Increasingly Bullish Prospects Of Gold Stocks

Despite the recent weakness we are becoming increasingly bullish about the prospects for gold stocks. Actually, it's partly due to the recent weakness that we are becoming increasingly bullish, because the extension of the downward correction makes it more likely that the overall advance from the May low will last well into next year.

We had thought that the most likely alternative to the overall advance extending well into next year was an intermediate-term peak late this year. But with the corrective action that began in September having continued until the third week of November there is now almost no chance of an intermediate-term peak by year-end. The correction has been long enough and large enough to lay the foundation for a rally lasting at least a few months.

We acknowledge that if there were another 2008-style market crash then gold stocks would be dragged down with all other stocks, but a 2008 repeat is unlikely in the extreme. We will continue to assess the evidence in real time, but at this stage we can't envisage the monetary backdrop changing over the next few months in a way that would give a 2008-style collapse a realistic chance. Also of relevance is the general point that the next crisis is rarely, if ever, similar to the last crisis. As things stand today, the last crisis was the 'mother of all' deflation scares. It involved large declines in the prices of all investments except the highest grade government bonds. We suspect that the next crisis will involve a melt-up in gold-related investments driven by rapidly-rising fear of what central banks and governments are doing. In any case, the start of the next crisis is probably more than a year away.

Moving on, the following weekly chart of the XAU/SPX ratio is one way to illustrate the upside potential of gold stocks relative to stocks in general, assuming that the long-term bull market in the XAU/SPX ratio isn't over. This is a reasonable assumption, because a) the long-term bull market in the XAU/SPX ratio shouldn't end until the gold bull market comes to an end, and b) in our 1st October and 29th October commentaries we explained why the gold bull market was still years away from its ultimate top.

Given that the XAU/SPX ratio is coming off its most oversold extreme of the entire bull market and is still near the bottom of its long-term channel, it is reasonable to expect substantial strength in the gold sector relative to the broad market over the coming 12 months as the major trend shifts from massively 'oversold' to 'overbought'. This should result in a strong rally in the gold sector even if the broad stock market is moderately weak. For example, a decline to 1200 by the SPX combined with a move in the XAU/SPX ratio to near the top of its long-term channel would translate into a rise to around 300 by the XAU.

We aren't forecasting moves to 1200 and 300 in the SPX and the XAU, respectively, over the next 12 months. These numbers were only mentioned to indicate the XAU's upside potential. Our forecast is simply that gold stocks, as represented by the XAU and the HUI, will handily outperform the broad stock market over the coming year and in the process achieve good absolute returns.

The above is a slightly modified excerpt from a recent commentary posted at www.speculative-investor.com.

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