Gold Fever

The Stock

The Trade: New Gold (AMEX: NGD)–Buy < 12.50

Why Now: The prices of gold and related mining stocks have endured a one-year correction after the precious metal hit an all-time high in the summer 2011. But another round of monetary stimulus from global central banks would bolster gold prices and shares of mining firms.

The Story

Back in the US after spending his summer in Greece, Yiannis calls Elliott to set up a meeting to plan the September issue of Cocktail Stocks.

Elliott: Welcome back to the States.  

Yiannis: Thanks, man. I have to chauffeur my daughters to school, so I don’t have much time to talk. Let’s meet at Taverna Cretekou at 9:00 pm to discuss the upcoming issue of Cocktail Stocks.

Elliott: Didn’t you eat enough Greek food this summer? How much weight have you put on since I last saw you?

Yiannis: I try to make things easier for you by setting up dinner in Old Town Alexandria, and this is how you treat me? We’ll order a bunch of appetizers and take our time eating.

Elliott: Fair enough. But be forewarned I’ll order my own entrée. You always inhale every appetizer that shows up.

Yiannis: Whatever. See you tonight.

Elliott shows up at Taverna Cretekou about five minutes before 9:00 pm and requests a table on the back patio. On this humid night, Elliott selects a bottle of refreshing and characteristically acidic Assyrtiko from Santorini. After his first sip, an animated discussion in Greek interrupts his reverie. Yiannis has arrived.

Elliott: How’s the Grecian sensation?  

Yiannis: We should sit over here.  

Elliott: What’s wrong with this table? It’s…

Yiannis: I like this table more, and the owner said I could have it.

Elliott and Yiannis relocate to the table Yiannis had discussed with the owner. The server moves the bottle of Assyrtiko to the new table and brings a glass for Yiannis.

Elliott: I can see why you were adamant about moving to this table. Not only is it 5 percent larger than the table I picked, but you also get to look like a big shot in front of all the other Greeks. Lap it up, my friend.

Yiannis: I do what I can. Thanks for picking a quality bottle of wine. Let’s order some sea stuff–I’m starving.

Elliott: We call it seafood. Anyway, let’s get down to business. The stock market’s continued resilience has surprised me, especially against a backdrop of weak US and EU economic data, Europe’s never-ending sovereign-debt crisis and uncertainty about US fiscal policy heading into the presidential election.

Much of this strength hinges on expectations that the Federal Reserve will implement a third round of quantitative easing (QE3) before year-end and that the European Central Bank (ECB) will formalize a program to buy Italian and Spanish government bonds. 

Yiannis: I agree that the Fed will likely launch QE3 if the economy continues to languish.

Elliott: Although the Fed’s quantitative easing has proved controversial, Ben Bernanke has made it no secret that he’s ready to apply further stimulus if the economy doesn’t improve. I’d look for an announcement regarding QE3 at the Fed meeting in mid-September or after the presidential election.

Yiannis: It appears that the ECB is moving toward a plan to buy bonds of EU countries, a move that would reduce borrowing costs. Also, the odds of an imminent Greek exit from the eurozone have decreased substantially since the election earlier this summer.

Elliott: The challenge for investors is that the market has already priced in these stimulative efforts, setting the stage for potential disappointment.

If the S&P 500 were hovering near its June low of 1,266, the likelihood of the ECB or Fed taking action to bolster the stock market would increase significantly. That’s exactly what happened in summer 2010, when Ben Bernanke hinted that quantitative easing was imminent in a speech at Jackson Hole, Wyo. A similar situation prevailed when the ECB announced its long-term refinancing operations for banks in late 2011.

This year, the S&P 500 is near a four-and-a-half-year high, and investors already expect a third round of quantitative easing and more bond purchases in Europe. If the market has already priced in these events, there’s a good chance that investors have bought the rumor and plan to sell the news.

The selloff could be even worse if the Fed announces QE3 after the election, or if the scope of the stimulus falls short of expectations. The ECB could also cave in to pressure from Germany and scale back any plan to purchase bonds issues by fiscally weak EU member states. EU policymakers don’t exactly have a great track record of meeting the market’s expectations.

At the same time, you have to wonder if these stimulative measures will bolster the US economy in a meaningful way.

Yiannis: Who let the bears out? Are you thinking of another short play?

Elliott: Nope. But we should consider taking profits on our short positions in Best Buy (NYSE: BBY) and Netflix (NSDQ: NFLX). Both stocks have plummeted despite the market rally, which goes to show that weak fundamentals can trump a rising tide.

Yiannis: I agree with you on Best Buy. The company’s founder, Richard Schulze, has announced he wants to take the company private for a price in the mid-$20s per share. I think he’ll struggle to finance the deal because of the headwinds facing the retailer. But there’s still an outside chance that Schulze will succeed in his takeover. At the very least, the former CEO’s bid could limit any additional downside. Let’s close our short position in Best Buy and book an almost 26 percent gain.

However, I’m not so sure we should cover our short position in Netflix. The recent deal between Amazon.Com (NSDQ: AMZN) and Hollywood studio Epix means that members of Amazon Prime will have access to even more streaming video content. Netflix now faces a lot more competition in the streaming video market than it did a few years ago. I see further downside in store for Netflix.

In light of our bearish outlook for the stock market, let’s also take profits on Splunk (NSDQ: SPLK). I like the company’s long-term growth story, but the stock could pull back significantly during a selloff. Sell Splunk and book a 21.8 percent gain.

Elliott: Sounds good to me.

Yiannis: What’s your pick for the September issue of Cocktail Stocks?

Elliott: Gold. The price of the precious metal has pulled back from its all-time high of more than $1,900 per ounce to a recent low of $1,525 per ounce in May 2012. I regard this recent pullback as a temporary correction of the uptrend in gold prices that started more than a decade ago.

After all, the Fed’s quantitative easing policy is all about keeping inflation expectations on the rise and preventing deflation–a bullish environment for gold. The price of the precious metal surged in the weeks after Ben Bernanke announced QE2 back in summer 2010 and immediately following the Fed’s unveiling of Operation Twist, which involved selling short-term bonds and using the proceeds to buy long-term bonds in an effort to drive down longer term interest rates.

Another round of coordinated monetary easing will push gold prices to new highs by early 2013. Gold recently broke through a point of technical resistance at $1,650 per ounce, suggesting that this uptrend is already under way. 

Yiannis: I’m right there with you. Gold has proved itself as a store of value throughout history. The rise of resource nationalism in South Africa and other gold-producing nations raises questions about whether growth in global supply will keep pace with demand.

At this point, the waiter arrives with their food. Yiannis’ eyes grow larger as the table quickly filled with stuffed grape leaves, a flaming platter of saganaki and a host of other small plates. Elliott pushes his Arni Kapama–a lamb shank in tomato sauce–to the side of the table that’s furthest from the hungry Grecian.

Elliott: Don’t even look at my lamb shank; you have plenty to keep yourself occupied. 

Yiannis: I only want to admire it from afar. Let’s get back to gold. We could make SPDR Gold Trust (NYSE: GLD) this month’s pick.

Elliott: I like that exchange-traded fund as a long-term holding, but I’ve got my eye on a mining firm. Shares of gold miners have lagged the precious metal for much of the past year but could take off if the catalysts we discussed come into play.

The Philadelphia Stock Exchange Gold and Silver Index formed a double-bottom base with its May and July lows. The widely followed index has broken out of that base and has plenty of headroom. My favorite gold play for Cocktail Stocks is New Gold (AMEX: NGD).

Yiannis: As I recall, New Gold is a junior miner with operations Australia, Mexico and the US?

Elliott: Correct. The company has four operating mining projects: New Afton in Canada, Mesquite in California, Cerro San Pedro in Mexico and Peak Mines in Australia. These mines produced a total of 387,000 ounces of gold in 2011 at a cash cost per ounce of less than $450–not bad when you consider that gold averaged about $1,700 per ounce over the past year.

New Gold stands out because of its declining production costs, a rarity at a time when rising diesel prices and labor costs have eaten into many operators’ profit margins. Management expects New Gold’s production expenses to decline even further when mine expansions and new mines come online.

Output has declined at its California-based mine, which has a production cost of more than $700 per ounce. Meanwhile, output from Cerro San Pedro continues ramp up at a cost of about $250 per ounce. The 100 percent-owned New Afton mine entered production in July 2012 and is yielding about 85,000 ounces on an annualized basis. When you factor in the copper that’s also produced at New Afton, the company’s cash costs for gold production are in the negative.

The El Morro mine in Chile is New Gold’s most exciting growth prospect. The junior operator owns a 30 percent stake in this project, while mining giant Goldcorp (NYSE: GG) owns the remaining equity interest and is funding the mine’s development. This site also yields substantial amounts of copper that help to defray mining costs. The mine is expected to begin producing commercial quantities of gold in late 2016 or early 2017.

Management expects New Gold’s output to increase to between 450,000 and 500,000 ounces in 2013 from 387,000 ounces in 2011. El Morro and other long-term projects should enable the miner to grow its gold output more than 800,000 ounces by 2017.

Yiannis: I like the story and the company’s partnership with Goldcorp.

Elliott: It’s settled: New Gold rates a buy up to 12.50.

Updates on Open Trades

August 2010: Vale (NYSE: VALE)–Buy < 25

Weak iron ore prices and concerns about Chinese demand have plagued the stock, but an improving outlook for the Mainland economy would send the stock higher.

September 2010: Teekay Tankers (NYSE: TNK)–Buy < 7

The tanker market remains oversupplied, but Teekay Tankers has disbursed $1.40 in dividends since we highlighted the stock almost two years ago. The firm will survive and emerge as a winner once the supply-demand balance tightens. This pick is for aggressive investors who have a longer time horizon.

February 2011: ProShares UltraShort 20+ Year Treasury (NYSE: TBT)–Buy < 25

Betting against US Treasury notes has been a losing proposition. This position could recover some lost ground when investors rotate funds from safe havens to equities.

June 2011: iShares MSCI Italy Index (NYSE: EWI)–Buy < 15

This play on Europe’s turnaround is less risky than our Greece-related bet. The exchange-traded fund also offers a 5.5 percent dividend yield.

July 2011: TransGlobe Energy Corp (NSDQ: TGA)–Buy < 15

Shares of this small-cap oil producer have gained thus far in 2012. The stock’s recent pullback reflects weakness in oil prices, but Brent crude oil has recovered to about $100 per barrel.

July 2011: Market Vectors Gulf States Index (NYSE: MES)–Buy < 23.50

This exchange-traded fund (ETF) has held its own since we featured it in July 2011. We’re holding out for a powerful upsurge.

August 2011: National Bank of Greece (NYSE: NBG)–Buy < USD3

This stock is our most speculative play to date and is only appropriate for aggressive investors who can stomach a bet that’s based solely on a turnaround in Greece. Any orderly resolution to Greece’s sovereign-debt crisis could send the stock price higher in a hurry.

September 2011: China Cord Blood Corp (NYSE: CO)–Buy < 4

Don’t let near-term volatility shake you out of this stock. Shares of China Cord Blood Corp are down marginally this year. Recently the private-equity firm KKR invested $65 million in the company through the acquisition of convertible notes issued by China Cord Blood. Expect more upside as the industry’s fundamentals turn.

October 2011: Infosys (NSDQ: INFY)–Buy < 50

A slower mover than other technology stocks, shares of Infosys should keep pace with India’s stock market, which has been pounded this year. Investors should adhere to our buy target and only add to their positions when the stock is below 50.

December 2011: Symantec Corp (NSDQ: SYMC)–Buy < 18

Internet security is a major growth market, and Symantec should continue to benefit. Investors should adhere to our buy target.

February 2012: Greenbrier Companies (NYSE: GBX)–Buy < 20

This stock has sold off significantly since we profiled it in February, but the company’s underlying growth story remains intact. Better economic numbers in the US would give the stock a boost.

March 2012: Best Buy (NYSE: BBY)–Hold Short Positions.

Results have disappointed, and the founder’s recent offer to take the company private doesn’t look credible. Stay short.  

April 2012: AU Optronics (NYSE: AUO)–Buy < 5

This stock has pulled back considerably but remains a solid turnaround play.

Roundy’s (NYSE: RNDY)–Buy < 12.50

The stock has rebounded from its recent low. Meanwhile, the company is expected to maintain its quarterly dividend of $0.23 per share, equivalent to a yield of about 9 percent at current prices.

Netflix (NSDQ: NFLX)–Sell Short >60

This stock continues to pull back even when the market rallies, suggesting that further downside is in store.

Splunk (NSDQ: SPLK)–Buy < 32

The stock has held its own since its initial public offering, and we remain bullish on its exposure to trends in Big Data.

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