Traders Edge 7-24-12- all that glitters

The S&P 500 took a drubbing (down more than 12 points or nearly 90 points) and so did our portfolios, due to our exposure to gold stocks. Precious metal stocks took a beating, as the Phily Gold/Silver Silver sector (ticker XAU) fell more than 2.7%. We expect the volatility in the precious metals and precious metals stocks to continue. However, we also think that silver and gold are tracing out a bottom.

The charts above are for the Spider Gold Trust (ticker GLD) and the Ishares Silver Trust (ticker SLV). What we see in the price action for both, since the beginning of May, is investor indecision following the profit taking that began in February. Although we are unsure of the timing, we think that Federal Reserve and other central banks in the developing world will embark on further monetary easing actions, culminating in money printing to pay down sovereign debts and the debasement of all fiat currencies. This would be a positive catalyst for the price of gold.

Looking at gold stocks, we updated our analysis of the of the price of the XAU index vs. the standard deviation of the gold prices relative to money supply.

Superior long-term entry points in gold stocks occur when the standard deviation of gold prices relative to money supply is less than -1 and improve with lower observed standard deviations. For instance, the average one year, buy-n-hold performance in the XAU since the end of 1980 is about 14.6%. This compares to an average one year return of 31.2% when an observed standard deviation is less than negative one. As for periods following a standard deviation less than negative two,  the average one year return on the XAU is 37.3%, almost 2400 basis points better than the base case. The current standard deviation of gold prices relative to money supply is -1.3 and we think investors would benefit from building positions in gold stocks.