarters, then that price target would surely rise higher still. Merrill Lynch has an even higher $29 price target, which equates to 1.5 times the net asset value of its mines. That multiple has historically stood between 1.0 and 3.0; it stands just below 1.0 at the moment. (My colleague Chad Tracy took his own deeper look at Barrick's valuation earlier this month.)
2. Royal Gold (NASDAQ:RGLD)
Some investors have soured on gold miners, which tend to repeatedly face unexpected delays in permits and cost overruns on major projects and engage in poorly timed pricing hedges. This gold company skips all that and simply collects royalty checks. Royal Gold started to raise capital in 1990 and now has stakes in more than 200 properties, 36 of which are currently producing gold and throwing off royalty income.
So what does the company do with all those royalties? Roughly 30% is paid out as dividends, and the rest goes right back into the next crop of mines. Royal Gold has an interest in 23 mines still in development, and another 100 that may be put on track for development in the next few years.
Yet the reason this stock now holds appeal may not be apparent. Royal Gold is sitting on nearly $400 million in net cash and has an untapped $350 million credit line at its disposal. The company has a history of periodic buying sprees when smaller gold miners run into financial distress. And with gold below $1,300 an ounce, these junior miners are having a hard time accessing capital to develop their mines. Royal Gold provides cash to these miners at times like this -- and reaps the rewards when gold process rebound and royalty payments spike.
3. Direxion Daily Gold Miners Bull 3X Shares ETF (NYSEARCA:NUGT)
Talking about this exchange-traded fund (or ETF) right now would seem foolhardy. It is so heavily leveraged to the price of gold that its shares have plunged from $97 in October 2012 to a recent $6.50, easily making this one of the worst investments in recent memory.
Yet that kind of price action can work both ways. So if you are expecting even a modest rebound in gold prices, then this ETF would likely double or triple from current levels in a very short time. To give you a sense of this stock's volatility, gold prices rebounded 1% on Friday, but this ETF rose a solid 2%. Of course this isn't an investment, it's a speculation, and as such, should be just a tiny piece of any portfolio.
Risks to Consider: The global economy is showing signs of distress, and if China or Europe weaken further, then gold continue its downward spiral.
It's unwise to call a bottom for gold. Instead, keep an eye on the price action. If gold stabilizes at current levels and moves back up above $1,300 for a number of sessions, that could be a sign that sellers have been flushed out.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.