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A Golden Wall of Worry

Gold is hopping and the gold stocks are on fire! Gold hit a new 16-year high last week.

This past Wednesday also marked the launch of the much anticipated StreetTracks Gold Shares (NYSE: GLD).

The World Gold Council is the sponsor of the Gold Shares, an exchange traded fund that allows American investors to make a play on gold in much the same way they use QQQ's to trade the entire Nasdaq.

Barclay Global Investors also has a gold exchange traded fund in the works, the Ishares COMEX Gold Trust, which is expected to trade on the AMEX before the end of the year.

Both funds are expected to attract over $2 billion in cash from investors over the next 6 months. That's a large enough figure to provide ample fuel to the gold bull market, just like mutual fund investors helped turn technology stocks into momentum vehicles in the 1990's.

Going forward, I see any dips in gold as temporary. I am convinced that gold is beginning wave 2 of its bull market and should continue to rise appreciably higher as the year goes on. However, it is clear that gold and gold stocks are climbing a steep wall of worry right now.

I'm getting this sense from reading other newsletter writers and from emails that I am receiving from subscribers and non-subscribers alike. Here are excerpts from two insightful emails I received:

"Hi Mike. It is looking like you and Dave were correct on your break out call. I read a fair bit of stuff during the day and especially in the evening. It is astonishing to me that when I got into gold last year the price was in the $375 range and people were so bullish! At $400 it was excitement and at $430 it was flat our euphoric. To me it was incredible that when gold hit $430 and closed over it, bearish commentators were calling for tops and the gold community was still in the doldrums. Even at the Toronto gold show with gold well over $400 there was little excitement and positive sentiment among the attendees. Even now at $440 I would venture to guess that excitement was greater last year at $370! Incredible."

"I have an opinion why gold is not taking off much faster. The Dow is also climbing and while we have guys like Kudlow and Crammer pounding the table on CNBC that we have a renewed Bull Market in general equities, gold will still be flying in under most peoples radar. It is in stealth mode. When this Dow and Nasdaq rally fails it could get even more exciting." WL

You are right the masses are certainly ignorant of the gold trend. But I am confident that will change over the course of the year. As the dollar continues to break down and inflation continues to grow people will recognize gold as a store of value. At one time during the 1970's it wasn't unusual for an investment advisor to recommend putting 5-10% of your assets into gold as protection against inflation. You have to remember inflation was running on average over 5% a year during the 1970's and at one point hit over 10% a year. People in bonds and fixed income instruments without exposure to precious metals suffered.

Bull markets climb walls of worry. As they go up people are skeptical and weak hands get shaken out. It takes continual buying to fuel a market higher and some people simply have to buy at higher prices than others. When you reach a point though when everyone is in who can be, that's when a bull run comes to an end. Consequently that is also the moment at which bullish sentiment is at a peak.

Understanding how sentiment works is important, but reading it is more of an art than a science.

I believe we aren't near the top of the wall of worry for gold. I don't even know if we can even see the top from here.

"Dear Mike,
The gold/gold shares markets didn't really go down yesterday...operators were just chumming for shorts.

Your piece yesterday was timely. I think, over the passage of time, it has become amateur hour for technical analysts: everybody who trades now watches the marginal indicators (obscure ratios, MACD's, stochastics, etc.), which are good in trading-range markets and can alert you concerning possible exhaustion, but really only tend to confuse you when you are in the middle of a strong trend. Hence, there are WAY too many bulls on the sidelines, waiting for the "perfect" correction, allowing them to buy while all of us other "buy-and-hold" idiots get what's coming to us. It seldom happens, this "perfect" reentry point, and the sideliners end up buying the tops just like everyone else." - GC

Being someone who makes most of his investment decisions based on charts I'm well aware of the limitations of technical analysis and indicators. Ratios and stochastics are some of the tools I use. I think you are correct in your analysis of the situation. I think there are two things going on that is contributing to a powerful wall of worry in the gold market.

First the nature of technical indicators is that none of them work 100% of the time and there are so many indicators that you can always find one that will tell you what you want to hear at any given time. You have to really know what you are doing, and that probably takes the experience gained by learning from mistakes.

Most indicators only work in certain market conditions. For instance stochastics only give accurate buy and sell signals when a market is going sideways. When a market is bullish and trending up the stochastics will repeatedly give you false sell signals. I know, because between 2000 and 2003 I used them with repeated success to short tech stocks when they gave me sell signals on the Nasdaq. But since March of 2003, they're no longer giving reliable short selling signals.

One of the most reliable patterns in the gold market is the relative strength of the gold stocks to gold. When gold stocks act stronger than gold both tend to go higher. However, if both have been going up and the stocks falter while gold continues to go higher a major reversal has always been imminent. This happened last year and in July of 2002 before large corrections in gold stocks took place.

Over the past few weeks I have seen several technical analysts, who I have a lot of respect for and don't consider to be amateurs, say that there is no way gold can keep going higher because the stocks are lagging. These people believe that a big gold correction is right around the corner. I heard one of them say that gold should go through the lows of May and totally crash.

I think they are seeing things wrong.

What these people are doing is noticing that gold broke out to a new 52-week high last week while the XAU and HUI have failed to do that and then are concluding that gold is leading the stocks - which is bearish if that were correct.

In reality the gold stocks have been leading gold since August. They have been rising at a much faster pace. In fact some stocks rose 15-20% earlier this week when gold broke above $440.

The reason why the XAU and HUI did not make a new 52-week high while gold did is because they fell so much more when gold had its correction in the first quarter. The XAU made a high of 113.41 in January and a low of 81.21 in May. That was a loss over 29% while gold fell only 14%. In order to just get back to par the stocks had to go up much more than gold did.

The price ratio between the XAU and gold is actually bullish and as long as the stocks continue to go up at a faster pace than gold I will remain bullish and hold the gold shares that I have.

The second big wall of worry is the simple volatile price action in the gold stocks themselves. In the past two weeks they have had a pattern of going up over 10% in just a few days and then falling 5-7% in one day. Those down days simply put the worry into people who hold gold stocks - often forcing them to sell in fear of losing profits - and has caused people to stay on the sidelines and remain skeptical while even baiting some short sellers into the market.

I believe this volatile price action is going to continue for some time and will prevent many people from getting into the gold market. The action should not be a surprise. Although the stocks and the metal have been breaking out, neither of them broke out of long bases. They bottomed earlier this year and rose straight up to their highs. They only paused for a short period of time in October and November before beginning wave 2 of the gold market.

This is important. Back in the winter of 2002 when gold stocks broke out and began a big bull run - and last year too - they did so by coming out of a long base. A long consolidation phase has the effect of transferring stock from weak hands to strong hands. The fact that we have not seen such a long consolidation process near the highs this year means that there are a lot of weak hands in gold stocks - who will sell on dips out of fear and help create the volatility in the gold market.

They are an important component of the wall of worry.

To find out what gold stocks Mike Swanson holds and plans on buying subscribe to his free Weekly Gold Report at http://wallstreetwindow.com/weeklygold.htm

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