Introduction

Quick update - the Aussie XGD (weighted ASX gold index) went its own way again yesterday (Monday 5th September 2009) rising 1.4% while the XAO fell 0.58%. Gold was up to US$1,017.50 overnight and this equates to an AUD gold price of $1,160. The Dow was up despite wide claims October will be a disaster. The XGD has opened up today (Tuesday) at around 2.5% at 5,300+ and it out performed the XAO yet again closing up 2.49% on the day.

Today our Reserve Bank raised interest rates here by 0.25% to 3.25% making an AUD / USD carry trade a no brainer. That puts the AUD interest rate at 3% over the US official interest rate. This will raise the AUD against the USD on massive demand in the coming months making Australian gold stock purchases into a double bonus for US investors.

I have been reading about concerns and nerves indicating uncertainty about the longevity of the current Australian gold stock rally so I have decided to question and cover the two potential outcomes from this point in time. Therefore this article is about risk / opportunity - risk & opportunity for our gold share portfolios.

The risk is of the current XGD rally tapering off and failing - an unpleasant subject but one we have to be aware of. The opportunity is that if we don't get a severe meltdown in the general financial markets - and then gold and the gold stocks are off to the races. We have to watch carefully at this time and manage this risk. Two options - we can either wait before entering the market or hold your gold stocks with caution to seize the opportunity with maximum upside leverage for your capital.

For the record I have not turned bearish on Australian gold stocks - far from it but one does have to keep an eye on the other side of the argument and the support levels as a professional investor. I am prepared to be wrong - this is correct thinking for any investor. Remember the market is always right and your first loss (if you are wrong) is generally your smallest loss.

Gold has not broken out yet - well unless it does during the time I take to finish this article and get it posted - which is possible. We need to see gold up above US$1,030 for a few sessions and perhaps test this level on the downside after the rise before we are absolutely in the clear. Equities have to hold reasonable levels up here and not turn highly volatile to the downside because if they do we face a very high risk scenario.

The logic I use here is not too complex. Global GDP is falling in all the larger Western economies and these banking systems are not growing their loan books. Therefore we will not see the growth required to justify current Dow and S&P valuations - or to create jobs.

The key to rising stock markets is the hedge funds and some higher level support and this does not necessarily have to change - until it does. It is a game and it is rebuilding those funds as these markets rise and profits are booked but the higher we go the greater the risk.

Now if things do change and we start down with a vengeance there will be no bid in many assets so it will be another rush for cash wherever investors can find liquidity. That could initially be gold and gold stocks so don't think we are immune just because the fundamentals for gold price rises are on our side.

If there is profit in gold and gold stock trades they will be liquidated whereas some other assets may be seen as; "I can't afford to sell these assets because they are in the red". This may well be a big mistake but panic does not bring out the logic in people when it comes to money.

Negating this risk somewhat (is that slightly?) is that most of the leverage (margin loans) in gold stocks may be gone so forced selling will be reduced compared to 2008 levels. This most likely means that any potential correction will not be as severe as 2008 if the downside eventuates.

The Big Bang

This is an interesting time in the equity markets and for gold as well - we are potentially at a cross roads in the stock markets and at a potential double top in gold. If we get the negative scenario unfolding this would be a negative 'big bang' which could be the sound of the banking system blowing up (again). This is not the Big Bang I am referring to in the title of this essay however.

If we don't get the "expected" melt down and the relative calm can be prolonged somehow then gold is likely to melt up in anticipation and possibly on extended stimulus cash flows to above US$1,030, Euro 800, C$1,250 etc. This might be another 'big bang' as gold passes through these ceiling barriers and into new price territory confounding the "gold is expensive" crowd. Maybe we get a sonic gold boomJ.

This would also propel the still mostly undervalued Australian gold stocks into a new phase where we would get a truly 'big bang' for our investment dollars. This is the Big Bang I am on about here.

Can the System Afford a Hit at This Time?

I do believe a phase two equity market sell off evolving into a melt down must occur at some point in the not too distant future but will it happen right now? Can the governments and global banking system allow it to happen now may be a better question. The funds may also fit into this category with less choice.

I strongly believe the banks need to continue the process of leverage reduction, high risk loan reduction (particularly unsecured loans, small business loans / overdrafts & low equity home loans) and continue to increase margins. They are playing the yield curve and buying lower risk assets - all the while credit supply contracts.

Restricted new loans are mostly going to refinance the 'A' list as we experience "crowding out". Crowding out means that there are not enough loans to go around - the queue for loans is bigger than the available supply.

Therefore the Central Bank support is going all out with Governments just to maintain the banking / financial system, talk things up and provide urgently needed time for the banking system to repair itself. The provisioning for bad debt has been wiping out most of the current bank profits so balance sheet repair is slow at best - it will take at least two more years by some estimates.

The possibility of further need for capital injection into the banking system during this repair phase is high because the lack of credit availability will force portions of some higher risk business sectors into failure placing their assets onto the market further depressing asset prices. There are some suggestions of nationalizing the banks so that lending resumes at increased levels which would slow the balance sheet repair process.

Capital injections into the banking system would push gold and gold stocks as the fiat currencies would be again diluted. Is this the catalyst that will fuel a rally in the later stages to a parabolic high? It would not be good for confidence and would come side by side with renewed fear and "safety trade" in gold.

If banking is allowed to follow the current course we will see more business and personal failures as unemployment grows and certain businesses find they are not viable in the new world economy.

Only the strong will survive, few industries will attract new equity or be able to raise serious capital via loans. Can "they" succeed in holding off the death of the old system without a complete restart? Excellent arguments are being made to suggest that a complete restart is inevitable.

What form would the restart take and is it already in place behind the scenes in case some rogue financial wave sweeps in by surprise - a fat tail event? I have more questions than answers on this topic.

With bank balance sheet destruction still in force during this repair phase we still see conditions that are not conducive to inflation - despite all the new money creation from the Central Banking system. Inflation may not come until a later phase in this ongoing crisis. Growth will not return in the short term but stimulus money is still out there and the effect is still there in the equities markets and the fund boys are still playing for now at least.

Call me a rabid contrarian but corrections seldom happen when the mainstream talking heads tell you it is going to happen. The government stimulus money is still sloshing around the system and assisting to provide ammunition for the bulls and the "all is better now" crowd. It appears to have been the hedge funds pushing the Dow and S&P higher since the short covering was completed a few months back.

I am wondering if this can continue for a few more months and form a topping pattern up here ...or will the markets tank in October? Perhaps the top forms from here to the end of the year as we roll over and perhaps we underestimate the lingering effect of all that stimulus money in its various forms.

I am in neither camp at present - fast reversal or slower rollover. We may not see the final end of this current rally until May next year. I have to admit this is a very risky statement and that the ever-present risk to the downside is immense.

Why am I on the fence at present on this? Top picking and going short are notoriously hard to get right - same story for bottoms. So far there is no weekly divergence on the Dow as yet and the picture is a little unclear on the daily Dow chart as well because the RSI just made a higher level with a new higher price top. I do not expect much upside either but there are two resistance levels just over the Dow 10,000 level which would make a nice sucker level for renewed bullishness and "back to normal" trading hype.

My interest on when the top is in is purely based on short and medium term gold stock movement. The Aussie gold sector has been behaving like it will run into February and even May of 2010. I have watched every phase of this gold bull evolve and the current behavior is most similar to that of the second half of 2005 when we saw broad interest ahead of a magnificent rally.

Therefore I am looking for signs of a general market top or total meltdown which could destabilize the current gold stock rally in Australia.

Gold Stock Power

For the record - I wrote an article titled Big Bang 2 back on the 6th September 2008. This was the final paragraph...

"Investors that pick off the cream of these stocks now and in the near future - and all of these stocks have their time in the sun when their operations flourish and grow rapidly - will reap the kinds of returns I speak of at the beginning of this article. Pick the ones that have enough cash and an operational plant and are at a point where they will expand production significantly and you will reap the rewards. For those that buy now and wait patiently for the other end of the cycle when euphoria is high and gold stocks are in the media - you will then be able to bag those awesome returns investors all dream of."

I was talking about the 10 bagger and 3-400% gains over a few months and that was what came to pass. Nerves were high and many investors sold instead of buying at that point in time. The euphoria and other end of that cycle I was referring to has not arrived yet so the gains could be mammoth if you choose the right stocks - even from this point in time.

I believe this is what lays directly ahead - the most likely scenario. I do so with caution ready to accept that I was wrong if we turn down so there is no comfort in this position at this point in time.

Let's assume I am right at this stage as I have not been proven wrong for now. However you must trade or invest at your own risk comfort level. We are monitoring the performance with news, chart sets and an, about to be updated, fundamental performance ratings table. Our Gold Members have access to this data and more so I hope they are making the most of this.

I have deliberately ranked the stocks in a particular way to show the comparisons in a simple format and included comments on the potential "why" they might be undervalued. The next upgrade includes an important benchmark merger and market valuation which should assist all of us to evaluate the potential gold stock upside for each of the stocks in this sector. It should also enable and empower investors with an outline and guide to identify which of these companies will outperform the rest.

Right now is a great time to get your head around this fantastic vibrant gold sector Down Under as all the potential signs are there. We have prepared a special file for our European, Asian and American friends so that that they can easily identify the Australian based gold stocks on the global exchanges. Take advantage of our special bonus time offer at GoldOz if you wish - but either way I wish you good times in gold over the coming months.

Good trading / investing.

Regards,