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Gold Stocks: Breakout or Another Fakeout

Gold broke through its significant resistance of $675 and appears to be on the way to $700. The technical picture has a number of bullish components, and this breakout from a long consolidation pattern in gold and gold stock indices could be for real this time. Relative strength of gold stocks compared to gold is positive while most major gold indices have cleared their resistance levels.

One of the reasons gold strengthened last week was Chairman Bernanke's implied reassurance that despite rising inflation, the Fed Funds rate is not going anywhere for a while.

Even though the technical picture is good and we are witnessing a typical wall-of-worry climb, the driving forces of gold prices appear to be of a short term nature. We are not about to jump in with both feet and start buying on a breakout. The reason we cannot turn completely bullish is that the fundamentals for gold stocks have not changed for the better. Profit margins for producers (who are the main leaders in the rally) are not rising and we are not sure conditions exist or even beginning to develop for their improvement at this time.

In fact, today's situation appears to be similar to the April-May 2006 rally when gold and gold indices made a spike and then gave up all gains in a matter of weeks. That turned out to be the final stage of the rally that was caused by an overabundance of liquidity provided by the Japanese Central Bank.

The chart below helps explain the nature of gold stock behavior during this bull market. In Stage 1 of the chart below, the 2001-2003 run in gold stocks occurred during weak economic conditions. Profitability of gold producers (who make up a vast majority in gold indices) was rising dramatically. Gold outperformed energy and most other metals and HUI gained over 300%.

In Stage 2, the global economy improved, world stock markets began their cyclical bull markets and commodity prices started to grow sharply. Gold producers were pressured by rising operating costs and despite slightly increasing gold prices, the HUI corrected by almost 40%.

In 2005-2006 when gold rose around 70%, the rally was fueled by a massive liquidity injection provided by the Bank of Japan (stage 3 on the chart). The distinguishing feature of this stage was that gold finally started rising in all major currencies, not just in the dollar or the yen. This created an increased investment demand not only for gold but also for leveraged gold producers from the rest of the world despite hefty valuation levels. Nevertheless, the leaders in this rally were not precious metals companies, but base metal and energy stocks. The reason for this was a wide disparity in valuation levels. Even now, after another year of gains, base metal and energy stocks remain much cheaper (PE of FCX - 13 while NEM - 30, ABX - 26).

In May 2006, Bank of Japan suddenly removed excess money supply from the markets and we entered into a consolidation period, Stage 4, in which we are still in today. Since then the yen again started to weaken as cheap money was once more let back into the markets. Gold is now on a brink of making a new high in yen while the US dollar is at a vital support level. Both the dollar and the yen are at critically low levels where they are most probably going to be defended. If this does not happen and the dollar declines further while the yen carry trade continues in full force, gold will rally much higher and Stage 4 will turn out to be merely a continuation of Stage 3.

The question is, how much lower will the yen be allowed to fall and continue to create an almost unlimited money supply for the whole world? Now that the Japanese economy is much stronger, the time is right to take the foot off the gas pedal. While the repeat of the 2005-2006 scenario with gold and gold stocks (Stage 3) cannot be ruled out, it is not very likely. Such a breakout will only be sustainable as long as the excess money supply growth remains. Once tightening measures are implemented as in May 2006, a serious correction will follow.

For a more favorable and sustainable upward breakout scenario in gold stocks, we need to see similar conditions as in Stage 1:

  1. A significant correction in the stock market, where gold stocks start to perform better than the rest of the market (first signs are now emerging)
  2. A moderation in global economic growth (only the US economy is showing signs of weakness)
  3. Gold rising again in all major world currencies (not yet)
  4. Widening bond yield spreads (still flat around the world)

None of these conditions are being fully met at this time and we remain cautious.

Short term gains and overbought conditions in gold and gold stocks now have to be digested. The behavior during the correction will give us further clues whether the rally will persist. For now, we are continuing to implement our successful strategy of buying Exploration I and Exploration II companies on the dips, mostly avoiding gold producers for the time being.

This is a fragment from the Resource Stock Guide Newsletter originally posted on July 20, 2007.


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