Most commodities have been strong in 2016, following a long-term decline. The recent strength has brought certain commodities–such as oil, gold and silver, for example–back to the forefront of the news, which entices many people to invest at exactly the wrong time. Oil recently traded over $50 in early June, nearly double its lows near $26 in February. So is now the time to invest oil stocks? What about gold and silver?
Oil, gold and silver stocks may continue higher from here, but this is not a high probability time to be investing. I will explain why below, as well as provide some ideas on a better time to buy (likely not in the too distant future) based on my investing methods.
When to Invest in Oil
In January I saw a major opportunity shaping up in oil and natural gas stocks. Prices had declined to levels so low that even a modest bounce in oil prices outweighed the downside risk (even if the companies I bought went bankrupt, and there was very little chance of that happening based on my analysis). The opportunities were such that every $1 invested was likely to yield $2, $4 or $6 in some cases. Those trades are still playing out, but the point is, the time to buy was in January and February, not now that oil has doubled. So the next question is “When is the next opportunity to buy?”
While I am doing very well on the oil and gas related stocks I bought in January/February, I actually want a pullback in oil. This will allow me to buy some more of the stocks I bought prior (most of which offer great dividends, with the potential for those dividends to increase, as well as offering larger upside over the longer-term), but also pick up some stock I didn’t have a chance to buy a few months back. That said, I only buy when prices come to me…I don’t chase. If a pullback doesn’t occur to the price I want, I don’t buy…and I will explain why in a second.
So I want to see a pullback in oil to the $39 to $36 region–and that is where I expect a pullback will go based researching historic oil pullbacks in this stage of the trend. At that price area I will be looking to buy more of the oil stocks, and I will likely be adding more stocks to the list as that pullback unfolds and stock prices drop enough to come close to my desired entry points.
You will notice on my charts that I have placed a number a Fibonacci retracement tools. I use these to see how far pullbacks have come, but I don’t give particular levels too much credit, unless I have done specific research on how far a market tends to pullback at particular stages of a trend (which I have done for the three commodities discussed in this article).
When to Invest in Gold and Silver
Gold and silver weren’t really on my radar at the start of the year. I was more focused on oil and gas…although I did pick up an iron ore company in my portfolio early in the year as I did see a lot of upside in that particular stock based on the climate in metals. A pullback in gold and silver will present an opportunity to get into stocks in that sector…but they need to pullback, as now is not my ideal time to buy.
For gold, I want to see a pullback to 1180 to 1145 before I start buying gold stocks. That would represent about a 50% to 60% retracement of 2016 advance…which is the type of retracement we often see in the gold market following trend-changing moves higher. The price already corrected about 40% though when the price pulled back to near 1200 after briefly trading above 1300. That may be all the pullback we get, in which case, I am content to sit on my hand and do nothing in gold. I will explain why I take this approach in a second.
For silver I would really love to see a pullback into the 15.50 to 15 region before I start buying silver related stocks. This means I want to see a bit deeper pullback in silver than in gold. There is a strategic reasoning for this: some of the silver stocks I am eyeing have flown off the charts to the upside…which means it is going to take a deep silver correction to spook traders into selling the stock off into the price area I want to buy. If I don’t get the silver pullback, that’s fine, I won’t trade. There are other stocks that pop up on my buy list that I can focus on instead. My price or no price….
Why Wait for a Pullback to Invest?
So why do I wait, and why I am so picky about the market coming to the exact entry point I want? It comes down to one word: multiple.
If I can buy a commodity related stock at $5, and based on my expectations for the stock I can sell it at $15, then I can make 2:1 on my money. In an absolute worst case scenario I lose $5 per share–if the company goes bankrupt, which is very unlikely with the companies I focus on. But based on a reasonable expectation I can make $10 per share (15 – 5 purchase price). That’s a good deal.
Of course that is not the only input, I look at a lot of factors which help me decide when to buy, but the multiple is one of them. But look at what happens if you start to get sloppy with the entries. Let’s say you see silver shooting up, and you get impatient and buy the stock at $7 or $8, instead of waiting for $5. Now your worst case downside is $7 or $8, and your upside is only $8 or $7…our upside is actually less than your downside in the latter case. The dollar amount of the stock doesn’t matter; it could be a $100 stock, but always think about the multiple. If a $100 stock can reasonably go to $400, then your $100 downside is much less than your $300 upside.
Why trade with favorable multiples? It should be obvious: you want to stack as many chips in your favor as possible. The stocks you own won’t always do what you expect, so you better be getting a price you are happy with. While it hasn’t happened to me yet, I assume that my risk on every investment is the stock going to $0 (even though I look through a whole bunch of criteria which indicate the companies I buy are healthy financially). Making that assumption means you will only buy the stock at the price that offers a great multiple.
My upside, at absolute minimum, has to be the same or greater than my loss if the company goes to $0…and even this scenario is pretty rare. This is what I call a 1:1. If I buy at $1, and based on my analysis it can reasonably go to $2, then I have $1 of upside and $1 of downside. Not super attractive on its own, so to make it worth while I will usually only take these types of investments if the company pays a nice dividend. If they are paying me 7% per year to be an investor, then I am fine taking a trade that only yields 100% if the stock price reaches my exit point (plus the dividend). Usually though I prefer taking trades that offer a 2:1 or higher reward for my worst case downside risk…and I still usually want a dividend.
Here are a couple things to keep in mind. Not every stock with a favorable multiple is a buy. Some stocks are falling because they are shit, and thus it doesn’t matter what upside target you concoct (creating a favorable multiple), that stock will never get there as long as it continues to be shit. So there is still a timing and analysis element to buying stocks. My commodity analysis above is part of that timing and analysis equation, since the stocks related to those commodities are typically going to be positively correlated with the movements of the commodity.
I am trying to buy on pullbacks near where I believe the selling will slowdown, and where the price will hopefully head higher from. I don’t expect to buy at the exact bottom though, nor do I try. I may opt to buy at $8 and the stock continues to decline to $7 or $6 before rallying again. I don’t care. I picked $8 because I wanted to own that stock and the upside justified buying it at $8.
Every stock I buy has an exit planned. It may change over time, as a lot can happen in a year or two while I hold the trade, but at all times I know where, how and why I am getting out. This is calculated based on commodity cycles (when applicable), stock-to-commodity correlations, P/E ratios (and other financial info) researching typical price tendencies in a commodity as well as some basic long-term averages and support and resistance areas. If you can’t come up with a simple price target (or an exit plan) based on some reasonable criteria, then you are not ready to buy that stock.
Ultimately, I do believe oil, gold and silver will head higher after a pullback. A pullback that may or may not result in the associated stocks reaching my buy points. That is why I continue to own all my stocks in these sectors, and will add to my positions in them if a pullback develops. But when I buy I always want to buy at a price that offers a good ‘bang for my buck’. That is just the way I trade and invest. This is not personal investment advice, or a recommendation for you to buy and sell. This is just what works for me.
I don’t care if a certain stock doesn’t reach my entry point, because there are always opportunities out there. While one stock doesn’t pullback to my entry point, another one will. While silver may not pullback to my desired entry point, gold might, or sugar, or lumber, which presents opportunities in those sectors. There is always a great opportunity popping up every once in a while, so don’t sweat missing out on something. Just keep focusing on trading (and only trading) the opportunities that do set up well.
This article is not a complete investing method…there is a lot of more that goes into it. But since I get ask constantly what to buy, and when, I thought I would write a bit about my investing method in relation to three hot commodities right now—oil, gold and silver. The bottom line is: don’t chase the price. Let the price to come to you, and only buy at a price that offers value to you based on where you think the price is likely (use historic evidence, not fantasy) to go. I always consider a worst case scenario when looking at my downside with investments. If you can assume a stock will go to $0 (even though it probably won’t based on your research which reveals the company is financially healthy), and you still have a good trade (more upside than downside), then you will be on your way to developing a much better investing strategy than you are likely using now.