Introduction

Our articles at Gold-Eagle typically include general commentary on inflation, the economy, gold and the Dollar, with specific financial market analyses and forecasts being reserved for our subscribers at www.speculative-investor.com (TSI). However, with a major trend change in the gold market having potentially occurred last week we would like to make an exception in this case and share the following commentary, originally posted at TSI on May-20, with the readership of the world's premier gold web-site.

Gold Stocks versus the Stock Market

In February, with the XAU trading at around 50, we explained why we thought the XAU would move to 90 within 3-6 months. That target remains valid as far as the next few months are concerned, but we expect even higher levels over the coming 12 months. As previously noted on several occasions, our 12-month target for the S&P500/XAU ratio is 10:1. Since we do not expect the S&P500 to trade considerably lower than its current level during the next 12 months we are obviously anticipating a lot more upside in gold stocks.

Last October we noted that the S&P500/XAU ratio was making the type of blow-off move that typically happens near the end of a long-term trend (in this case the trend was the dramatic out-performance of the S&P500 relative to gold stocks as indicated by a steep upward trajectory in the S&P500/XAU ratio). After the ratio peaked last year we were confident that the trend had changed, but all forecasts must be confirmed by price action in order to be valid. That price confirmation occurred on Friday. As the following chart shows, the 'bubble trend' in the S&P500/XAU ratio that began in 1997 has just been broken. Note that the spectacular XAU rally in September-October 1999 did not break this trend, meaning that the current rally is potentially more significant.

Friday's break in the S&P500/XAU 'bubble trend' may be one of the most important events in years from a technical perspective, but we doubt that you will read about it anywhere else.

Where are we now?

We've argued quite persistently over the past 6 months that the US credit bubble remains in tact. If the current US bubble ends in a similar way to other great bubbles of the past 100 years, then its bursting will be preceded by a period of substantial gold price strength and currency (US$) weakness.

We have thought, for the past few years, that the greatest opportunity to make money from gold investments would occur during the final stage of the credit bubble's existence. Going by historical precedent the final stage of the bubble's existence would last for about 2 years. So, using the October 2000 peak in both the S&P500/XAU ratio and the Dollar Index as the starting point of this final stage we can make a rough projection that the US credit bubble will end during the second half of 2002. However, the current bubble is unprecedented in three important ways. Firstly, valuations and debt levels have reached greater heights than ever before. Secondly, public participation in this bubble is far greater than ever before. Thirdly, whereas the monetary authorities made a conscious attempt to deflate the previous great bubbles, US officialdom is working hard to perpetuate the current bubble. Therefore, as is generally the case with financial market analyses, we should have no preconceived ideas as to when the bubble will end.

The inability of the Dollar Index to exceed its October 2000 peak over the past several months, combined with the 6-month rally in gold stocks and the recent bounce in the gold price, strongly suggest that we are in the final phase of the bubble. We are yet to see the Dollar break sharply lower, but the action in the gold market suggests that such a break will happen during the next few weeks.

There are often important differences between the current market situation and prior situations that invalidate any comparisons. However, as long as these differences are understood then the historical performances of markets can sometimes provide clues as to where we are currently headed. In looking for a historical parallel to the present we came up with early-1987 (see chart below). If we are right and this is the final phase of the credit bubble then we should expect to see the gold sector, the overall stock market and long-term interest rates all trending higher over the next several months.

Gold versus the Dollar

Gold stocks have been rallying for 6 months and the gold price itself has now bounced, but the Dollar is still near its highs. So, does this mean that gold is going to experience a major rally regardless of what happens to the Dollar?

In the financial markets anything is possible and we certainly won't be complaining if gold rallies in the face of a strong Dollar, but we see such an outcome as having a very low probability. Gold and the Dollar have a strong inverse correlation, but the markets aren't so simple that every down-day for the Dollar corresponds to an up-day for gold and every up-day for the Dollar corresponds to a down-day for gold. The daily and weekly fluctuations are not important, it is the overall trend that is important. For example, we do not think it is coincidental that the XAU bottomed in November 2000, 3 weeks after the Dollar peaked.

It must also be remembered that the financial markets discount the future. The gold market is very small in comparison to the foreign exchange market and the market for gold equities is miniscule, so a small shift in perception that is undetectable in the foreign exchange market can have a substantial effect on the prices of gold equities. This is what we think has happened over the past several months and continues to happen - a belief is gradually taking hold that the Dollar has peaked.

In summary, we think the Dollar is headed much lower and that gold equities, and to a lesser extent the gold price, are moving in anticipation of a lower Dollar. If the Dollar does not fall and instead moves to new highs, then any rally in gold will probably be another unsustainable spike. However, we absolutely do not expect decisive new highs in the Dollar (a move up to re-test the October 2000 peak of 118.90 is, however, a possibility), particularly with the US monetary authorities now following a surreptitious 'weak Dollar policy'.

Current Market Situation

As at May-15 the Commercials were net-short COMEX gold futures to the tune of 14,000 contracts and their net-short position will almost certainly have moved higher after the rally of the past few days. We have previously mentioned that gold rallies always begin when the Commercial Traders are net-long, but that they typically move to being net-short during the early stages of a rally. We've also noted that the biggest gains tend to occur after the Commercials become net-short (this is certainly what happened during the 1993 gold bull market). The Commitments of Traders Report is supportive of our view that the US$ is about to embark on a substantial decline, with the Swiss Franc and the Canadian Dollar having particularly bullish traders' commitments.

In the latest Interim Update we mentioned that a short-term pullback in gold and gold stocks appeared likely, but that if this is the bull market we think it is then we are still in the early stages and most surprises will be on the upside. Last Friday certainly qualifies as an upside surprise, although the sudden move in the gold price was necessary to bring the commodity market into line with the equity market. The last time the XAU was at current levels was February 2000 when the gold price was around $300, the difference being that gold was then on its way down whereas it is now on its way up (hence the premium that has recently been built into the gold shares). Importantly, by blasting above resistance at 274.80 in the June contract (the Mar-12 high), Friday's gold rally has broken the sequence of descending peaks dating back to October 1999.

Price spikes always generate some excitement for those who are on the right side of the market, but the best medium-term gains are usually provided by markets that work their way higher in a stair-step fashion. There are imbalances in the gold market, such as the huge physical short position, that make the occasional price explosion inevitable. However, we believe that a lot more money will eventually be made from investing in gold stocks if the rally can remain as inconspicuous as possible for as long as possible. As such, the occasional pullback to deflect attention and increase skepticism would help to ensure the longevity of the move.

At this stage we are not considering taking any profits as we are likely still in the early stages of the move. As they usually do the North American gold stocks have led this gold rally, with the South African gold stocks trailing and the Australian gold stocks running a distant third. As at May-18 the Australian Gold Stock index (XGO) had moved up by only 27% from its lows compared with a gain of more than 50% by the XAU, but we expect this under-performance to be eliminated over the coming months. Below is a chart showing the performance of the XGO during the 1993 gold bull market.

Steve Saville
Hong Kong

23 May 2001

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