Prepare For A White-Knuckle Ride With Volatility Being The 'Norm'

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Includes: AEM, GLD
by: Bob Kirtley

In the early days of this bull market in precious metals we all did well as most mining stocks sprang to life and made considerable gains. The quality producers made spectacular gains and the turkeys made moderate gains. It has changed a lot since then, the mining indices such as the HUI* were outperforming gold prices by leaps and bounds, however, for the last few years they have failed to keep pace with gold and indeed still lag behind as evidenced by the chart below.

As a reward for taking on all the inherent risks involved in the process of mining we require the stocks to outperform gold by a ratio of three or four to one. This sort of reward does not exist at the moment so the metal itself is a better proposition. For those who do not wish to hold the metal and wish to 'play' this bull, then there are alternatives such as the gold funds, which have proved to be very popular with investors, partly due to the ease in which they can be entered and exited at the push of a button. A large position in a gold producer is not so easy to exit and may take a little time to recoup an investor's funds.

Yet the situation is tantalizing in that these stocks have been badly beaten down at a time when they are generating large amounts of cash. There is also the mantra emanating from many of the big names in this industry to buy now as they will never be this cheap again. For the average retail investor doing research as and when time permits, the pressure to make acquisitions right now is well and truly on. We feel the same pressure but we are also aware that a number of rallies by the stocks have come to nothing. Some call these moves head fakes or sucker rallies as the immediate euphoria that surrounds one of these rallies makes it rather difficult to sit on one's hands and observe. Doing nothing when everyone around you is backing up the truck is nerve racking at times, but that is what we have done for well over a year now, in that we have not increased our exposure to the mining sector. We are pleased with this strategy as the producers are cheaper now than they have been for some time. Our preference has been to look for leverage via the options route as it suits us to do so, but it is not everyone's cup of tea.

Going back to the chart we can see that what once was a support level of 500 has failed and become a resistance level for the HUI. As we can see a gain of 50 points or 11% is needed in order to make a challenge. Also note a second double top, which has added to the negativity on the HUI. More recently we can see that the HUI has now breached this downward trend with a 75 point rally, which is a positive move. The RSI is heading north with room to go higher, which is also good sign. Finally we have shown the price of gold behind the HUI so that you can see the divergence and form your own opinion as to where next.

In our view gold is still outperforming the stocks and this needs to reverse for the gold producers to become a worthwhile investment. We are in no rush to commit any more of our funds at this stage, but the landscape is changing and that speed of change would appear to be accelerating so it's not a time to take one's eye off the ball.

A victory for the pro-Europe party in the Greek election at the weekend will do little to calm the markets. A coalition needs to be formed and then it has to face the music regarding austerity. The eurozone may be able to assist by offering more time for Greece to get its house in order, but that's the same as expecting pigs to fly. Expect this pantomime to continue for some time as the eurozone leaders do not want the Greeks to leave and experience the revival that Iceland is now enjoying. Such a move could be contagious as other debt-laden countries ponder the wisdom of staying in the eurozone.

Pressure is building on the Italians, however their auction of €4.5 billion ($5.62 billion) in medium and long-term debt was well supported, although Italy's 10-year government bond yield was up three basis points at 6.23%. The eurozone is struggling along with apparently no real solution to the heavyweight burden of debt that it is trying to carry.

Also note that the yield on Spanish 10-year bonds jumped as high as 7.26 percent at one point, the highest since Spain joined the euro. Only a week ago, Europe unveiled a massive bailout of Spain's banks hoping that the markets would be calmed, however, it had the opposite effect as investors are well aware that a much larger amount of cash is required by Spain's financial community.

The situation is aptly summed up by Nigel Farage in this clip regarding Europe when he points out that Italy will provide 20% of the funds for Spain for a return of 3% whilst having to borrow the money at 7%, as he says "The euro Titanic has now hit the iceberg and sadly there simply aren't enough lifeboats"

In the short term it may pay to wait a little while longer before increasing your exposure to the producers, however, in the longer term gold and silver will continue to rise as fiat currencies are recognized for what they are: worthless.

With that in mind, a trade for the longer term would include a slow but steady transfer of your assets into this sector, which should pay off handsomely in a few years from now.

As for stocks, we are yet to be convinced that this is as cheap as they will ever be. However, a stock that we do own is Agnico-Eagle Mines Limited (NYSE:AEM), which does appear to be in recovery mode as it has moved from $32.00 to $42.00 over the last few months. Agnico-Eagle is a $7.0Bln company and has traded as high as $73.00 so it just might be one to put on your watch list.

However, it will be a white-knuckle ride with volatility being the 'norm' as the stupidity of our political leaders hits your screen with monotonous regularity.

Go gently and take good care of yourselves.

Footnote:

*The HUI is The AMEX Gold BUGS (Basket of Unhedged Gold Stocks) Index, which represents a portfolio of 15 major gold mining companies. The Index is designed to give investors significant exposure to near-term movements in gold prices - by including companies that do not hedge their gold production beyond 1 1/2 years.

Disclosure: I am long AEM.