More Gains Ahead for Gold

There are some bullish signs in the sector, so here's how you can play it.
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This column was originally published on RealMoney on Nov. 10 at 7:54 a.m. EST. It's being republished as a bonus for TheStreet.com readers.

Gold and silver showed some strength Thursday after a breather following a rebound off early October lows. Is this just a head fake or the real deal?

Several factors point to further gains ahead, according to gold sector analysts. Here are the highlights.

Since 1979, the yen and gold have traded nearly in lockstep, points out Jason Goepfert, a technical analyst who runs SentimenTrader.com. Whenever the yen rises, so does gold. Over the past six months, this relationship has been particularly tight.

The correlation between the five-day rate of change in yen futures and the five-day rate of change in gold futures has been 0.6, meaning there's less than a 1% chance that this connection is due to change. Now, it looks like the yen will continue to rise, and so will gold.

Goepfert thinks the yen will strengthen in part because large speculators have a big short position in yen. He defines large speculators as position holders with more than 400 yen futures contracts who haven't identified themselves as using the futures market to hedge a business risk. Over time, these large speculators have been a good contrary indicator for the yen: Typically when they are short, the yen goes up.

Of course, saying that gold strengthens when the yen moves up is another way of saying that bullion trades higher as the dollar weakens. But here, too, there are potentially bullish trends ahead for gold. The dollar looks like it will continue to lose ground because the

Federal Reserve

has stopped hiking interest rates while Japan and Europe are still in tightening mode, says Deutsche Bank analyst John Mackinnon.

Frank Holmes, the chief investment officer of U.S. Global Investors and a co-manager at

(UNWPX) - Get Report U.S. Global Investors World Precious Minerals Fund

, the top-ranked gold fund for the past three years according to Lipper, agrees that flat or falling interest rates in the U.S. set gold up to challenge the $720-per-ounce level hit last May. "I don't think it is going to explode here, but I am constructively bullish," says Holmes.

Large speculators have unusually small positions in gold and silver -- lows not seen for several years. Goepfert defines large speculators as traders with more than 200 contracts of gold futures or 150 contracts of silver futures, who aren't using futures to hedge day-to-day business operations. These traders now hold around 30% of the long gold futures contracts and less than 30% for silver. The last two times that levels were this low, the

PHLX Gold & Silver Sector Index

, or XAU, enjoyed runs that lasted several months.

Likewise, speculators who use Rydex funds as trading tools are currently blasé about precious metals. This is often a sign that strength lies ahead.

"When traders in the Rydex family of funds shift a large amount of their funds to one sector or another, it has proved to be a consistently effective contrary indicator," says Goepfert.

The percentage of Rydex sector assets in precious metals funds is now about 11.5%, down from highs of 15% last May.

"The smaller traders got spanked and they are out of the game," agrees

Northern Orion

(NTO)

CEO David Cohen. "This is positive for the price of gold."

Gold has also traded in lockstep with oil recently. Here again, near-term trends in oil pricing will likely be bullish for gold, because oil prices typically strengthen through the winter heating season, says Holmes. In a worst-case scenario, he doesn't see gold falling below $580 per ounce, because of demand below $600 from India and China, and the Middle East, where oil tycoons are recycling petrodollars into bullion.

If gold strengthens from here, the following two companies should benefit, says Holmes, who has positions in both.

Freeport-McMoRan Copper & Gold

Freeport-McMoRan

(FCX) - Get Report

is one of the world's largest gold and copper producers. Its main mine, Grasberg in Indonesia, contains the largest single gold reserve and one of the largest copper reserves in the world. The company also owns a copper smelter in Spain and a 25% interest in another smelter in Indonesia.

Holmes likes this company because it is a low-cost producer and pays a solid dividend. Freeport-McMoRan pays a combination of regular and supplemental dividends that could hit $5.25 next year and stay at those levels through 2009, believes Canaccord Adams analyst Gary Lampard.

"The company distributes virtually all cash flow in excess of normal capital spending," says Prudential Equity Group analyst John Tumazos. "There is absolutely no risk of their undertaking a foolish acquisition." Tumazos has an $82 price target on the stock, which recently traded for $59.

The bad news is that when you own this stock you are betting on its single main asset: the Grasberg mine. It has "fantastic economics," but its location in Indonesia brings political risk, says Morningstar analyst Parvathy Krishnan, making Freeport-McMoRan an "all-or-nothing proposition."

Northern Orion Resources

Based in Vancouver, Northern Orion holds a 12.5% interest in the highly profitable Alumbrera copper and gold mine in Argentina. Northern Orion Resources should take in $150 million in cash from this operation this year, says CEO Cohen. That's about one-third of the company's enterprise value of $474 million, if you subtract the $180 million it recently had in cash from its market cap of $654 million.

Northern Orion also has a 100% interest in the Agua Rica copper-gold-molybdenum project in Argentina, which is anticipated to start operations in 2010. In the first 10 years of operation, the project could produce 135,000 ounces of gold per year, 365 million pounds of copper per year and 15 million pounds of molybdenum per year, according to a study paid for by the company. "We will be the cheapest producer of any of those three metals if you consider the other two byproducts," says Cohen.

Holmes believes Northern Orion's valuation and holdings make the company a potential buyout candidate. In the meantime, positive seasonal trends for copper producers should favor this stock from November through March, he says.

Other Potential Plays

Another gold company that may benefit is

Yamana Gold

(AUY) - Get Report

. The company announced a 36% increase in production last quarter, and costs crept higher as well. But Raymond James analyst Paul O'Brien still has a strong buy recommendation and a $14.25 price target on the company, which has been expanding through acquisitions.

In early October, I purchased a long-term position in

Golden Star Resources

(GSS) - Get Report

, a mining company with operations in Ghana. Golden Star has been punished because of ongoing production and earnings disappointments. But chief executive Peter Bradford recently bought $490,000 worth of the stock for $2.39 and $2.59 a share, a bullish sign. One potential catalyst on the horizon: Golden Star plans to use a new bio-oxidation process so it can extract more gold from ore produced at its Bogoso operation in Ghana.

At the time of publication, Brush was long Golden Star Resources, although positions may change at any time.

Brush is an award-winning New York-based financial writer. In addition to writing for

RealMoney

, he has a weekly market column on

MSN Money

called Company Focus, and a column called Insiders Corner at InvestorIdeas.com. Brush has covered business and investing for

The New York Times

,

Money

magazine and the Economist Group. He studied at Columbia Business School in the Knight-Bagehot Fellowship program and the Johns Hopkins School of Advanced International Studies. He is the author of

Lessons From the Front Line

, a book that offers insights on investing and the markets based on the experiences of professional money managers.

Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brush appreciates your feedback;

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