It’s widely known in the investment community that gold has been one of the best investment opportunities of the first decade in the new millennium. Gold was trading at around $250 per ounce at the turn of the century; 11 years later, it’s over $1500 and even briefly soared past $1,900 in September of 2011. The reason? Gold is a function of sovereign debt and currency instability; we live in a world where nation-states are drowning in debt, and the odds are growing that the only way they can manage to pay off this debt is by expanding the money supply — i.e. printing money, an event that will most likely have the effect of significantly devaluing the currency. As investors see prices rising due to expansion of the money supply (which continues to soar to new all-time highs), they naturally grow fearful of watching the value of their savings erode; and thus, they turn to gold, which historically has been the asset to turn to when governments destroy the value of money.
This is crucial to note because it tells us why gold is rallying, and how long it may continue to rally. So long as the sovereign debt crisis remains unresolved and even unacknowledged, the odds favor a continued rally in gold. And given that the nation-states of the world are facing bond coupon payments in excess of $7.6 trillion in 2012, it seems as though the best may be yet to come for gold. Buying gold bullion is the first step towards investing in this massive wealth transfer out of currencies and into precious metals, although for those with appetite for some risk and looking for an even stronger upside, gold stocks may be of interest.
Of course, the more risky the asset, the more important risk management becomes. Here are three guidelines I use to mitigate risk while preserving opportunity for profit via gold stocks:
1. Focus on royalty stocks. Royalty stocks can be thought of as similar to the venture capital of the mining industry. These firms focus on raising lots of cash and investing in lots of mines in exchange for a royalty stream of income when the mine goes into production. Royalty stocks have two major advantages: (1) they typically do not have to bear the cost or responsibility of mining, passing that off instead to a joint venture partner and (2) they are able to invest in many mines, and thus offer investors a valuable means of diversification. My two favorite royalty stocks are Franco Nevada (FNV.NYSE) and Eurasian Minerals (EMXX.NYSE).
2. Follow the Rule of 2. The “Rule of 2″ is simply a strategy that calls for exiting half the position if price doubles. This rule, which is especially important for controlling risk when speculating in tiny stocks that are prone to much greater volatility, helps investors control risk while still allowing investors to hold positions for the duration of long trends. By taking half the position off if price doubles, investors are taking back the original capital they invested, thus allowing them to “play with the house’s money” — to borrow jargon used by professional gamblers. Because investors have taking their original capital off the table, they can patiently wait for the trend to fully develop and for the maximum profit opportunity to be revealed.
3. Gold peaks before stocks do. A careful examination of gold’s bull market in the 1970s reveals that gold peaked BEFORE gold stocks did. I consider it somewhat likely this scenario will repeat this time around in gold’s bull market. From this perspective, the first sign that that the market may be getting ready to peak is if gold makes a strong, parabolic move — such as doubling within 6 months. So far we have not seen anywhere near this type of price acceleration in gold. When gold starts to fall after a parabolic rise but gold stocks are still rising, it may be time to start cashing out of gold stocks.
4. Take direct registration of your shares. There are several ways to own stock shares, although the two most common are direct registration and street registration. Street registration is the default option that occurs whenever an order is placed via an online broker and no request to the contrary has been made. Street registration actually puts the shares in the broker’s name, which puts shareholders at risk; if the brokerage firm collapses, the shares will be gone. Direct registration, on the other hand, puts the stock in your name. Our current financial system is fraught with instability, and so I think direct registration is a preferable option for stocks investors plan to hold for the duration of the bull market.
By following these four guidelines, investors can safely participate in what may end up being a bull market that transforms the global monetary system.