Gold Stock Bull

Gold made a huge run from $650 to $850 during the back half of 2007. After this run, gold corrected and consolidated around the $800 level and support at $790 proved to be a very solid floor from which the second run was launched that took gold from $800 to over $1,000. Fast forward to 2008 and gold’s most recent correction has seen the price fall back to this very important floor once again. On three separate occasions during the past month, gold has tested this support level and has bounced off with vigor. We also see in the chart below that gold’s stochastics have bottomed and are turning up. From a technical point of view, it looks very much like gold has found its floor.

Fundamentals are also pointing toward higher prices, as we head into the Indian wedding season. The latest statistics are showing extremely robust gold sales, with imports up 45% during August. But it is not only India that is showing signs of surging demand for the precious metal, Abu Dhabi reported gold sales were up 300% during August. We also have news of significantly lower supply coming out of the world’s largest gold producers. Rising demand and declining supply always equals higher prices.

With inflation out of control and the dollar extremely overbought, I anticipate a rally in precious metals and energy over the next several weeks. With the economy coming out of a consolidation phase and looking ready to continue downward, we should a powerful spike at funds rush back into commodities and out of financials, housing and blue chips.

I admit to being caught off guard in terms of the severity of the recent correction. It seems likely that the government and banks are colluding and using paper contracts to massively short precious metals and drive the price down. They don’t want to see an alternative currency gaining popularity and a rising gold price confirms fears that inflation is much more severe than their statistics suggest. Ted Butler’s “Smoking Gun” article is recommended for more on this topic, as is Jason Hommel’s “Tribute to 7th Grade Math.”

I believe the gig is up and that market forces will pull precious metal prices back to levels dictated by true supply and demand. Shorts will need to be covered and huge sums of money will be looking for a “safe haven” as more banks fails and the U.S. economic decline gets worse. Now it the time to buy both gold and silver and realize significant profits as the prices bounce back just as forcefully as they declined.

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SEMAFO is undoubtedly one of my favorite junior gold miners. The company is grossly undervalued with 2.3 million M&I ounces of gold and a market cap under $300 million. Annual production should come in just shy of 200,000 ounces of gold, which is impressive for a company of SEMAFO’s size. But the story gets even better.

On August 12th, the company released stellar Q2 results that support a much higher share price. SEMAFO delivered record results in terms of gold production, gold sales, operating income, net income and operating cash flow. They produced 54,500 ounces of gold during Q2, nearly doubling the previous year and generating $11.7 million in earnings. I pulled a few charts from their website to better illustrate just how impressive results were from the latest quarter.

Production is up about 100% from previous quarters. SEMAFO successfully brought new mines into production during 2008 and is on track to meet or beat production estimates for 2008.

Not only did the company substantially increase production, but they managed to lower their costs significantly to under $400.

This charts speaks for itself, with SEMAFO increasing operating income by 400% from the previous quarter and continuing to trend upwards from the negative income during Q3 of 2007.

Last but certainly not least is cash flow from operations. SEMAFO again posting record results and generating more cash than the previous five quarters combined.

The recent correction in precious metals provides an excellent opportunity to pick up SEMAFO at bargain prices. A support line exists around $1.22 with resistance at $1.62. Traders can certainly profit within this range, although I view SEMAFO as a long-term investment destined for a share price of $4 or higher during the next year or two.

Disclaimer: I own shares of SEMAFO and recently added to my position.

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In the short-term, sentiment and emotion rule the markets more than fundamentals. This type of trading pushes stock prices to extremes, whether the extreme is overbought or oversold. As a contrarian investor, I like to trade against these extremes and invest in the opposite direction of the herd. The wild action in markets, the dollar, gold and financials over the past few weeks leaves the door open for a few contrarian trades that I will be looking to make as trading opens this week.

1) Financials and SKF - The SEC is lifting its emergency ban of naked short-selling on 19 U.S. financial stocks. I believe this will swing sentiment and add a fresh round of downward pressure on financial stocks. The ruling certainly had the desired effect, as financial stocks rallied and the SKF ultra-short financials ETF lost nearly 50% of its value in just over a week. Is the rally justified? Are the bulk of write-downs over? No way. Financial stocks will get hammered again, more banks will collapse and SKF will again push towards $200.

Contrarian play #1: Pick up SKF around $115 with a price target of $155 in the coming weeks.

2) The U.S. Dollar and Gold - The dollar posted a surprise rally in the past week, after European central banks signaled that they would not raise rates. The story goes that the move is bearish for the Euro and therefore bullish for the dollar. The dollar bulls have been looking for any reason for a rally. A dollar run from 71.50 to 76 in a matter of days, solely on this news and in the face of declining wages and the highest inflation figures in a quarter of a century? Gold, which has an inverse relationship with the dollar, lost $100 alongside the dollar run. All of this while a new war rages at the border of Russia, which could easily widen and become much more dangerous. We also have reports of a massive U.S. naval armada heading for Iran. The dollar is now incredibly overbought and gold is extremely oversold and resting on key support at $850. The massive debt, economic ills, negative real interest rates, deficit spending and aggressive foreign policy of the United States has not changed. There is no fundamental reason for a dollar rally of this magnitude and it will not last. This is likely the last buying opportunity for gold under $900.

Contrarian Play #2: Sell the U.S. dollar and purchase gold and silver stocks. Buy producers or near-term producers. If you don’t want to pick individual stocks, consider the gold stocks ETF GDX.

3) Energy and PBR - Oil was undoubtedly overbought around $150 and the correction was necessary. But I don’t think we go much lower from here, especially not with the above-sited war raging between Georgia and Russia and signs of an intensification of the stand off with Iran. Peak oil is not a theory, it is a verifiable fact. Argue with this notion all that you want, but production had peaked and has been declining ever since this peak. That is the very definition of Peak Oil. Higher prices did dampen demand somewhat, but not nearly as much as could have been expected. The economies of China, India and other developing nations will continue to increase their demand for oil and supplies will continue to decline. A cursory understanding of economics points towards higher oil prices.

Contrarian Play #3 - Buy the sell-off in energy stocks. I purchased shares of Petroleo Brazileiro or Petrobas (PBR) on Friday at $50. Long-term, they are one of the best energy plays within one of the strongest and fastest growing economies in the world. Short-term, this stock should rally. I took a small position and will continue to purchase on any additional weakness.

Contrarian investing, commodity investing and short selling are not for the faint of heart. Investors are always concerned with “catching a falling knife” and most investors will lose large amounts of money trying to call tops and bottoms. It takes discipline and is difficult to buy when everyone else is selling, but I believe buying low and selling high is the objective. And you don’t need to go “all in” with these plays. Consider averaging in by taking small positions at these levels and adding to your positions as things play out.

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