How vulnerable are the Markets really?

The Dow closed above its July highs on Wednesday, signalling the potential for further gains. Gold Stocks will likely follow higher.

Dow Theorist Richard Russell says it is unlikely that the battered down Transports would confirm an upside break of the Dow lending doubt to the sustainability of any short term rallies.

Although the Major averages have been range bound for the past 2 months their action belies a much different picture. Beneath the surface, one key sector after another has broken down - Retail, Housing, Recreation, Consumer Services are all looking Poor.

To gain an understanding of what the near term holds (especially for Gold Stocks) we need to look beneath the surface to expose what REALLY is going on with the market.

What would cause Gold Stocks to awaken from their Slumber?

At this time, the catalyst for a Surge in Gold Stocks would need to be higher gold prices + higher stocks prices. Gold stocks have been moving in lock step fashion with Major Averages. So what would bring about higher stock prices? Especially if we consider that continued strength in the Bond market implies a softer economy ahead (and by extension a continued deterioration in key sectors).

The answer can be summarized thus - A FLIGHT TO SAFETY.

Is this what is happening?

Let's take a look:

Chart 1- S&P500 vs Russell Small Cap (and Mid Cap below)

The weekly chart of the S&P500 against the more speculative Small Cap Russell 2000 (or Midcap index $RDG) does indeed show a trend reversal in favor of the safety of the S&P500 Large Cap Stocks (green circles).

The same thing is evident in the S&P500 vs. more Risky Emerging markets Index (not shown)

It seems likely that a Flight to Safety from Small, Mid and Emerging Market Stocks to Large Cap stocks began in April 2006.

How about interest rates?

Chart 2 - 1-3 year Gov Bonds vs Corporate Bonds

Same thing!

Since Aug '05 Investors favored the safety of 1-3 Year US Government Bonds as opposed to more risky Corporate Bond issues.

How about this one?

Chart 3 - Gold vs. Industrial Metals

There seems to be evidence that Gold is beginning to Out Perform Industrial metals. Gold performs better than Base Metals during Weak economic conditions. This trend has not yet exerted itself fully but is certainly evident in the chart above.

[Remember, these are Weekly charts where trend changes are more significant than for Daily charts.]

The truth is these reversals are still in their infancy. But there is no mistaking they are there. There seems to be a gentle shift towards safer assets - not quite a RUSH yet.

Why does this mean for us?

A Flight to Safety ultimately means Higher Gold Prices and (initially) Higher Large Cap Stocks which is exactly what will accelerate Gold Stocks higher.

Chart 4 - HUI setting up for a Bullish breakout

The HUI is now looking very constructive.

The correlation with a strengthening Stock Market looks likely to affect Gold stocks positively and the odds favor a break above July's high of 350.

Interestingly enough, a break above 350 would signal a target of 425 which is a break out above the May high of 400. (Support comes in around 310).

In contrast to the prevailing mood of Boredom, Gloom and Disinterest, the HUI could quite easily move to new Bull Market highs in September / October as a Flight to Safety accelerates.

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