How to Play This Pullback in Gold

by Sean Brodrick
Cart in gold mine - underground

A Note From the Editorial Director: Investors often tell us they think of gold as their "forever" investment. For them, short-term price movements don't matter. But the shiny metal also provides ample opportunity for fast-acting traders. It's important these investors keep a close watch on gold's price movement, and know what's driving those movements. If you're in that group, play close attention to Sean's column today.

- Andrew Snyder


There's no sugar-coating it. Gold got off to a no-good, horrible, very bad week on Monday, and it hasn't yet recovered. I expect to see the yellow metal test important support this week or next. The question is, what should active traders do when gold slumps? Let me show you some options.

First, let's look at what has pounded gold.

The Bad News

On Monday, a key private survey of China's manufacturing sector, the HSBC China Flash Purchasing Managers Index (PMI), slumped to an eight-month low of 48.1.


That's bad for two reasons. First, economists were looking for China's flash PMI to rise - whoops!

Second, any reading below 50 signals a contraction.

China is the world's No. 1 buyer of gold. A slowing economy there could drag on Chinese gold purchases. You can see why traders are nervous.

And this is on top of a recent spate of bad economic news for China, which has seen weak investment, industrial production and export numbers in the last couple of months. And short-term interest rates are rising in China, which can also drag on economic growth.

This comes on the heels of last week, when we also saw gold get smacked around because of comments by Fed Chair Janet Yellen.

She said the Fed might start raising interest rates sooner rather than later. That sent gold lower and the dollar higher.

In fact, Yellen said that the Fed could hike interest rates as soon as within six months of the end of the current round of quantitative easing, currently on pace for the fourth quarter of 2014. This boosted the value of cash and short-term bonds in the near term. It also reduced the appeal of precious metals, which do not have a yield.

Yellen's announcement seemed to mark a short-term top for gold, and it has been on a slippery slope since.

The Good News for Gold

Luckily, Yellen does not get the last word on gold.

Gold performs well in a low to negative real interest rate environment - that's inflation minus a country's interest rate. We know from history that the tipping point for gold is when real interest rates go above 2%.

At the end of 2013, the current real interest rate in the U.S. stood at 0.52%. In other words, interest rates have a long, long way to climb before we get into danger territory for gold. And what happens to inflation during that time is anyone's guess.

China's Bad News Could Be Good for Gold

What the market doesn't realize is that China's government isn't likely to sit still and watch its economy roll over. How do we know that? Because it didn't sit still for it last year!

It may seem like ancient history, but China experienced economic weakness in 2013. So the government used a one-two combo of faster infrastructure investment and a loosening of monetary policy to spark growth.

Fast-forward to earlier this month, and China's government approved five railway projects projected to cost a total of $22.8 billion. That hints at a more expansionary stance.

When the PMI data came out, HSBC's China economist said: "We expect Beijing to launch a series of policy measures to stabilize growth. Likely options include lowering entry barriers for private investment, targeted spending on subways, air-cleaning and public housing, and guiding lending rates lower."

And Reuters reports that the central bank is prepared to loosen monetary policy in order to keep the economy growing at 7.5%.

If China opens up the floodgates of easy money, that should lift gold's boat higher.

It's true that investors and traders are bearish on gold now, and sentiment is a huge part of the market. I'll definitely keep an eye on that. And this is the season for a gold pullback. But I'm not too worried yet.

Why? Because all of the bigger, longer-term forces that I've been pounding the table about are still there. China is still buying... Central banks are buying... ETFs have stopped selling huge amounts of gold into the market... And rising industry costs are supportive of higher prices.

What's more, I got a big buy signal on gold last month. Gold would have to go down quite a bit more to change that.

And let's not forget that the last few months have been quite bullish for gold. There is plenty of support below, as you can see from this chart...


It's hard to predict exactly what will happen. But I like gold's odds here. And folks who look at gold as a trading vehicle versus a long-term store of wealth should look at these pullbacks as buying opportunities if they get steep enough.

What You Can Do

If you're already long on gold and watching it drop, be proactive. A lot depends on your time frame. If you're in for the long haul, there's not much you should do. But if you're trading the market shorter-term, raise your protective stops to lock in gains.

Heck, this year my Oxford Resource Explorer subscribers have chalked up three double-digit gains and zero losses. That's pretty good in a volatile market.

Editor's Note: Sean's being modest. That's great in this market. Find out how you can share in these profits by clicking here.

Are you bearish on gold? You might be right in the short term. But if you decide to short gold, keep your eye on the exit.

If you're bullish on gold, keep an eye on the support levels. If/when the yellow metal bounces from one of those levels, that could be a great time to add new positions.

Good investing,

Sean


P.S. I know that many of you are nervous about precious metals prices right now, and you're probably bursting with questions. So fire away. Click the comment button below or email me at mailbag@investmentu.com to ask me anything about the state of the market. I'll do my best to answer one or more of your questions next week. Just remember, I can't give personalized advice.

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Another Way to Handle a Metals Slump

Metals investors are often on the lookout for high-quality miners, which offer more upside potential than, say, funds that track metal prices.

But when prices get whacked, the share prices of the miners usually take a haircut, too, especially the ones whose operations aren't tight enough to weather tough times. That's one reason Sean often speaks fondly of so-called "streamers," companies that don't do any mining but instead finance the best-run miners.

And Sean's favorite streamer these days is Silver Wheaton (NYSE: SLW), which has picked up 15% since he recommended it to Oxford Resource Explorer subscribers in January.

Sean explained what he likes about the company in a recent update:

"Silver Wheaton is not a miner but a metal streaming company. That is, it invests in gold and silver projects around the world. It gives miners an upfront payment to finance projects in exchange for a piece of their future production. The benefit of this model is that streaming companies like Silver Wheaton don't have to deal with the ongoing capital investments or cost overruns that have plagued the rest of the industry these past few miserable years.

"Some of the points made by CEO Randy Smallwood and other company reps, in formal presentations and chats with me, included:

  • While gold and silver were getting crunched, Silver Wheaton seized that as an opportunity. It used the crisis to beef up its asset portfolio.
  • Silver Wheaton is becoming a preferred source of capital for smaller companies, which gives it great opportunities in developing rich mines.
  • Over the past two years the company has stepped up to provide financing for a number of cash-starved mining projects.
  • An example of that was the gold streaming agreement Silver Wheaton entered into with Sandspring Resources last year. Silver Wheaton paid Sandspring $13.5 million in exchange for the right to purchase 10% of production from Sandspring's Toroparu gold project in Guyana. The total value of the deal is around $149 million plus an ongoing production payment. This is an example of how Silver Wheaton works. For relatively little money upfront, the streamer gets access to high-quality, earlier-stage projects.
  • The company focuses on assets that have healthy operating margins. It wants projects that can not only ride out fluctuations in metal prices, but also shifts in taxation and government regulations.
  • Smallwood says that the company has three more deals in the works with at least one possibly being completed this year worth more than $1 billion.

"Silver Wheaton is also renegotiating existing deals for projects that got crushed by the falling price of gold and silver last year.

"For example, Barrick's (NYSE: ABX) Pascua-Lama project has been seriously delayed and Silver Wheaton had a deal to get 25% of the mine's output. Silver Wheaton could have asked for the cash back. Instead, it extended the terms and agreed to continue taking all of the output from three separate smaller mines.

"It could still lose money on Pascua-Lama if the project doesn't go into production by 2016. But the beauty of Silver Wheaton's business model is it has many irons in the fire, and one delay or failed project won't hurt it too much."

- Bob Keaveney with Sean Brodrick

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