Originally published December 2, 2003

The USd is the Dependent Variable, Not Gold
In reality, to be sure, there is only one sector that truly benefits from a weaker dollar, and it's the sector that's foretelling more of it right now.

The US dollar certainly is a dependent variable - its value dependent on the outlook for the value of assets it is denominated in, as well as how well it serves its function as a medium of exchange amid the expansion of world trade. Money is subject to an independent valuation. Indeed. But the US dollar's value as money depends.

In its capacity as a vehicle currency, the main determinant of value is foreign currency demand for dollar denominated assets - a function of differences in relative outlooks for real and liquid returns between assets in various currencies. There are other factors that determine its value, like trade, politics, and monetary policy.

Of course, monetary policy affects the dollar's value as a medium of exchange as well as a vehicle currency. So you could have various forces playing off on one another determining value as it were, and usually is.

In fact, in the real world the dollar outlook is fought over daily by the bulls and bears of Wall Street, on the COMEX, and the Mideast bond exchanges.

Hence, the Dow's march upwards alongside the gold sector (an atypical coupling) is a virtual race between the forces underpinning the dollar, and the forces undermining its value if you will. A tug-of-war.

Nonetheless, the action in currency markets suggests the forces piled up against the dollar are powerful. But it's a mistake to think a declining dollar is actually bullish for the Dow and the economy. I believe this will be the market's undoing. It's a sentiment that survives only so long as there is no perceived consequence for interest rates.

When earnings or incomes grow because of a currency devaluation, and interest rates have not yet risen to account for the devaluation, the likelihood that those earnings become overpriced in the interim is high.

If the Dow is rising right now because of a so-called liquidity push, at these stretched valuations it is a self-evident mistake& and gold bulls know it. And the higher gold prices go the more bulls will know it, and the sooner they'll whip the broader market into shape& make it the distinguished dependent variable.

Corrections are a matter of life in efficient markets. It's when corrections are postponed that imbalances build.

The higher the Dow goes without offering the dollar support (because returns are better elsewhere or USD gold prices are strong), the harder it will fall, because sooner or later bond holders have to sell that trade, as they did in the fateful spring of '87.

The only reason that stock prices haven't turned down yet in my best view is because the yield cap has remained somewhat effective. I'm assuming yields are still below market; but it's an assumption that's clearly hard to dispute in light of developments in almost any other market.

If true, the longer the yield cap remains in force the higher gold prices go. And the higher gold prices go the harder it is to maintain the yield cap. This is how markets work, and it is exactly the mechanism policymakers ignore. Strong gold, strong commodities, higher yields, and a weak dollar absolutely never have resulted in a happy ending for a stock market priced at 26 times earnings - for very long.

That's what story gold is telling us.

So we expect a resolution to the irregular bullish correlation between the Dow and gold sector. Except, contrary to what fund manager Mark Johnson hinted at in a recent interview with Business Week, we expect the gold spike to cause investors to sell stocks and buy gold. I think it is much more likely than the notion of further gains in the Dow causing gold prices to fall at any rate... especially in a world where the Dow's gains are entirely inflation induced - i.e. the liquidity push. After all, that's what gold is telling us.

I don't think anyone buying gold today is really afraid of a higher Dow. Indeed, for those that think the Dow is rising because of a liquidity driven recovery in prices, the point is such inflation has never been good for earnings multiples. The point is, they don't get it.

Gold Shares Overheated, Due for Correction after Blow Off
While gold prices and Wall Street both push for higher ground, the environment has remained ripe for gold stocks which have seen gains to dizzying proportions in some cases.

The HUI is up about 23% month to date. Our gold shares are up an average 16% month to date (NEM = +16%; GOLD = +29%; GFI = +2%; KGC = +16%).

Gold Fields has continued to be a laggard. I'll make the comment now that maybe the market is telling us something, as it did with Agnico Eagle - recall its chronic underperformance before bad news struck.

On the other hand, the other pure South African plays (producers) have also been generally under-performing for familiar reasons. The Rand price of gold remains the weakest gold currency on the planet.

Gold prices are up on most currencies over one year except for the Rand and Australian dollar. Over one month too, gold is up on everything but the Rand.

Even over the past week the Rand price of gold has remained weak, and there's only one month left in the fourth quarter. Unless this changes rather quickly, I'm afraid the South African and Australian producers are likely to report another humdrum quarter.

The best performing precious metals stocks continue to be the silver producers, which the market expects have more leverage to changes in the price of silver.

Aiding and abetting this trend is the contracting gold/silver ratio (which means silver has been outperforming) since June. The ratio has fallen from 78.6 to under 74. Prior to June, gold has been gaining on silver since 1998.

In this freshly bullish silver environment (new four-year highs) stocks like Coeur d'Alene (CDE) are up 60% month-to-date, while Hecla (HL) is up almost 50%, and Pan American (PAAS) is up about 35%.

Coeur d'Alene is no longer a cheap turnaround bet. It's an expensive turnaround bet. A subjective read of the chart based on my experience suggests it is as equally likely to overshoot to about the $7 to $8 neighborhood, as it is to put in an intermediate top here and now.

For readers that bought it when we wrote it up in the summer, it's probably wise to book some profits now, yet hold back enough that a blow off to $8 wouldn't cause any angst (for missing it).

At current share prices we're guestimating that the market is discounting about a $7 silver price.

So in broker's lingo, Coeur d'Alene would be a hold for the long term, a partial sell for the medium term, yet still a buy for aggressive short-term accounts& day-to-day trade, not for the faint of heart at this stage.

At the risk of sounding repetitive, in our short-term outlook, gold shares are likely to retain their bull market momentum UNTIL the broad market (Dow) rolls over or until gold prices stall out. I don't think it's as likely that gold prices will stall out; as it is that when they break through $420 the Dow must (sooner or later) give.

As we hinted at in the prior section, this window of euphoria for gold shares is small. It is likely to get slammed shut on a broad market downturn. In other words, the scenario that gold prices are foretelling (higher rates, lower stocks, lower dollar) is bearish for gold shares in the short to medium term once more of it is seen to arrive.

Indeed, the traditional leaders all appear to be in blow off mode right now on the chart - running away from trend in an accelerating fashion for instance. Our fundamental and technical targets have been surpassed in most cases save the South African shares.

There is only one action that makes sense in light of our outlook for the Dow - to further reduce our gold share allocation despite the probability that gold itself might go higher still.

It took a fair amount of consideration.

But if we're going to be wrong about the Dow, specifically, if it goes higher and knocks the gold sector on its bum per chance, we'd be right to sell some gold shares here.

On the other hand, if we're going to be right about the Dow, then here too I think it would make sense to sell some gold shares, or at least hedge them with a short bet on the broad market.

During the 1987 crash gold shares fell even as gold prices went higher.

The same was true of the 1973/74 melt down in the Dow.

Two years ago we argued that gold shares weren't vulnerable to the Wall Street bear market. But at that point they hadn't seen a good rally in seven years.

This is no longer the case. Now they've been leading the rest of the market higher for more than eight months.