Gold Consolidation Phase Continues

Gold stocks continue to outperform the metal. This is important because the action in the stocks tends to lead the action in the metal. When gold stocks act stronger than gold it is almost always bullish for both. And as you can see from the rising XAU/gld and HUI/gld ratios, last week this trend strengthened.

Do you remember a week ago how I was concerned about a pullback in gold stocks? Going into last week the volatility in the XAU had shrunk and the stocks dropped faster than the metal that Friday. Every time this happened since May we got a sizeable dip in the stocks. I wasn't sure if this was going to happen this time, but I closed out my margin position as a result.

We did get a dip. But it only lasted a day and a half, and once it was over, the XAU jumped back up into its 140-150 trading range. For a week in which several indicators screamed that they should drop, gold stocks held their ground. This is bullish, folks!

It looks like we are headed for another week of consolidation and then a key breakout for gold. Once gold closes above its downtrend resistance line, now sitting at 650, I expect it to make a run for its highs to start the next big rally.

In fact, this action is typical for gold and gold stocks at this time of year. Usually gold bottoms in the Spring, consolidates in the Summer and sets up to break out for a big late Summer/Fall rally. This phase of consolidation is typified by gold stocks trading in a range and giving false signals while gold bugs get worried. Right now, we are seeing this range-bound trading and we are indeed seeing many terrified gold bugs. Check out some of the recent articles being posted on Kitco, gold-eagle, and 321gold.com by writers who are usually very bullish and you'll see exactly what I'm talking about.

A response to Chris Laird - Will a Stock Market Crash Take Down Gold Stocks?

One such commentator is Chris Laird, who claims that gold should be way above $700 an ounce because of all of the bad news in the Middle East, including Israel's attack on Lebanon and the airline terror scare. He presents two theories. One is that of the Bill Murphy "GATA" camp which claims that gold is being manipulated.

Laird writes:

"...gold manipulators have a very heavy hand in the gold markets right now. I.E. that they are forcing gold to act in an atypical way to normally gold bullish economic news. In effect, the idea is the gold manipulators are telling speculators not to play in the gold sand box or they will get sand kicked in their faces."

"Now I know that there is debate about how much influence a gold manipulating cartel can have. I personally believe in gold manipulation, but have had the view that it can be done within the context of general market moves only. Gold cannot be totally suppressed without an unlimited supply of bullion to sell. (not just futures)"

"Murphy and I came to a conclusion that it is possible that there is super heavy handed gold manipulation at this particular juncture because there is becoming less and less bullion to dump to suppress the price. Therefore- a panic that the gold price could just be about to get out of hand. If they don't act very heavy handed now, it will get beyond their control. Hence gold is heavily manipulated down on bullish news. This would fit with the rather steady gold price this week in the context of easing oil prices, an easing Mid East war situation, and an easing Alaska oil situation. Gold should have dropped even $20 at least as of Tuesday, but what might have happened is short covering by the gold manipulators! Hence, gold does not drop even on gold bearish news as the shorts cover and build ammunition for the next round. Gold is only down to 624 now -down only about 6 bucks from Friday. The gold manipulation scenario does fit this situation."

Personally, I really don't see anything unusual about the recent trading in gold. What we have seen so far is a normal Summer consolidation phase and those phases are marked by low volume and low volatility, which is exactly what we are seeing. Those phases are also typified by moves within a trading range that bring wild hopes and great fears to market participants as gold goes up and down inside of the range.

Eventually it will break out, but until it does, you can expect to see more manic-depressive writings and theories on the gold websites.
I have seen no evidence over the past few weeks that gold is being manipulated and, without such evidence, I can't blindly believe manipulation theories no matter how popular they may be. They are akin to believing that we never went to the moon.

Where is the evidence???

If you have evidence that gold has been manipulated over the past few weeks then send it to me and I'll publish it in an article. I have an open mind. But I think some people are looking at the gold market too closely and trying to draw meanings from every little fluctuation when nothing really important or noteworthy is happening - yet - except investors getting nervous.

But no matter. Murphy believes that the resolution will be to the upside very soon and I agree with him.

More important is Laird's fears of a gold crash, which he has discussed in other recent articles and posed as a second theory for gold's supposed "weird action."

This second theory is that gold is about to get dragged down along with a crashing US stock market. Judging by some of the emails I've recently received, this theory has terrified a lot of gold investors. Some are so scared that they can't pull the trigger right now on what is an incredible buying opportunity.

As you know, I've been saying over the past few weeks that we are beginning a new cyclical bear market in the broad market so I agree with Laird when he worries about a big stock market drop. I just don't think we are headed for an immediate crash and disagree with him on what this will mean for gold stocks.

He claims that "Big stock drops are very deflationary. A lot of money is lost in these things and people and companies really pull back spending. That can be a very downward force on gold ultimately, unless there is a currency crisis at the same time. Also, a big US stock drop (probably to include Japan) would be a currency boost to the US and the Yen as people flee to cash domestically. So if the USD and other currencies strengthen, then gold would find this somewhat suppressive. That could be the initial reaction."

I totally disagree.

I think we are heading for a slowdown in the economy that will bring a large decline in the Dollar. The inverted yield curve is proof that the Fed is not going to start jamming interest rates up again. The chart for the Dollar shows short-term support at 84 and it appears that it is about to crack this number and go down toward 80. A fall below that will take us into no man's land for the Dollar and cause an explosion in gold prices. This is where we are headed!

The Fed does not want a deflationary financial crisis. With a current account deficit over 6% our country simply couldn't survive one. The next year will prove that the bullish case for gold is tied to a falling US dollar, which Laird admits would cause a bull market in gold. We just have to sit and wait for it to happen and not get scared and overanalyze every little fluctuation, when oftentimes there is nothing to worry about. Fluctuations are a characteristic of the financial markets and most of the time they don't mean anything at all.
Now, what about Laird's theory that a falling stock market could drag down gold stocks?

If you study past bear markets you'll find that, historically, there are sectors that continue to rise until you get near the end of the bear market. It isn't until the very last inning of a bear market that everything gets dragged down. Frank Barbera has an excellent article on this at FinancialSense.com.

He looks at several bear markets and finds sectors that held up until the end of the bear market and then once the bottom was in they bounced back hard.

In comparison to the current situation - and for a worst case scenario - I think his examination of the 1987 stock market crash is instructive. He writes:

"For the Gold Stocks, both the 1929 and 1987 Crashes produced staggering losses. In the case of 1929, the losses proved to be very temporary as the depression commenced and moved the purchasing power of gold to new all time highs. As a result, during the Great Depression and in its immediate wake period of 1934-1937, the Gold Stocks were the most defensive group, racking up huge gains and paying huge dividends to shareholders. In the 1987 instance, physical Gold managed to hold up very well on the day of the crash, gaining $18 dollars an ounce, and continued to make upward progress for two to three months after the crash. The result was a sharp recovery rally in the Gold stocks immediately after the crash, but as gold weakened amid growing fears of a recession, the gold stocks rolled over and resumed the "decline."

"In 1987 the United States, while indebted on a fiscal basis, was still the world's largest creditor with a positive surplus of trade. In todayÂ’s environment, the potential for a recession to lead to a debtor revolt in the currency markets is at unprecedented levels, implying that the fundamentals for Gold and Gold Stocks could assure that things turn out differently if a panic were seen today. Of course, one can never be too sure as Gold Stocks are by nature, a high beta asset class. But the key in assessing their performance probably resides in the underlying nature of the problem inducing the crash. If the problem is a currency market decline centered about the Dollar, odds are very high that gold will find traction and with it, increasing chances that gold stocks will be defiant in a panic."

Through his study of all of the sectors and historic market data, Barbera concludes that "gold Stocks tend to have the strongest non-correlation to the market but will only hold up and perform well if the price of gold itself is gaining momentum and showing tenacity in the face of whatever economic event is driving the bear market. If Gold rolls over, the Gold Stocks can very quickly turn into a high risk proposition and can very quickly give back accumulated gains."
You can read this entire article here:

http://www.financialsense.com/Market/barbera/2006/0808.html

In the final analysis, whether or not gold stocks rally, a US bear market will depend upon what the US dollar does. If the Dollar indeed declines, as I expect, we should have a spectacular rally in gold stocks.

I think this is what is going to happen. We are likely to see a 10-12 month US bear market and an 8-10 month bull market in Gold and gold stocks.

Gold stocks will probably top out in the final inning of the bull market and go through a vicious correction. Why? One reason is that the stocks will most likely go up ahead of the metal and top out ahead of a bottom in the Dollar bear market . That Dollar bottom should coincide with a US stock market bottom.

I may be getting ahead of myself to project this far into the future - but it seems like a logical scenario. I will discuss it much more if we do start to see this happen in the Fall because tracking the relationships between gold stocks, gold, and the dollar, will eventually give us an important sell signal.

What gold is doing in reaction to the S&P 500, DOW, and Nasdaq should become immaterial. It's a red herring. The Dollar is what's important.

Charts to Watch

Drug stocks are continuing to act bullish. As I noted last week, they appear to have put in major bottoms late last year and they have rallied hard the past few weeks. Last week Pfizer broke out of an ascending triangle pattern and surged up.

Drug company ABBI looks like it is going to break out and make a quick 5-10% jump too.

TARO has rallied the past few weeks to trade up towards its 14 dollar resistance level. If it can consolidate here and break out in 4-8 weeks it should rally up into the 20's.

Those of you who are long time subscribers might be able to remember TARO back in the Fall of 2000. When the entire stock market started to drop we played TARO and other drug stocks. They bucked the bear market until the ninth inning and gave us great returns.

It's interesting that TARO is once again on the radar and the stock market is once again starting entering the first inning of a new cyclical bear market. The drug sector tends to do well at the start of bear markets.

MNG is a small gold company. I don't own it but I have my eyes on it. It's been going sideways since April and should have a big run into the end of the year.

Does MNG look like its going to crash? Stop watching every little fluctuation and scaring yourself.

WSW Power Portfolio

I picked up shares of HL and LIHRY on Friday. The WSW Power Portfolio is now 110% invested. I don't plan on adding to this position heavily until gold stocks consolidate a little more and gold is on the verge of breaking out. If somehow gold stocks dip below last week's lows I'll likely trim some of the positions, but I do not expect this to happen. This should be a fun month!