It's been an exciting couple of months. Gold broke out to a 16 year high rising to near $460 and the U.S. dollar fell a nine year low. This week, however, gold was down sharply. So what's going on?

In recent months we've been to several investment conferences. One impression from these conferences is that many investors aren't fully aware of the big picture and what's happening in the economy or the markets. They seem more focused on short-term events, but they also know something's not right.

While certainly important, short-term events have essentially reinforced the major trends which have already been underway for a few years in both gold and the dollar. But these markets have been rising or declining for other reasons.

The most important factor driving these markets has been the new era that started in the late 1990s. Since then, the stock market bubble burst, deflation forces intensified, interest rates were cut to 45 year lows, monetary stimulation exploded, gold embarked on a major bull market rise, and so did oil and commodities while the U.S. dollar began a major bear market decline.

Events following 9/11 basically fueled this new era. In record time, the government budget surplus quickly turned into the biggest debt and deficits the world has ever known as the war on terrorism took hold. The massive military spending for Iraq and Afghanistan combined with tax cuts sent the deficit soaring to an unprecedented $600 billion this year.

The current account deficit is also at record highs and these twin deficits combined with low interest rates have been the main reasons why the dollar's been dropping. This in turn has kept upward pressure on gold and commodities, but there's more...

INFLATION HEATING UP

Gold is a leading inflation indicator and its quiet rise since 2001 has been signaling inflation is coming. This year we began to see this with the most obvious sign being the super rise in the oil price. Energy prices, for instance, soared at an annual rate of 82% in October and nearly 22% in November, pushing producer prices up the most in 14 years to a whopping 13% annualized rate in the past two months. This strongly suggests inflation is far more likely to be the economic concern moving forward rather than deflation.

Plus, unprecedented government spending, and the debt and deficits nearly guaranties it. If the war on terror continues, which is nearly certain, this deficit spending is going to fuel even more inflation, which is going to be bullish for gold and bearish for the U.S. dollar.

For now, the markets are looking ahead and the breakouts last month are telling us they expect no end in sight to the spending, debt and deficit situation. Wars are expensive and many will argue the spending is justified, but that isn't the point. The point is, we've been spending on a scale never seen before in history.

That's the big picture and it's basically why the markets are behaving the way they are. Understanding this is important in making good investment decisions.

GOLD: At onset of major rise

As time passes and seeing how big picture events are unfolding, we're more inclined to believe this bull market in gold is going to be a big one, which could surpass the old highs at $850. If that proves to be true, then this mega bull market will likely be composed of three psychological phases.

The first phase is when the so-called smart, big money buys. In the second phase, mutual funds and some investors start moving in, attracted by rising prices. The third phase is when the public jumps in, which pushes prices up to levels higher than most expected. That's what happened to gold in 1980, Japan in 1990 and tech stocks in 2000.

Interestingly, our dear friend Chris Weber was at a barbecue near Monaco several months ago where several billionaires were present. (Chris is an extremely successful investor and he writes a great newsletter we highly recommend; www.weberglobal.net.) When the conversation turned to investments one of the party goers wondered what to invest in these days. Almost in unison, the billionaires all said gold. They obviously bought in the first phase of this bull market. Another dear friend Richard Russell believes we're now in the early second phase and this tends to be the longest phase.

WHERE GOLD STANDS NOW

Last month gold broke above $430, triggered by the drop in the U.S. dollar, which was very important for several reasons...

First, it meant gold was entering a stronger phase of the major bull market. It also meant the rise was on track and it completed its function by hitting a new bull market high, which reinforced the bull market in gold is strong.

But no bull market goes straight up or straight down. There are downward corrections along the way and gold is now starting a downward correction following its steep rise since September, which is completely normal.

By now you know that gold's been moving in an A through D cyclical pattern since the 1970s (see Chart 1A, which shows gold since 2001). The As and Cs coincide with intermediate gold rises while the Bs and Ds coincide with intermediate declines. Gold has been in a C rise, which are the best rises in the cycle.

The timing of the C rises has been fairly consistent. Since 1999, for instance, they've lasted eight to 10 weeks on average. On that basis, the current C rise was due to end at any time.

Plus, gold's leading indicator was at the level of previous C peaks (see Chart 1B). This told us gold may not go much higher for now. This week gold declined below $445 and if it now stays below that level, the C rise will clearly be over and a D decline will be underway.

These declines are the steepest ones in the cycle and if you want to take some profits, this would be the time to do it. But as we said earlier, we believe this gold bull market is going to be a big, long lasting one and it's best to stay invested throughout the major rise. So if you do sell some, continue to hold your core gold, gold shares and other metals for the long-term. Gold's major trend will remain up above $404, its 65-week moving average.

Regardless of the upcoming D decline, it's interesting to note that gold is stronger than stocks or bonds on a mega trend basis (see Chart 2). In other words, gold is still where your focus should be and normal downward corrections within the major bull market shouldn't sway you. Instead, look at these downward corrections as another buy area.