Today Gold Price & Gold Stock Price Ignore Bullish Fundamentals

August 5, 2007

There is an old market adage which says every Bull market contains the seeds of the next Bear market.

Not only is that true but we would extend it to read every correction brings into being the next up leg and here I am referring to the Gold market.

Many new investors get turned off gold stocks because they are incredibly volatile and require oodles of patience. What investors sometimes don't realize is that Gold stocks, unlike other stocks, have the entire banking establishment to contend with. That is, the Fed and Wall Street remain kings for as long as the system is denominated in the very asset they control -- paper money. Once investors flee paper and move into bars of Gold or bars of Silver, the game is up. The establishment therefore fights tooth and nail to prevent Gold prices and Gold Stocks from fully expressing themselves.

Of course their efforts are doomed to failure in much the same way as any exercise in market suppression is doomed to fail. Case in point is the fact that the gold price has moved up over 1.5x and major gold stocks over 5x since the beginning of 2000 (even whilst faced with all this opposition). No amount of paper will prevent the gold bull from ultimately expressing itself but it will take time. A lot of time. Investors must realize this and learn to exercise Herculean amounts of patience!!

In July Gold Stocks finally looked like they were embarking on the long awaited breakout but as has been the case for over a year and a half they were rudely turned back.

Chart 1 - XAU turned back at 160

Once again we are left asking ourselves has anything really changed or is the latest breakout part of a long series of false breakouts?

We believe the answer is yes, although it is hard to recognize, the fundamentals for gold stock prices are becoming more bullish.

In recent articles we discussed how credit spreads have been widening and that gold will ultimately become a beneficiary of this flight to quality.

In addition we have been telling subscribers the next round in the gold bull market would only get started once the stock market began falling. Well we've got that now! A falling market would cause the Fed to reduce interest rates and with it the real rate of interest would fall (the real rate of interest is the nominal rate less expected inflation - in a falling stock market environment the expected inflation rate would be falling along with the nominal rate). Lower real interest rates make holding Gold (an instrument which has no yield) more attractive.

And here is yet another cog quietly clicking into gear - Gold versus Economic Sensitive Industrial Metals:

Chart 2- Gold vs. Industrial Metals (top); Gold stock price (bottom)

We all got excited back in October 2006 when the Gold started outperforming Industrial Metals (the chart moved higher). The reason is that industrial metals are economically sensitive and the implication is that if they are weakening against Gold, global growth was slowing. With slow growth comes the prospect of lower interest rates and an increase in money supply as authorities try to stimulate the economy.

Unfortunately October turned out to be a red herring and the entire move was retraced between February and May 2007. Now things are looking up again. The market value of Gold is once again outperforming Industrial metals and has achieved two important technical milestones in the process:

The first is a double bottom in the 1.25 - 1.3 range. This support has been tested twice (October 2006 and May 2007) and held both times.

The second is that the chart has recently broken out of a reverse head and shoulders pattern (marked in blue) portending to higher gold versus industrials metal prices in the immediate future.

Finally, Gold stocks (bottom of chart 2) exhibit a somewhat positive correlation with the above ratio, so aside form the short term pain, the implications are that Gold Stocks may yet buck the trend and prove themselves a worthy counter cyclical asset of choice.

Gold is found in nature in quartz veins