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What's Wrong With Gold Stocks?

After peaking in January 2003 gold stocks have been on the skids for the past several weeks. The TSX Gold and Precious Metals Index was down almost 30% at its lows. The Philadelphia Gold and Silver Index (XAU) fell 25% and the Gold Bugs Index (HUI) fell 26% to recent lows. Gold fell roughly 13% from its highs near $390 testing its breakout level near $330.

All in all it is not what had been expected from the gold stocks in the early part of the year. Despite the drop stocks have held their long-term bull uptrends even though they dropped rapidly through their short-term bull trends. Most telling was March 13 when gold fell an eye popping $10.70 in one day and the stocks ended the up on the day. This had been in sharp contrast to previous days when gold prices were either flat to up and the stocks broke down through short term up trends.

Three reasons were given for this weakness in gold and gold stocks. First and most obvious, gold prices that soared to $390 were both overbought and had reached near extreme bullish consensus. Gold stocks were non-confirming, as they did not go to the highs seen in May 2002. Second as tensions appeared to ease on the geopolitical scene gold sold down. Conversely as tensions increase gold will increase. Thirdly and possibly the most important is that there had been built up late in the fourth quarter and on into the first quarter large short positions in numerous index related gold stocks particularly in junior unhedged miners.

While this build-up was not readily seen in a large miner such as Newmont Mining (NEM-NYSE, NMC-TSX) it was easily seen in an intermediate such as Glamis Gold (GLG-TSX, NYSE) where short positions increased from about 780 thousand in the 2nd quarter 2002 to 3,220 thousand in the 1st quarter of 2003. Others such as Durban Roodepoort Deep (DROOY-NASDAQ) rose from 155 thousand in the 2nd quarter 2002 to 6,423 thousand in the 1st quarter 2003. Even some smaller silver juniors such as Silver Standard (SSO-TSX Venture) and Hecla Mining (HL-NYSE) had seen large increases in their short position.

Increases in the short positions of this extreme for this particular sector are unusual. Remember that the total market value of all gold stocks is still less than the market value of Coca-Cola (KO-NYSE). So short positions built up in numerous miners particularly unhedged juniors can prove quite dangerous if an event occurred that forced the prices higher. But the short positions aside even the first two reasons while valid are also somewhat spurious.

Extreme bullishness is not unusual in a strong bull market. But that extreme bullishness will only persist for a lengthy time at the end of the run (remember the tech bull of 1999-2000) not in the early stages of the bull, as we believe we are. Second gold prices responding to the shifting winds of geopolitical concerns are also not unusual but it is not the prime reason for the rise of gold. That real reason belongs to the falling US Dollar.

As the world polarizes and we move towards a war that many do not want even as many do (and may already be under way by the time this is published) the United States with a $450 billion annual trade deficit, a growing budgetary deficit that will hit over $300 billion this year and 40% of its debt in the hands of foreigners and an already falling currency can ill afford to get into trade wars with the rest of the world. But this is very possible by-product of the fall out at the United Nations. Already the exchanges between the US and France in particular could prove to be quite debilitating. Boycotts of French goods are growing in the US while some of the dialogue between leaders has veered off the normal course of diplomatic splits.

The huge trade deficit coupled with the budgetary deficits and huge holdings of US debt in the hands of foreigners acts like a huge put on the US. If even a small portion of the debt came back coupled with an outbreak of trade wars (that were in some cases already underway) the US Dollar, which is the world's reserve currency, could fall even further. The US Dollar has fallen 17% as measured by the US Dollar Index, which is the US$ measured against a basket of world currencies. The bull up trend that began in 1995 has clearly given way as our monthly chart shows. We have also fallen under a key area of support/resistance that defined the top of the entire 1987-1999 bottoming pattern.

But gold rising as a response to a falling US$ is only part of the picture. Despite the rise in prices demand for gold remains firm. The world's central banks no longer have the capability to sell or lease gold that they did in the past. It is estimated conservatively that at least 15% of the world's central banks gold have sold or leased (5000 tonnes) over the past several years, and some have estimated that it could be as high as 45% (15,000 tonnes). Some countries such as Canada have literally stripped the vaults of their gold reserves replacing it with now depreciating US Treasury Bonds/Bills even as gold prices rise.

Demand is rising in the world's fastest growing economy China and remains firm in India the world's second most populous country (and for silver as well). The Chinese central bank has indicated a willingness to add to its gold reserves even as other central banks sell theirs. As well next year we are expected to see the introduction of the Gold Islamic Dinar to act as a medium of exchange for Muslim countries. This will add to world demand. Gold's annual demand has been in the area of 4000 tonnes/year with upwards of 1500 tonnes/year being required to fill shortfalls from mine supply and other sources.

Similarly there are growing severe shortages in the "poor man's" gold, silver. Previous large supplies have fallen sharply and mine output is insufficient to meet potential demand in the years to come. Yet silver prices have remained quite depressed. This should change going forward. Supplies of dealer silver are low enough (estimated around 55 million ounces - annual usage at Kodak (EK-NYSE) alone is roughly 50 million ounces) that if someone asked to have a large futures contracts position to be delivered it could cause a price spike.

Irrespective of those who believe that resolution of war will result in a huge market rally the US economy remains weak. Couple this with large unsustainable consumer debt levels as unemployment rises, the potential for trade wars, large budgetary and trade deficits, money supply that continues to grow well beyond the growth of the economy and low interest rates now falling below of levels of inflation then gold as money is a logical purchase. Investors can of course purchase bullion either directly through banks or dealers but they can also buy it by purchasing Central Fund of Canada (CEF-AMEX, CEF.A-TSX) (905-648-7878, www.centralfund.com), a closed end fund, and the Millennium BullionFund (416-777-6691, www.bullionfund.com) a mutual fund trust.

But the beat up gold stocks could prove to be most compelling. More companies have been lifting their hedges demonstrating that there is growing confidence that prices will move higher. The most attractive gold stocks are oddly enough the ones that garnered the most attention in the short positions. Some that should prove attractive are Agnico-Eagle Mines (AGE-TSX, AEM-NYSE), (416-947-1212, www.agnico-eagle.com), Glamis Gold (GLG-TSX, NYSE), (702-827-4600, www.glamis.com), Goldcorp (G-TSX, GG-NYSE), (416-865-0326, www.goldcorp.com), Durban Deep (DROOY-NASDAQ), (212-815-5133, www.drd.co.za) and silver stocks Hecla Mines (HL-NYSE), (208-769-4100, www.hecla-mining.com), Pan American Silver (PAA-TSX, PAAS-NASDAQ), (604-684-1175, www.panamericansilver.com), and Silver Standard Resources (SSO-TSX Venture), (604-689-3846, www.silver-standard.com).

Our long-term monthly charts also show the Philadelphia Gold and Silver Exchange (XAU) and gold (NYMEX) in clear uptrends but currently testing their bull trend lines. We expect these to hold. We are also showing the monthly chart of the Dow Jones Industrials/Gold ratio. This ratio peaked at 45 in 1999. It was 1:1 in 1980 when gold topped at over 800 and the Dow Jones was also near 800. As we can see it is in a clear downtrend favouring gold over holding paper stocks. Its long-term support is near 8 while currently trading near 23, down almost 50% from its highs.

There is a great deal of uncertainty going forward on the geopolitical scene. Early elation that a war might get under way could quickly evaporate in the face of either a more difficult chore ahead or an increase in the current global polarization. Still a big collapse in the market could set up a significant buy at that time but pre-empting that possibility may result in disappointment as the level of fear in the market is not as yet at extremes (Volatility Index (VIX) currently in mid thirties with extremes usually seen in the mid to high 50's). Conversely a continuing weakening of the US Dollar and the US economy is positive for gold. The current weakness in gold stocks should be a classic buying opportunity within the context of an ongoing bull market in the metal.

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