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  • Gold has fallen significantly since peaking in March.
  • The U.S. Dollar could retreat, providing a floor underneath gold prices.
  • Gold mining stocks have fallen much more than gold, potentially creating an intriguing entry point.

Gold hasn't been a very good hedge this year. The SPDR Gold Shares ETF  (GLD)  rallied substantially in February after Russia's invasion of Ukraine, but it's fallen 17.8% since early March. That's significantly worse than the 4.9% drop in the S&P 500  (SPY) .

Gold's performance is disappointing, but there's reason to think it's due for a rally. Historically, gold and the U.S. Dollar are negatively correlated, so the U.S. Dollar's strength this year has been a big headwind. If the U.S. Dollar weakens relative to other currencies, buying gold or gold mining stocks at today's low prices could be profit friendly.

A strategy to buy gold

In "Wanna Bet a Buck on a Gold Play?" Real Money Pro's Ed Ponsi argues that the U.S Dollar may have gotten ahead of itself, giving investors an opportunity to buy gold near key support. He writes:

"According to the charts, the dollar appears ready to dip. The global reserve currency is still in a bullish channel (diagonal lines), but may need to cool down after extending to its upper channel line.

Another indicator is also signaling a pullback in the dollar. The greenback's RSI (relative strength index) is falling from an overbought level (arrow), and is now giving a neutral reading.

Meanwhile, gold's decline has taken it to its lowest level since August. Gold has pulled back to the $1,700 area (black dotted line), which worked as a key reversal point on several occasions last year (arrows)."

Since the U.S. Dollar could experience some mean reversion, buying Gold near the $1,700 level could make sense, especially if you enter a stop loss below support to protect yourself if you're wrong. 

Here's how Ponsi is approaching this trade:

"I'm buying gold as close to $1,700 as possible (green). If support breaks, we'll know immediately that the trade isn't working out, and we'll exit at $1,660 (red) or higher for a manageable loss."

How much does Ponsi think Gold can rally? He's setting three targets ($1,740, $1,780, and $1,825), and he plans to move up his stop loss to protect gains at each of level. He writes:

This trade includes three separate targets (blue). At each target, we'll exit one-third of the position and raise the stop.

If the first target of $1,740 is reached, we'll raise the stop to just below $1,700, removing any risk from the remaining portion of the trade. If the subsequent target of $1,780 is achieved, raise the stop to $1,740, to lock in gains.

Even if we only get an oversold bounce to $1,740, this trade will be a winner, because we'll close one-third of the trade and raise the stop approximately to break-even. Naturally we're hoping for more, but as worst-case scenarios go, this one isn't bad.

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Ponsi is approaching gold as a short-term, opportunistic trade. If you don't want to fuss with the futures market, you can consider buying the SPDR Gold ETF (each share represents a little less than 1/10 an ounce of gold) instead. However, you'll need to use different numbers for your stop loss and target levels because the GLD doesn't track gold perfectly (it's tracking error is about 0.93% annually). 

For instance, his stop loss is 2.3% below his entry point of $1,700. Adjusting that percentage drop to the GLD means that if you buy the GLD at $160, you'd set your stop loss below $156.25. That's similarly below the lows made in March and April of 2021 and spring of 2020, so it's in the right "ballpark." 

As for Ponsi's targets, back-of-napkin calculations suggest you could target $163.75, $167.50, and $172.84 on the GLD.

A strategy to buy gold stocks

In "Understanding Headlines Can Lead to 'Golden' Opportunities," Real Money Pro's Paul Price also thinks buying gold after its recent drop could pay off. However, he thinks investors ought to consider gold mining stocks. He writes:

"Profits of miners swing wildly as the all-in cost to produce is relatively stable. Higher gold pricing leads to much better EPS. Lower gold quotes can lower earnings or even cause losses for higher-cost producers. 

While physical gold lost 7% over the past year and about 19% from its winter peak gold miners' shares plunged from up 27% to minus 29% since around March.

The huge selloff in mining shares makes for a great entry point for those wishing to trade gold. Extreme volatility allows for quick upturns following gold price declines.

Gold prices can fall below a company's expenses, so miners can lose money. Therefore, the cyclical nature of gold makes investors more gunshy about gold miners' outlook when gold is falling; however, this same dynamic works in reverse. Because miners' costs are relatively stable, investors tend to flock to them when prices climb, increasing returns relative to the precious metal itself.

CHART-Street-Smarts_2_072022

For this reason, Price thinks that if investors are modeling for higher gold prices, and they can stomach the volatility, then they should buy SSRM Mining  (SSRM)  and the closed-end fund ASA Gold and Precious Metals Ltd.  (ASA)

Previously, Price recommended buying SSRM last September when it was $14.38 per share. That proved savvy because shares peaked at $24.58 in April, a nearly 71% gain. Since then, SSRM has fallen 33% to $16.50, putting it at levels Price thinks could make it "time to play it again."

As for ASA, Price writes, "the closed end fund topped out at $23.79 [In March]. ASA actually made an intra-day low of $13.04 last Friday. Monday's share price of $13.36 represented a 13.19% discount to the fund's Monday liquidation value of $15.39. That was a nice bonus on shares that had already dropped back by 38.88% year-to-date."

If ASA were to return back to its prior 52-week high, Price notes that would work out to about a 78% return from its close on Monday.

Of course, nobody, including Price, can predict what will happen, but value investors like to buy when nobody else is interested. Arguably, that's where we are today with gold. In Price's words, "It's always best to buy when things are out-of-favor and cheap rather than popular and expensive." 

If you agree, then tucking some shares of gold mining stocks into portfolios could make sense.

The Smart Play

Gold is volatile, but if the U.S. Dollar loses some of its recent gains relative to other currencies that volatility could be to the upside, rather than the downside.

The U.S. Dollar's strength has largely stemmed from the Fed's rate hike policy, which has been viewed as more hawkish than foreign central banks. Recently, however, there's increasing discussion of faster, bigger interest rates in Europe and elsewhere. For example, Canada just increased rates by 100 bps, the European Central Bank is contemplating a 50 bps increase on Thursday, rather than the 25 bps increase it had discussed, and the Bank of England is targeting a 50bps increase at its next meeting in August. 

Like in the U.S., inflation is running rampant overseas, so it's not surprising foreign central banks are getting aggressive. If the pace of rate increases globally accelerates, it could reinvigorate the Euro and other currencies relative to the U.S. Dollar, particularly if front-end loading rate hikes this year in the U.S. allows the Fed to tilt dovish after September.

Overall, if you buy gold or gold mining stocks, use stop losses and control your position size to protect yourself in case the Dollar moves to new highs and gold fails to hold Ponsi's line in the sand at $1,660.

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