Gold Investors' Stress Test

By Jeff Clark, Senior Precious Metals Analyst

NEW YORK ( Casey Research) --We've spent the past couple issues of Big Gold and the International Speculator examining our recommended companies in depth.

We've analyzed all-in costs, tracked insider holdings, and projected stock prices based on lower metals prices. We've monitored political risk, reassessed the viability of projects, and examined past corrections to determine when gold might bottom.

But there's one factor that trumps all these.

The investor's attitude. More specifically, his or her emotional reaction to the gold industry's current retreat. After all, even if a company has high-grade projects, top management, low political risk, and below-average costs, it doesn't do the investor any good if they don't own the stock.

The realities of gold's price action over the past couple months dictate that our emotions not control our investment actions. We should coolly evaluate the circumstances based on facts, trends, and historical similarities.

Let's look at some of those facts and consider their implications.

Gold has had huge corrections within bull markets before.

Consider that gold fell...
  • 29.5% in the autumn of 2008
  • 22.6% in the spring of 2006
  • 47% from 1974 to 1976

Today, gold has fallen as much as 28.5% from its 2011 high (based on London PM fix prices). Yet none of these corrections signaled it was time to sell.

The fundamental case for gold is growing, not lessening.

In spite of the downtrend in the price, the conditions that support owning gold are increasing in importance. The U.S. and Japan alone will flood the world with almost two trillion new currency units (dollars and yen) over the next 12 months. Europe's problems have not been solved, and the eurozone continues flirting with recession. As of last month, not one G20 country had a balanced budget. The current fiscal and monetary paths of many major countries remain unsustainable. No amount of gold selling by short-sighted traders and hedge fund managers has changed any of these facts.

One might argue that these issues have had less of an effect on the gold market than we expected, but the effects of these actions have not played out yet. There is no easy way out of the corner our political leaders have painted themselves into. In other words, the damage has already been done to our fiscal and monetary systems. The endgame to the global debt situation hasn't changed, and when the ramifications begin setting in, investors will return to the gold sector.

Investors must be willing to hold through down or sideways markets to realize profits.

The trend we're betting on has taken an unusually large detour, but it has not changed in any material way. It may take some time for the market to stabilize before it makes a significant move up, and with summer knocking on the door (often gold's low season), we could easily see the gold market remain weak for a few more months. A huge rally in the immediate future is unlikely unless a black swan hits (for example, a deterioration in European sovereign debt, a sharply lower U.S. dollar, a major bank failure, etc.).

The message is that, as in any market with favorable fundamentals, you must have the mental wherewithal to stay in the game, however painful, in order to seize a big profit.

The drop in stock prices exceeded the drop in company NAV, based on lower gold prices.

This is important to recognize, because it highlights the difference between value and price, and points to opportunity. This will eventually correct, as all mispriced markets do. Further, while gold and silver prices are down, many management teams are focusing on reducing costs so that profitability remains intact. This is not true with all companies, however, so it's important to be picky.

A lifetime buying opportunity is shaping up.

By any reasonable analysis, gold stocks are about as cheap as they've ever been. Therefore, focus on positioning yourself ahead of what we think will be an extraordinary rebound. The more spectacular the selloff, the more spectacular the opportunity -- and this selloff has been one for the record books. We're witnessing a setup that only comes along a few times in an investor's life. Our goal is to prepare for it, not lament an unexpected correction.

Consider if averaging down is right for you.

The table below shows the investment required and the impact of averaging down. In our example, the investor initially bought 100 shares at $10, for a total investment of $1,000. The stock has now fallen by 50%. Here's what averaging down would look like (excluding fees), plus projected returns if the stock rises to $12.50 (a 25% gain from its original price) and $20 (100% gain).

Amount of  Additional Shares 
Dollar Investment
% of Original Investment
New Cost Basis
% Rise from New Cost Basis If Stock Hits $12.50
% Rise from New Cost Basis If Stock Hits $20
25 shares @ $5
50 shares @ $5
100 shares @ $5
200 shares @ $5

For a modest investment of only 12.5% of your original amount, you can lower your cost basis by 10%. Investing half the initial amount brings your cost basis down by 25%. An identical investment lowers it by a third. And your prospective return grows commensurately.

The percentage drop in the stock you're considering will dictate actual results, of course, along with how well the stock eventually performs. The point is that while you can't bring your cost basis down to current prices, you will increase your profits come selling time. Unless you have too much money devoted to gold stocks, our view is that every investor should prepare to take advantage of the selloff.

The bottom line is that during this downdraft, let's have the big-picture forces guide our gold investing decisions, not our emotions.

It's completely understandable that the downdraft in precious metals have many investors asking lots of questions. You have an opportunity to get answers from some of the best minds in investing today... people like Doug Casey, Eric Sprott, and Jim Cramer, among others. They'll call on their decades of experience in precious-metals markets and investing in general to explain what's going on and point out how to profit from it.

This all-star lineup will come to you completely free, in a webinar that TheStreet and Casey Research have teamed up for. GOLD: Dead Cat or Raging Bull? will premier on Tuesday, June 25 at 2:00 p.m. Eastern time. Sign up today to reserve your spot - you can't let this life-changing opportunity pass you by.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

If you liked this article you might like

SPECIAL REPORT: Should You Pay $1 for 60 Cents Worth of Bitcoin?

SPECIAL REPORT: Should You Pay $1 for 60 Cents Worth of Bitcoin?

3 Ways to Play the Falling U.S. Dollar

3 Ways to Play the Falling U.S. Dollar

This Is a 'Stalking' Market Right Now

This Is a 'Stalking' Market Right Now

Let's Try That Again ... Buy GLD Calls

Let's Try That Again ... Buy GLD Calls

Using Market Softness to Add to Stocks Incrementally

Using Market Softness to Add to Stocks Incrementally