Article originally sent to subscribers on Wednesday 29th August 2006....

Why has the Amex Gold Bug Index struggled to break above 350?

For months on end Gold Stocks have been positively correlated with Stock Averages. Moving lock step with averages such as the Dow Industrials. But what's this? The Dow broke above resistance at 11250 during the middle of August. The HUI has so far failed to follow suit.

Chart 1 - HUI 350 resistance holds; INDU (below) resistance at 11250 surpassed

Now this may all resolve in the next day or so.
Gold Stocks may very well break out and head higher along with the Stock Averages.

But for now it may be worthwhile taking a deeper look into this puzzle.

I mentioned in a previous article (Gold, Oil and Interest Rates) that the Stock Market has been following the Bond Market with a 1 month lag time. I mentioned that Bond prices had broken above previous resistance and that the Stock Market would follow towards the end of August. Indeed, this is what happened. But on closer analysis, it was the interest rate sensitive stocks e.g. banks that pulled the averages higher.

However, non-interest rate sensitive stocks have not fared as well. Stocks which are more dependant on economic growth than the cost of debt such as mining, IT and transportation have been lagging.

The reason (once again) seems to be the absence of Fresh Liquidity.

Chart 2 - Yen and Yield curve (below)

The 2 major sources of liquidity are the Yen Carry Trade and the Yield Curve.

The Yen is retesting old lows and has so far not provided a hugely cheaper Yen to induce more money into the trade.

Short term rates have continued to outperform Long Term Rates and here too there is little incentive to borrow short and go long - a means of expanding liquidity.

What scares me is that in the absence of a Money Pump, the economy tends to soften quite quickly and quite dramatically.

The Fed cannot tolerate a slowdown in growth for long (even if interest rates fall). The debt bubble becomes infinitely harder to service when asset prices fall quicker than nominal debt levels.

The money pump will have to be turned on soon (to the benefit of Gold Stocks) or the Stock Averages will roll over and head South into historically, the worst period of the Year!

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