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How to Play the Next Potential Upleg in Gold: Some Contrarian Advice

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While you can buy the larger miners, here's why you should consider the smaller ones and the royalty companies instead.

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When it comes to gold and precious metals, investors seem to find no middle ground: They are either huge gold bulls or bugs who believe that gold will soar in sort of an investment-doomsday scenario, or gold bears who feel gold has overdone its run, doesn't earn interest, and is a relic of the past. Warren Buffett himself once said that gold just sits there.

However, gold's properties and its ability to stand the test of time -- and currencies -- give it value. We don't use tetradrachms (the currency of ancient Greece) any more , which was debased to almost nothing. The pound used to be sound, but has lost 70% of its value against the US dollar since the fall of the British Empire. The dollar itself has lost 90% of its value against everything since the 1913 Federal Reserve Act was passed, and it has lost about 60% against most major currencies since the 1960s.

Gold has, despite what its naysayers say, kept its value against inflation and paper currencies that have come and gone. Yet gold still trades in major cycles, having outperformed equities and other assets during the 1970s, underperformed during the '80s and '90s, and outperformed again since bottoming in 2001.

So the question arises: Does gold have further to climb, or was August 2011 the top of the current cycle?

In 1980, gold spiked and blew off to $850 an ounce, then collapsed to $280 an ounce by mid 1982.

Gold climbed from $35 per ounce to nearly $200 per ounce in January 1974, then fell to $103 per ounce in August 1976. This was a 21-month decline that took 45% off the price of gold. After this decline, gold climbed over 800% in the next three-plus years. It took around five to six months for the 1976 market to bottom (which would have us breaking out later in the year).

I think the current decline is more similar to the 1974-1976 decline vs. the 1980 decline for the following reasons:

1. The Dow-to-gold ratio. This is a ratio that simply calculates how many ounces of gold it takes to buy one share of the Dow Jones Industrial Average (INDEXDJX:.DJI). At major tops for gold and bottoms for the Dow, it tends to get in the 1-2 to 1 range, meaning it takes only one or two ounces of gold to buy a share of the Dow. At this most recent top, it only got to about 6 to 1. In 1980, it was just a hair above 1 to 1. At the moment it stands at over 10 to 1.

2. Junior mining stock bubble. Usually near the end of a major move in gold, there will be a bubble in the smaller exploration stocks and smaller producer stocks. These have actually underperformed for years and were not trading at bubble-like levels in mid 2011.

3. Monetary policy. Near the end of booms in gold and inflation, the Federal Reserve raises rates and cuts the money supply. This occurred in 1949, 1980, and other major tops for gold and resources. Right now it's still printing money and is nowhere near any real tightening of policy.

4. Time and scope. This decline lasted 22 months and took 38% off the price of gold, which was very similar to the 1976 decline in both time and scope.

I feel that we are in the stages of bottoming, and that 2013 will be a lot like 1976 -- a major correction within a major bull market.

So what to look at for investment purposes?

There has been a lot of mismanagement in the gold-equity arena. Many companies did not increase production in the mid 2000s as gold began to rise, and then tried to make up for it by taking over assets and overpaying for mines in the last few years. All-in costs (cost of development and production) are now at nearly $1,100 per ounce. However, there is almost universal bearishness on these equities, which, as a contrarian, you have to love.

If you want a basket of equities, the easiest way to go is through the Market Vectors Gold Miners ETF (NYSEARCA:GDX) and the Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ). GDX holds large-cap gold stocks, and GDXJ holds smaller ones. The smaller cap stocks are now cheap versus the index's high in 2011; between the 2011 high and the 2013 low, the GDXJ lost 80% of its value. It trades at a P/E of nine, which is pretty unheard of for gold stocks.

While you can buy the larger miners such as Barrick Gold (NYSE:ABX) or Newmont Mining (NYSE:NEM), I prefer either smaller miners -- such as New Gold (NYSEMKT:NGD), which has increased production and kept costs under control -- or the royalty companies such as Franco-Nevada (NYSE:FNV) and Royal Gold (NASDAQ:RGLD). Royalty companies invest in other companies and mines and earn interest in the profits. They do not have to directly deal with costs and so forth.

I think that gold is in the process of bottoming and will do so before it begins its secondary move up.
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