As 2011 comes to a close, investors will reflect on one of the most tumultuous years in market history. Though the stock markets were essentially flat on the year, those who've had skin in the game probably feel like they just stepped out of a barrel that went over Niagara Falls.

In assessing what worked in 2011, investors can yet again take solace in "old reliable". For the eleventh consecutive year gold will have returned positive gains. Not only has gold's secular bull delivered consistency, it has delivered robust returns that have greatly rewarded investors. Since its low of $256 in 2001, gold has soared 640% to its high earlier this year. And with only a couple days remaining, gold is looking to close out 2011 with a 9%+ gain despite its recent selloff.

But while gold was one of the top-performing assets in all the markets this year, the same can't be said for the stocks of the companies that bring it to market. You'd think that gold stocks would have been a sector that worked for investors in 2011 considering gold's strength, but they had a dismal year. And this is alarming considering the nature of their business.

Exploring for and mining gold is a risky business. Mining companies are faced with geological, operational, and geopolitical risks among the many. On top of this they are slave to market risk, with the price of their product at the mercy of traders. If these companies are to be successful they need to discover economically-feasible gold deposits, and then produce the metal at low-enough costs to deliver profits for investors. And many quality miners are doing just that.

But in order to entice investors to take on the risks of owning these companies, their stocks simply must outperform gold. If they don't materially outperform gold, then it makes no sense to own gold stocks. Investors would be better off just owning the metal.

For the most part over the course of gold's bull gold stocks have indeed outperformed the metal. Investors have seen legendary gains in some of the elite explorers and producers, outperforming the metal by many multiples. When gold is up, gold stocks are usually up big. But as you can see in the chart below, gold-stock investors didn't feel the love in 2011.

Gold has had a pretty-good year overall, ascending within a relatively-tight uptrend in which the trend channel had only been pierced twice. The first time was in August, when gold powered through resistance to achieve an all-time high, a high that represented the climax of a rather-unusual summer rally. The other piercing is the current one in which gold has knifed through support, representing an offsetting selloff that is again countertrend to seasonal precedent.

Overall gold's 9%+ gain on the year so far would normally have been a harbinger of great things for gold stocks, but this was not the case. In fact, gold stocks have been acting as though their underlying metal was down 9%+ for the year!

In taking the pulse of the gold-stock sector we can first look at the performance of the GDX Gold Miners ETF, represented by the red data series above. GDX is the most popular gold-stock ETF, offering investors exposure to the world's biggest and best gold-mining stocks. And it had a terrible year, falling by over 18%.

Like gold, GDX was confined within a nice tight trend channel in 2011. But unlike gold, it trended lower on balance despite achieving an all-time high in a September breakout. Most of the world's best gold stocks disconnected from the performance of their underlying metal, and sold off hard.

We can drill down even farther and next take a look at the performance of the junior gold stocks. With gold up, the juniors should be flying right? In looking at the performance of the GDXJ Junior Gold Miners ETF, the blue data series, again this is not the case. In fact, the ETF that is comprised of many of the elite junior gold explorer and producer stocks had a dreadful 2011, down over 40%!

As the riskiest of gold stocks, juniors are naturally going to exhibit violent swings. On balance when gold rises, the juniors tend to have big positive leverage. But this leverage is seen on the downside as well. If gold falls for a prolonged period, juniors tend to sell off faster and harder. When capital leaves the gold-stock sector, the juniors on the front lines feel it the worst.

If gold was down 9% on the year, it would perhaps make sense that the juniors would exhibit downside leverage. But with gold up, the junior carnage we've seen in 2011 has baffled many investors.

So what are we to make of this gold-stock, particularly junior, disconnect? I believe there are two angles to take on this. First is from a tactical perspective, the "why" of what we've seen. And second is from a strategic perspective, what is likely to play out in the future and what we can do about it.

Tactically much of this gold-stock malaise is attributable to the recent sentiment storm that has wreaked havoc on the entire commodities sector. And one of the impetuses for this sentiment storm is global recession fears. Regardless of the validity of these fears, since a recession inherently implies lower commodities demand investors tend to aggressively sell commodities producers.

And boy have the commodities stocks been sold hard in 2011, with the gold stocks even getting sucked into the fray as irrational as it may be. The "risk-off" mentality that has been trumpeted by the financial media has created incredible fear amongst investors, which has caused serious damage to the gold-stock sector as seen by the performances of the GDX and GDXJ ETFs.

But this tactical action is unfounded for a variety of reasons. As my business partner Adam Hamilton pointed out in his "Recession Crazes" essay last week, the commodities sentiment storm drummed up by economists' stock-market-driven groupthink is a psychological phenomenon that has generated unwarranted fear, leading to the type of recession talk that is usually seen at stock-market lows.

For a strategic perspective we can look to gold's structural fundamentals. And thanks to fundamentals that are exceptionally bullish, gold-stock investors can look past this anomalous tactical behavior to a bright future. As more and more individuals add gold to their portfolios and central banks continue to diversify away from fiat reserves, demand for this most precious of metals will continue to rise over time. Couple this with the supply chain having ongoing issues, and gold's price ought to remain strong for years to come. Though the stocks have recently disconnected from the metal, they will eventually reflect gold's positive fundamentals.

Provocatively I heard something the other day that for me took the gold-stock fear trade to the height of madness. To no surprise a popular CNBC anchor said he didn't like gold stocks. But what was surprising was this stalwart weathervane's reason for not liking gold stocks. He doesn't like gold stocks because, get this, they can't find gold.

After I finished laughing out loud, I realized that this was yet another confirmation that the fortunes of gold stocks are due for a change. Now in a sense this bald-headed anchor is correct, gold companies are indeed having trouble finding economic deposits at a fast-enough pace to renew reserves and grow production. But contrary to his logic, the fact that the supply chain is coming up short is exactly the reason for folks to invest in this sector.

If mine production continues to struggle to keep up with what is expected to be growing demand, then those select explorers and producers actually succeeding in this business should be very much in play for investors. As long as gold's fundamentals remain solid and prices stay strong, finding, developing, and operating gold mines will be a lucrative business.

Adding to the attractiveness of gold stocks in a strong fundamental environment is their need for investors. Though investors have been fleeing, their return is vital for the success of the gold-mining industry.

With such a hefty amount of capex required to build a mine, even the biggest and best miners that have strong operating cash flow need a shot of capital in order to develop their pipelines. When at all possible gold miners prefer debt over equity financings to limit dilution. But debt is not always easy to come by, especially considering the current lending environment birthed from the recent financial crisis. Banks just aren't as willing to take on the risk or offer fair terms considering the volatile nature of commodities prices. These miners must therefore rely on selling their shares in order to raise capital.

Juniors in particular are heavily reliant on equity financings to meet their capex needs. For explorers that have no cash flow the only way to fund operations is to raise capital via the sale of shares. And even those producers that are operating a smaller mine or a group of small mines usually have insufficient cash flow to carry out big growth projects. They also need to sell their shares.

Throughout the course of gold's bull these miners haven't had a problem finding investors to purchase their shares. Both the issuers and subscribers were confident that return on investment, in the form of stock appreciation, was imminent in the very near term. And if these stocks had quality assets, they would indeed positively leverage gold's upside. Unfortunately this symbiotic relationship has been broken over the last year.

Considering the lackluster share performances, juniors especially have had a real tough time procuring capital. As a result, those that were undercapitalized going into 2011 have been forced to get by with leaner operating budgets and/or have had to delay exploration/development projects. And those that have pursued aggressive financings have had to issue a lot more shares than hoped, greatly diluting shareholders.

If these financing woes are prolonged, the brilliant observation of that CNBC anchor will be that much more prevalent. Less money to explore for and develop gold mines will eventually lead to an accelerated drop in supply. While this will only strengthen gold's fundamentals, which will keep prices higher for that much longer, this can be very dangerous for the health of many gold stocks.

Gold companies already have a tough job without having to worry about funding. With the low-hanging fruit long gone, it is getting harder and harder to find gold. In order to sustain and grow supply the miners therefore need to look for gold in harder-to-access locations and develop lower-grade higher-cost deposits. They need more capital than ever to do what they do!

To encourage miners to take on these high-risk endeavors, as mentioned the price of gold must remain high. But they can only do so much if they are pinched for capital. And in order to get this capital their shares need to perform in a fashion that will entice investors.

If this sector is to thrive, investor confidence needs to be regained. And this will only happen via gold stocks outperforming gold. The only way to strengthen supply and future pipeline is to restore that self-fulfilling circle of higher gold prices, higher gold-stock prices, and ready availability of investor capital. Gold stocks really have no choice but to fall back in line.

Investors en masse will soon realize the foolishness of these precipitous gold-stock declines. But the contrarians that have the gall to go against the herd, to defy the mega talking heads of the financial media, can take hold of an incredible opportunity right now. There are many excellent gold stocks with quality assets that are currently radically oversold. And they will likely see spectacular gains once their sector reconnects with its underlying metal.

But just because we see value in gold stocks, it doesn't mean investors shouldn't exercise extreme caution when deploying their capital. Now more than ever it is important to vet the gold stocks, as there are a dwindling number with high-quality assets, high-potential prospects, and strong financials.

Overall with gold stocks poised for a breakout, we wanted to know which ones had the highest potential for success. And this prompted us to take a look at one of our favorite gold-stock sub-sectors, junior gold producers. These juniors are producing gold at a current annual rate of fewer than 200k ounces, and really represent the sweet spot of the mining side of the business.

Within this group of stocks are brand-new producers that just commissioned their mines, mature companies that operate one or a handful of smaller mines, and emerging mid-tier producers that are in the process of expanding existing mines, developing new mines, and/or in pursuit of growth via the M&A path.

Our expert research team looked at the universe of 100 or so junior producers trading in the US and Canada, and after thorough analysis whittled this group down to our dozen fundamental favorites that we believe have the highest probability for success. Each of these stocks is profiled in detail in our hot-off-the-presses 34-page research report that is now available for purchase on our website. Buy your copy today!

At Zeal we use reports like this to feed trades in our acclaimed weekly and monthly newsletters. And we recently issued new buy recommendations on several of our favorite junior gold producers. We anticipate that these stocks will see gains akin to the 51%+ average annualized realized gains that we've had in nearly 600 stock trades recommended in our newsletters since 2001, and hopefully better. Subscribe today to see our current trades and get truly contrarian stock-market analysis.

The bottom line is even though gold continues to forge higher, gold stocks have disconnected from the historically positive leverage that investors are used to seeing. Not only have the gold stocks not kept pace with gold, they've sold off hard, with the juniors just getting brutalized.

But so long as gold's bull remains intact and its fundamentals compelling, this gold-stock fear will prove totally unjustified. The most ardent of contrarians realize that gold stocks can't be held down for long, and that the carnage we've seen, especially in the juniors, offers huge buying opportunities. Selling has likely reached the point of exhaustion, so carpe diem before the herd returns.

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Dec 30, 2011
Scott Wright

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