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The Gold Report: You have published a recent e-letter for investors called “Fighting Battles to Win the War.” Please sum up the major themes of the issue, especially around how small-cap stock investors can combat impatience and deal with the emotional stress associated with temporary market downturns.

Eric Muschinski: Investor psychology is a major passion of mine and I write about it frequently. Stocks go up and down and sometimes moves are cyclical (shorter term) and some secular (long term). The “war” is referencing where we are in the junior mining, gold(NYSEARCA:GLD), and silver (NYSEARCA:SLV) markets cycle and where we are heading. The battles referred to several of our recommendations that were experiencing retracements at the time. It’s good to remind myself and readers about the bigger picture because the battles are inconsequential if you have your head on straight, are patient and know the ultimate victor of the war.

Gold went up for 12 straight years from 2000–2011; that is simply unheard of in any asset class secular movement. If we take a step back and put that into perspective, it makes sense that gold would take a “breather” and consolidate for two or three years before its imminent “blow-off” phase.

“For big gains in mining stocks, we generally have to wait for the sector to turn in earnest and the tide will lift all boats.”

 

Frankly, the fact that we haven’t given up 50% since the 2011 highs is a testament to how strong this bull market is overall. The people who have emotional stress at this juncture likely were buyers when gold was $1,800/ounce ($1,800/oz) and silver in the $40s/oz, whether mining stocks or the physical metals.

However, I am quite confident that the market is going much higher and I am joyful beyond belief because this is gifting me more time to accumulate my favorite assets and mining stocks at substantial discounts. If gold is going to $3,000/oz or silver to $150/oz, do you want to own a little or a lot? This is a secular bull market that I am betting so significantly will change my life forever net worth-wise. I would encourage folks who have emotional distress to hit the reset button and get in the game; now is the time to be a buyer. Once gold is much higher, I’ll be selling it to investors who buy based on emotion and excitement; anyone who has a habit of buying/selling on emotion will always lose money over time.

TGR: Are the prices of shares in precious and base metal mining firms directly correlated to the overall market, or do they have some independent movements?

EM: It seems as though share prices of precious and base metal mining companies are now lacking correlation with the overall markets, which is good. Many investors are chasing the indices now for returns/alpha when the contrarian and wise investors are looking at hated assets like junior mining stocks. However, I learned years ago that any given stock tends to trade based on this breakdown, more or less: 50–60% due to overall market, 30–40% the sector it trades in and 10–15% the company’s business performance itself. This explains why all gold stocks are in the gutter. People often ask what’s up with this company or that and my typical reply is. . .nothing.

For big gains in mining stocks, we generally have to wait for the sector to turn in earnest and the tide will lift all boats. Sometimes, with very special discoveries, a junior can buck the trend, as we saw with our top pick the last year, Zenyatta Ventures Ltd. (ZEN:TSX.V), but large counter moves to a sector are rare. If the general market gets smoked and it’s a liquidation race, gold and silver stocks will get hit, but they tend to recover after the initial blast. And once we’re in full stride of the phase 3 bull frenzy, we will likely see the market going lower and mining stocks skyrocketing.

TGR: The gold markets have been lingering low for a while now. Why should investors contemplate buying gold stocks? Is bullion preferable to stock? If so, why?

EM: I recommend a mixture of both bullion and stock. First and foremost, investors in the space should initially take a position in physical gold and silver bullion, which is money. Second, mining companies indeed have leverage to the prices, as we’re experiencing now on the downside, and will again experience on the upside. The ounce-in-the-ground valuations for mining stocks are the lowest I’ve ever seen since I’ve been following the sector.

 

“The ounce-in-the-ground valuations for mining stocks are the lowest I’ve ever seen since I’ve been following the sector.

However, there are a handful of markets where the cyclical bear move was similarly devastating; 1975–1976 was very brutal and many investors capitulated right before we saw a four year, 850% rocket in the price of gold. Thirteen months after a bottom in gold stocks the average weighted return tends to be around 80%. That’s a violent bounce because it is a volatile (NYSEARCA:VXX) sector, but I suspect the major move in gold stocks will see many multibaggers occur.

Once gold breaches $2,000/oz, the leverage in the junior miners will be incredible. There were gold stocks that went from pennies to hundreds of dollars per share between the mid-1970s and 1981. Even if we don’t see anything close to that, sometime in the next couple of years returns from current levels will be quite attractive.

Bottom line, every single soul in the world should have at least 10% of his or her investable assets in gold and silver. Folks with a lower risk tolerance who mainly want to protect their purchasing power should swing heavily in favor of gold. Those who want to take on more risk may want to weight more exposure in silver and mining stocks.

Personally, mining stocks are so cheap I have been putting new money 2-to-1 into the stocks over physical bullion. I also own more silver than gold, which as the poor man’s gold will kick in big time toward the end of the cycle because the common man may not be able to afford an ounce of gold at $2,500–$3,000/oz.

I have long-term price targets of $3,200/oz gold and $150/oz silver. The rationale is quite simple: If you take the percentage move that gold had in the 1970s ($35/oz low to $850/oz high) and cut it in half, you get $3,200/oz gold. A typical 16-to-1 ratio on silver at that price is $187.50/oz, which I cut down to $150/oz to leave room for error. Gold and silver may indeed go much higher but these are the price targets I am banking on and will not consider selling any physical metals until they hit these price targets. You can argue all day that the environment today should propel a much more severe percentage gain from the 1970s but I feel the analogy above is reasonable.

The important thing is to know how secular bull/bear markets work—this thing is not over yet. Bull market frenzies don’t end with virtually nobody yet owning the asset. Even in 2011, how many of your friends and relatives had 10–20% of their assets in gold? Maybe 1 out of 100 even in my circles, but that ratio will be much higher in the blow-off stage when the public comes in en masse. In contrast, a market bottom typically sees vast investor hatred, frustration, disgust, aversion, avoidance and indifference. Does this sound like the recent sentiment of your favorite gold stock?

TGR: Please define the term “market fundamentals” and explain why investors should pay attention to the much talked about Pareto Principle. Given that it may be a true principle after the fact, how can an investor make predictions using it in real time?

EM: I’ll give the exact definition of the Pareto Principle here from Investopedia and then comment: “A principle, named after economist Vilfredo Pareto, that specifies an unequal relationship between inputs and outputs. The principle states that, for many phenomena, 20% of invested input is responsible for 80% of the results obtained. Put another way, 80% of consequences stem from 20% of the causes. Also referred to as the ‘Pareto rule’ or the ’80/20 rule.’”

“We’re now in a junior mining market where the fundamentals and assets of many of these companies are being valued at pennies on the dollar.”

 

The Pareto Principle could actually discount the validity of market fundamentals. His theory is translated that 80% of a market’s movement will occur in the last 20% of time. This has proven very true in the work I’ve done looking into secular bull markets. It speaks to the “frenzy or blow-off” stage of markets. Frankly, whether it was Internet stocks in 2000, real estate into 2007 or eventually gold and gold stocks in the future, it makes no difference. The investor psychology component seems to be the driving force of ultimate returns as the masses slowly then quickly get involved in these markets toward the end while smart money is selling. Look at what gold did from 1978–1980 or Internet stocks from 1998–2000 and it would seem this principle holds water. It’s also a very exciting theory because, if true, “we ain’t seen nothing yet” as it pertains to precious metals and mining stocks.

This speaks to why being on the right side of the emotional curve when investing is critical. Fundamentals are important to me as a back stop and we’re now in a junior mining market where the fundamentals and assets of many of these companies are being valued at pennies on the dollar. Fundamentals will improve drastically when gold goes up but I consistently stress the importance of regular accumulation of your favorite assets until the asset exceeds your buy price. For example, I’m a regular buyer (monthly or when I have a cash infusion) of physical gold up to $1,600/oz. I just buy it wherever it is as long as it’s below that price. That way, the longer the cyclical bear correction lasts or the lower it goes, I will have more ounces when it eventually goes up, at an average price accumulation.

This also speaks to “stress free” investing as it does not put pressure on me to buy the low all at once, which is highly unlikely even for the best of us. This is a psychological defect that cripples many investors. They tell themselves it’s all or nothing and zero or hero—no middle ground. However, I’ll gladly buy a stock at $2 then $1.75 then $1.50 then $2 if it is eventually going to $5. If I didn’t buy at $2 initially, chances are that I would not have pulled the trigger at the low of $1.50. Investing is a process for me and operating this way also allows for the fun in it to flourish, versus much undo pressure people put on themselves when they allow no flexibility for volatility, which is normal.

TGR: How does a wise investor hedge gold investments? How do inverse funds work?

EM: There are plenty of simple hedges these days that can be bought just like a stock. PowerShares DB Gold Double Short ETN (DZZ), VelocityShares 3X Inverse Silver ETN (DSLV) and Direxion Daily Gold Miners Bear 3X Shares (DUST) are all examples of leveraged shorts on gold, silver and mining stocks. These can come in handy when investors are jittery about their holdings or when gold or silver breaches a key technical support level. Instead of rushing to the dealer with a 42-pound monster box of silver American Eagles, you can simply buy DSLV as a hedge on your holdings. I only use these vehicles for trades, not against long-term holdings.

TGR: Are dividends worth the trouble of keeping investments in the gold companies when share prices are stuck low? What about royalty companies?

EM: Dividends definitely help! There are some awesome companies in the gold mining sector that pay handsome dividends currently. I like IAMGOLD Corp. (IMG:TSX; IAG:NYSE), which is paying 5.4%, and Market Vectors Junior Gold Miners ETF (GDXJ), the junior mining index, is actually paying out a hefty 7.3% annually right now. Not only is there big upside in these companies long term, but we can also get paid for our time holding with juicy distributions. One other one worth mentioning is Gabelli Global Gold, Natural Resources Income Trust (GGN), which is paying $0.12 cents per month and you can buy it under $11/share. This trust has paid a very consistent dividend around this level for a decade and I like it for a yield play right here.

TGR: What do you think of royalty companies?

EM: Royalty companies are the cream of the crop due to the way they structure their deals with producers. They do not suffer from cost problems because their take is on gross revenues/production so the income streams are much more predictable and the overhead for the companies is usually very low. Silver Wheaton Corp. (SLW:TSX; SLW:NYSE) has a $7 billion market cap and only 28 employees. There’s a similar situation at Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX). Those two are the blue chips in the gold and silver royalty space and are worth having a piece of in one’s portfolio.

TGR: You have been championing Zenyatta Ventures for a while. But its stock slipped from $5 to $2/share. That is bad news for those who bought in at the high, is it not? Is it good news for investors looking to buy in at a low? What does Zenyatta have going for it in the graphite mining, copper and platinum space?

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