(07/15/13) A Bullish Outlook for Gold and Resources

We view the decline in gold as a mid-cycle correction, the type that all long-term moves have. In both the gold and the resource sectors, we have looked to move from weaker to stronger positions, says Adrian Day in his second quarter portfolio review for Adrian Day Asset Management.

Until now, throughout this bull market, gold has not had a year-to-year decline, so a correction was overdue.

Moreover, though a peak-to-trough drop of 33% is painful, there have been two previous pullbacks of more than 20% and, on each previous occasion, gold was back at new highs within 18 months.

During the great 1970s bull market, gold dropped 43% in 1975-1976, immediately before moving eightfold throughout the rest of the decade; and it had two other drops of 28% and 29%, yet bounced back.

And it remains above trend lines going back to the onset of the bull market. So, contrary to the assertions of some analysts, based on price action, this bull market is by no means over.

There are many reasons to be positive on gold, and to think that the decline is near an end. We are not suggesting that gold will promptly bounce back to new highs. But we are suggesting that the conditions are right for a recovery.

Physical demand for gold remains strong (as was evidenced after the mid-April plunge).
Central banks continue to buy gold (with Russia and two ex-Soviet republics buying in April).
Sentiment is extremely weak (a good contrarian indicator).
There has been no increase in supply.
Global short-term real interest rates remain negative, a positive indicator.

In addition, gold stocks are great buys. The gold stocks themselves are now very undervalued. By most valuation metrics, they are at their lowest for the entire bull market, and relative to bullion, the lowest levels in 70 years.

The short-term traders and speculators are out, and gold stocks are now in much stronger hands, so I suspect a rally could be powerful.

We have therefore been adding to gold bullion, focusing on those with the strongest balance sheets that could withstand any further decline on ongoing weakness in the financing markets.

We added no new gold stocks this past quarter, instead adding to the most solid of our favorites, including Franco-Nevada (FNV), Virginia Mines (Toronto: VGQ), Royal Gold (RGLD), and Almaden (AAU).

Resources, like gold, were hurt by growing talk about a future exit from stimulus, as well as a slowdown in demand caused by China's slower growth. In some resources, such as copper and iron ore, there are also fears about over supply.

We believe any legitimate supply concerns are more than priced in, while declines on stimulus and China are overdone. As with gold accounts, we have looked to move from weaker to stronger positions.

As with the gold accounts, we added to some of our favorite resource holdings including Freeport-McMoRan Copper (FCX), which was down on a fatal mine-site accident as well as general concerns about copper supply, and Altius Minerals (Toronto: ALS), which was soft on lower iron ore prices, but still selling for less than NAV and with high royalty potential.

Though this year so far has been painful, we remind ourselves that it is generally neither time to buy after stocks have moved up a lot (US equities) nor time to sell after they have collapsed (gold stocks).

When the urge to liquidate gets strongest, the worst is normally over. We are also very mindful that rallies in gold stocks can often be furious, meaning one needs to be exposed before the rally.