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The Coming Bottom in Gold Stocks

Last Wednesday, the Treasury Department reported that foreigners bought $48.1 billion in securities in October. This was down from the $67.5 billion they purchased in September. It was the lowest figure of the year and did not exceed the trade deficit which came in at a record $55.5 billion to the surprise of economists.

Since the summer, foreigners have been buying fewer US securities. In fact, they were net sellers of US stocks in August. The reason for this is simple. Foreigners lose money when the dollar declines. If you are a European investor who managed to buy the DOW on its July 2002 bottom you would only be break even right now, because the dollar has declined while the DOW has risen.

The trade deficit is only going to get worse and the dollar is going to continue its secular decline. At some point, foreigners are going to fear losing even more money in their US assets due to the dollar's decline and will sell out in a panic. Is this the end game of currency bear markets and the crisis phase? I think so. But According to the Economic Policy Institute, we are only starting to approach that point:

"If the dollar were being supported by demand from investors who find the U.S. market attractive, then steady growth in capital inflows from private investors to finance rising deficits would likely occur. However, private inflows have fallen in the last three years. Instead, foreign governments have been intervening in foreign exchange markets by purchasing a rapidly growing volume of U.S. government assets (shown as foreign government purchases of U.S. assets in the figure below). These inflows reached an annual rate of $348 billion in the first three quarters of 2004, or 55% of the funds necessary to finance the U.S. deficit. These same official government inflows were 47% of the total in 2003."

So in effect, the only thing keeping the dollar together right now is the intervention of foreign governments. In August, China made an emergency intervention in order to keep the dollar up. Foreign private investors pulled back their money and China came in to make the difference. But at some point even China will go away.

Next year is going to be a precarious one for the dollar. But, at the moment, the dollar appears poised to continue its current bear market bounce above 80. Eighty is a support level that has held for over 20 years on the US dollar index. We are likely to see the dollar continue to rally towards the top of its resistance line in the downtrend channel:

At the same time, gold stocks appear ready to make one more leg down. The chart above is the price of the $XAU divided by the price of gold. When it rises, gold stocks are leading the price of gold higher and when it is falling then gold (the metal) is acting stronger than the stocks. When gold stocks outperform gold it is bullish and when the metal outperforms the stocks it is bearish. When the relative strength of the XAU turned up in August, I got back into gold stocks and I sold in November when their strength faded.

They are still showing weakness. Since November, we have yet to see a day in which the gold stocks open to the upside and close on a high. Morning rallies are consistently getting sold into the close.

Despite last week's bearish data on the dollar and the current account deficit, gold stocks went nowhere. On Friday, they gapped up and then closed on their lows while the price of gold itself closed on a high. The weakness in the gold stocks is continuing and is likely to lead to another leg down and the creation of a true mini-panic bottom that will set the stage for a breakout to new highs and a new bull run in 2005 for the stocks.

The Coming Bottom in Gold Stocks

Right now, the XAU has support at 98, but recent action suggests that this level will be broken before the week is out. If this happens, then 95 will become new support, however, this is simply a minor support level with little strength to it. Ninety-Eight is the number to watch. If that gets broken then we are likely to see the XAU fall to the 90 area or even slightly below. I think this is area is going to be where the next true bottom in the XAU is formed.

A drop below 98 will likely lead to a panic sell-off in gold stocks. A huge amount of volume flowed into the large-cap gold stocks on 12/08 when the XAU gapped down to 96. The big caps are the darlings of institutional investors and hedge fund investors because they provide the liquidity they need to make a play on gold stocks. Volume on the 8th was huge in these stocks and this tells me that a lot of these players were trying to guess the bottom. If the these stocks fall, causing them to lose their profits, then they will quickly sell out of their positions. This would, in turn, lead to a high volume panic bottom in the XAU.

Such an event would bring fear to gold bulls and shake a lot of people out of the gold market - but it would be a wonderful buying opportunity for the prudent investor. The dollar is likely to break down through 80 next year, this would be a major market event that would catapult gold stocks to heights we haven't yet seen in this gold bull market.

A buying opportunity like this will be a gift from Santa Claus. We may look back a year from now and see that this next bottom in gold stocks was the buying opportunity of a lifetime. It is one I want us all to take advantage of. After the XAU breaks 98, I will put a list together for you of the gold stocks I plan on buying.

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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