Another Way to Look at Cheap Gold Stocks

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By Jeff Clark, editor, S&A Short Report
Friday, May 20, 2011

The gold sector looks ready to bounce.

It's been a rough year for gold stocks. Even though the price of gold is up 5% so far in 2011 (near $1,500 an ounce), gold stocks are underwater. The Market Vectors Gold Miners ETF (GDX), for example, is down about 10% for the year.

And as my colleague Steve Sjuggerud pointed out, you see the same pattern over the longer term, too:

Over the last three years, the price of gold is up over 60%... But gold stocks (as measured by the big gold stock fund GDX) are up less than 20%.

This action has a lot of gold stock investors scratching their heads.

With the commodities complex selling off a bit recently in reaction to a bouncing dollar, many gold bugs are throwing in the towel. They're selling their stocks. And in the process, they're creating some bargains in the gold sector.

Lots of big-name gold stocks like Newmont Mining (NEM) and Agnico-Eagle Mines (AEM) are trading at historically low valuations. The gold sector itself trades at a discount to the S&P 500. The dividend yields on many of the larger companies are higher than the rate on two-year Treasurys.

You don't often see gold stocks trading this cheap. The sector is approaching oversold levels and is at least due for at a short-term bounce.

Take a look at this chart of the gold sector bullish percent index (BPGDM)...

A bullish percent index (BPI) is a measure of overbought and oversold conditions for a market sector. A sector is overbought when the BPI runs above 80, and it's oversold when the BPI drops below 30. Typically, the best time to buy into a sector is after the BPI has reached oversold levels and starts to move higher.

As you can see from the chart above, the best buying opportunity of the past two years for gold stocks was in February 2010 (the blue circle).

Of course, we don't always have to wait for the "best" time to buy to take advantage of opportunities. The red circles on the chart indicate "good" spots to jump into the gold sector. Each spot occurred right after a deep decline in the sector and proceeded with a sharp rally higher. The BPI dropped sharply each time, but didn't quite fall to "oversold" levels.

Look at how GDX behaved each time...

So while the best time to jump into the gold sector is when the BPI drops below 30 and turns higher, the BPI can point out other good times to buy, too. I believe we're approaching one of those times right now.

The gold sector bullish percent index is acting similar to how it was last year. It bottomed in late January/early February... ran higher for a few months... then dropped hard in May. That action led to a bounce in the sector that popped GDX 15% higher in one month.

That's the sort of bounce we should see this year as well.

It's certainly possible, however, that the gold sector will just keep dropping until the BPGDM drops below 30 and the sector becomes officially oversold. You'll want to have plenty of cash available to buy gold stocks if we ever get to that point.

But given the bargain basement pricing of many gold stocks, it's worth it to take a small bullish position in the sector right now.

Best regards and good trading,

Jeff Clark