Last week, gold stocks hit new highs…

The popular Market Vectors Gold Miners Fund (GDX) shot 51% higher (to a seven-month high) in less than one month.

If you’re holding gold stocks, it feels good… and overdue.

But I’d guess that a lot of folks sold their gold stocks just before the big move. And they’re now kicking themselves.

[ad#Google Adsense 336×280-IA]You see, the big move higher came on the heels of a steep decline that took gold stocks to a 13-year low.

GDX dropped 16% in seven trading days. On January 19, it closed 81% below its 2011 high.

Some of the most popular gold stocks had it even worse…

Gold-royalty firm Royal Gold (RGLD), for example, plummeted 35% in eight trading days.

Yamana Gold (AUY) fell 33% in seven days… and Seabridge Gold (SA) dropped 38% in seven days.

This sort of steep drop – one that takes an asset to a new short-term low and is followed by a big rally – is called a “shakeout”… And it could mark the end of the four-year-long bear market in gold and gold stocks.

To understand the shakeout, it’s helpful to be familiar with another market phenomenon called the “guillotine and the sandpaper.” This was first described by legendary market analyst Bob Farrell…

You start with a dramatic drop. Prices fall 20%, 40%, even 70%. That’s the “guillotine.” Then comes the “sandpaper.” This is a period when prices move up and down without going much of anywhere.

This go-nowhere action exhausts nearly everyone who is still left holding. Eventually, they give up and sell. When there are no sellers left, prices can start to rise.

When shareholders refuse to throw in the towel, though, the sandpaper phase will sometimes end in a shakeout. The sharp decline “shakes out” a final group of shareholders. And it reduces resistance to an upward move (because there are fewer sellers to push prices back down in a rally).

That’s what just happened with gold stocks. The guillotine. The sandpaper. And the shakeout. As I said above, the rally that followed took GDX 51% higher to a seven-month high.

This was the largest percentage rally in GDX in more than five years. And it came right after a classic shakeout. It looks like a bottom.

But calling bottoms is a risky business. There have been at least two or three other times over the past few years when it looked like the bear market in gold stocks was over. Then, another guillotine.

Even if the January low holds, though, I wouldn’t suggest buying gold stocks today. After such a big, rapid move higher, there’s a good chance we’ll see a sharp correction. That will be a better time to buy.

But if you bought gold stocks during the latest sandpaper phase, you got in at great prices. Hopefully your stops were wide enough to keep you invested during the shakeout… and you’re now sitting on big gains.

If you are, you may want to consider widening your trailing stops. A look at the NYSE Arca Gold BUGS Index (which I like to use in place of GDX for historical studies because of its longer history) shows why…

From October 2000 to March 2008, the index soared 1,331%. Along the way to that spectacular gain, shares dropped 25% or more, from peak to trough, five times. Three of those times, they dropped between 35% and 38%.

From October 2008 to September 2011, the Gold BUGS Index shot 319% higher. It dropped 25% and 28% during that run.

So if you want to hold on to gold stocks for 100%-plus moves, you’ll likely need to use wide trailing stops. Whether you’re holding individual gold stocks or a gold-stock index fund like GDX, I’d suggest using a trailing stop of no less than 35%. For smaller, more volatile gold stocks, a 50% trailing stop could be appropriate.

We may now be in the early stages of a new bull market in gold stocks. If we are, you want to hold on to your positions for the length of it. Make sure your stop strategy is aligned with that goal.

Regards,

Ben Morris

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Source: Growth Stock Wire