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Gold Sector Update

Below is an extract from commentary posted at www.speculative-investor.com on 25th January 2004. Note: A lot of the short-term downside risk in the gold sector that we emphasized near the highs in December and January has now been wrung-out and some new buying might now be appropriate for those investors/traders with minimal exposure to the sector.

Overview

Signs that an intermediate-term peak is in place in the gold sector include:

 - The breakdown in the HUI/gold ratio
 - The huge upward move in silver stocks relative to gold stocks over thepast two months (refer to the 12th January Weekly Update for an explanation)
 - Pronounced weakness in leading gold stocks such as Goldcorp and GoldenStar Resources since early December

However, we haven't yet seen the level of speculation amongst the exploration/development-stage juniors that we would expect to see near an important peak (many of the juniors are still under-valued). Also, historical data indicate that the gold sector is unlikely to reach a major peak until some time after -- most likely a few weeks after -- the Dow industrials Index has peaked. With the Dow having hit a new recovery high last Wednesday and, we think, being at least 2-3 months away from its ultimate recovery high, the historical record tells us not to expect a major peak in the gold sector until at least April-May.

We've taken these conflicts to mean that the positive trend in the gold sector will remain intact until at least April-May but that the HUI might not exceed its December-2003 peak. In any case, regardless of whether the HUI does or does not exceed its December-2003 peak over the next several months we think that gold stocks -- particularly the stocks of the under-valued exploration-stage companies and the South African majors -- will perform very well for a few months after the current correction runs its course.

Gold stocks versus the stock market

Below is a chart of the HUI/S&P500 ratio showing the upward trend -- reflecting persistent strength in the gold sector relative to the overall stock market -- that has been in place since November of 2000. 

The upward trend in HUI/S&P500 is intact. However, at last December's peak the ratio had completed three upward pushes (or waves) separated by consolidations; and advances during bull markets often take the form of 'three pushes to a high'. Also, note that the third upward push (or wave) was weaker than the first two. We therefore need to be open to the idea that a major peak (one that will hold for more than 12 months) was put in place last December for the HUI relative to the S&P500. This idea appears to be in conflict with the fundamentals, but it is consistent with the recent upside breakout in the S&P500/gold ratio and it is not uncommon for price action to lead the fundamentals by several months.

Current Market Situation

As mentioned in recent commentaries we are anticipating new correction lows over the coming weeks and that a bottom will be in place by the end of February at the latest (most likely within the next three weeks).

We've repeatedly warned of the short-term downside risk in the gold sector over the past two months. And when the HUI was trading in the 240s and 250s we suggested, in no uncertain terms, that anyone with substantial exposure to the gold sector consider taking some money off the table.

However, while there is still some short-term risk the risk is a lot lower now, with the HUI in the low-220s, than it was when the HUI was in the 250s. This is not so much because of the modest 10% slide in the HUI itself, but because a lot of the froth has been taken out of the market. For example, speculative favourites Goldcorp (NYSE: GG) and Golden Star Resources (AMEX: GSS) are down by 25% and 35%, respectively, from their highs. And in Goldcorp's case, the stock has just reached an area of strong support defined by its January-2003 peak, its post-July-2002 trend-line and its 200-day moving average (see chart below). We are not interested in GG as an investment because it still appears to be over-priced, but there can't be many worse times to sell than AFTER a stock in a long-term upward trend has just plunged 25% to a level at which it is likely to find strong support. We wouldn't be surprised to see GG spike below this support during the next few weeks, but we doubt that it will drop more than 10-15% below its current level before a substantial rebound gets underway.

Another high-profile gold stock that is nearing a potentially important support level -- in this case, the bottom of a 1-year price channel -- is Barrick Gold (NYSE: ABX). 

When important support levels are breached a result is that many chart-watching traders turn bearish and sell. However, when a stock breaches an important support level after having already experienced a large decline the break of support often turns out to be a 'bear trap'. In such cases the knee-jerk selling in reaction to the support break often sets the stage for a sharp rally.

The upshot is: although we expect to see one more downward leg in the gold sector before the correction is over the time for selling has past. Instead, anyone who wants to increase his/her exposure to the gold sector should now be preparing to do some buying. With this in mind we mentioned, in last week's Interim Update, reasonable under-the-market buy prices for sixteen gold/silver stocks that look good from a valuation perspective. Furthermore, there are many other stocks that we could have mentioned but didn't. In general, though, buying your favourite gold/silver stocks following pullbacks to near their 200-day moving averages should work out well over the short-term and the long-term.

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