Gold has been showing exceptional strength in the last couple of weeks despite a number of factors that could have caused a significant pullback. For example, a number of US economic indicators were recently revised to the upside, reducing the expectations of further rate cuts this year. In addition, Axel Weber, an influential member of the European Central Bank's governing council and president of Germany's Bundesbank, expressed concern about inflation indicating that further monetary tightening could continue in the euro zone.

But this did not deter gold from moving higher. Big money continued to flow into the Street TRACKS ETF (GLD), which added 15 tonnes in two weeks for a total of 593 tonnes.

Is gold going to spike (in the style of the April-May 2006 run) to an all-time high of $850, or pullback to the lower $700's? A pullback now would be much more favorable as it would be a setup for a further, more powerful run later this year. But we cannot exclude the possibility that an upward spike could occur in the near future either.

No one can predict what will happen in the next few weeks: a spike above the trend channel or a pullback. But we do believe that selling gold stocks now is appropriate only for those investors who are fully or close to fully invested in the sector. High volatility makes it difficult to buy gold stocks back at lower prices on quick pullbacks.

Those investors who have a large portion of their portfolio invested in the still undervalued small cap junior mining stocks and hold a sizable cash position are safe to endure a pullback in gold. The quality of a pullback, which could come at any moment, will be an important factor. If gold stocks act strong in relation to gold, and the yellow metal remains above $720 or at least above the 50-day moving average, we will make a decision to increase our exposure to the sector and decrease our cash position.

There are a number of signs that a pullback in gold is close. Out of the last eight weeks, only one week was negative for gold and gold stocks. During this time period, gold equity indices became, although not extremely overbought, but dangerously overbought nevertheless.

Another warning signal comes from the Commitment of Traders report. Large commercials net short positions hit an all-time high on Tuesday of last week.

At the same time, there is not a single indicator for a major top in gold stocks that is flashing a red signal at this time. For example, over the past six years, a major sell signal occurred when the Gold-XAU ratio fell to the upper 3's. It accurately predicted the 2002 and 2003 tops, but was a little premature in pointing to a top in the early 2006. We have not seen the final and most profitable spike in the precious metals sector thus far as the ratio remains in a relatively "safe territory."

Yet another valuable indicator is the Gold-Silver ratio. We watch this ratio to identify HUI and XAU tops. Silver, a more speculative and cyclical metal, usually sharply outperforms gold in the final stages of the rally. To date, silver has remained relatively weak despite strong world economies and stock markets.

In the last few years, rallies ended when Gold-Silver ratio made a clear spike down, and we currently don't see anything close to that. Although there will be bumps along the road, this indicator suggests that the rally is far from over. This also means that a number of silver stocks remain very attractive at current prices.

This is an excerpt from an RSG Newsletter published on October 14, 2007.