If Down Is Up and Bad Is Good, Gold Stocks Must Be Hot

One of the stock market's laughingstocks is poising itself for a powerful rally, and the risk of tossing a bit of money into this sector doesn't appear to be too high for some market pros.

That's right; the gold bugs are biting.

While you're doubled over with laughter at the prospect of putting even a dime to work in gold stocks, consider that a handful of analysts think the maligned sector could be ready to climb. Excuse the fact, if you can, that the belief is based mostly on the fact that the strong negativity and indifference the market is showing toward gold stocks mean things almost have to get better.

To contrarian investors, who believe strong sentiment in one direction is a signal that a cycle is ending and a stock or sector will soon reverse course, the loathing for gold stocks is bullish.

While few expect gold stocks to become a stock leader, or think that people should bet heavily on the sector, the group could still provide a decent opportunity for investors to make some money.

One of the key signs they've found is in the bullish consensus on gold, which stood at 16% Monday, just a bit higher than the 12-month low of 13%, notes Richard Ishida, president of Market Vane.

Jay Shartsis, options strategist at R.F. Lafferty in New York, notes that the 13% bullish consensus mark on gold preceded a short rally in the sector last year. "The pessimism is interesting," Shartsis says, adding that the risk in buying these stocks is very low.

Another sentiment reading that rekindles the gold bug in Shartsis is the put/call ratio on the Philadelphia Stock Exchange Gold/Silver Index, or XAU, which measures the number of puts traded against the calls traded. Typically, traders see a high put/call ratio as a bullish sign because it means investors have gotten very negative on a sector.

The XAU put/call ratio, which has spent about the last year around the 40 to 50 level, on Tuesday was around 140, showing that 14 puts traded for every one call, notes Shartsis. Even compared with the overall equity put/call ratio during market swoons -- that measure hit 77 during one of those awful April days -- that number is astounding in its pessimism.

That level, however, still isn't as high as the 190 reading that it hit before the aforementioned 1999 rally, Shartsis says.

The first signs of a bounce may have started on Friday, a day when Shartsis says he bought some Newmont Mining (NEM Quote - Cramer on NEM - Stock Picks). The XAU on Friday popped 4.5% to close at 52.99. On Monday, after trading lower, the XAU managed to close the session higher, up fractionally to 53.02. Tuesday saw a 2.75% gain and the XAU finished the day at 54.48.

The XAU is trading a little higher than its 52-week intraday bottom, which it hit on Aug. 3, when it cratered at 49.55.

In a research note Monday, Bear Stearns analyst Michael S. Dudas noted that the XAU has found support at 50, a level not seen since Aug. 31, 1998, shortly preceding a dramatic rally over the following six weeks. "We find current investor sentiment quite similar to that July-August 1998 time frame when the world was accelerating into a commodity deflationary spiral," he writes.

Even the addition of Phelps Dodge (PD Quote - Cramer on PD - Stock Picks), the copper mining giant, into the XAU is being seen as a positive because it tosses another dirt-bomb at the gold and silver companies.

The move "provides anecdotal evidence of a sentiment washout within the group, in our view," Dudas writes. "Phelps mines gold and silver only as a byproduct of copper mining and derives less than 1% of sales from precious metals."

Dudas writes that he believes North American gold stocks are oversold and "the shares have overly discounted investor apathy, summer weakness in overall commodity prices and recent gold price performance," which has held the low end of rather narrow $270-$290 per ounce range. He says it's an encouraging view given the ample liquidity, reduced commodity exchange activity, increased official reserve flows and diminished pricing view among investors.

Neither Dudas nor the other gold watchers expect mining stocks to replace Cisco (CSCO Quote - Cramer on CSCO - Stock Picks) as market leaders, but they do see the potential for a good short-term pop.

All things considered, that'll be just fine.