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Gold and Gold Stocks

Below is an extract from a commentary originally posted at www.speculative-investor.com on 5th August 2007.

In our 30th July commentary we wrote the following regarding the gold sector's short-term prospects:

"Last week's low might have to be tested at some point over the next two weeks, but we suspect that the correction is essentially complete. At least, if we are right that the intermediate-term outlook has turned more positive then the correction should now be complete in terms of price, with a period of 'testing' possibly occurring over the coming weeks before the next rally begins in earnest."

The HUI made a couple of attempts to bounce over the past week, but kept getting dragged back to near the prior week's low due to weakness in the broad stock market. We therefore think it's fair to say that the period of testing mentioned above is in progress.

Although the HUI ended last week at roughly the same level at which it began the week, big things happened beneath the surface. For example, the following chart shows that the HUI/gold ratio has just plunged from its highest level of the year to near its lows of the year. This effectively cancels-out the earlier bullish signal generated by this ratio.

The surge in the HUI/gold ratio during the first three weeks of July never really made sense given that it was not accompanied by a significant improvement in the real gold price (gold relative to other commodities and investments). Interestingly, though, even while gold stocks were weakening considerably relative to gold bullion over the past fortnight the backdrop for gold stocks was becoming more bullish. To illustrate what we mean by this we've included, herewith, a chart of gold relative to the Industrial Metals Index (GYX) and a chart comparing the HUI with the gold/SPX ratio (gold relative to the S&P500 Index).

The first of the following charts shows that the gold/GYX ratio has just moved to a 4-month high. This, in turn, suggests that the May-2007 low for this ratio was a successful test of the October-2006 low.

The second of the following charts makes the point that there is a strong positive correlation between the HUI and the gold/SPX ratio (the green line on the chart). This relationship makes sense because there would be no good reason for stock market participants to bid-up the prices of gold stocks unless gold bullion were out-performing the broad stock market; or, to put it another way, it would be unreasonable to expect investors to become enthusiastic about gold-related investments unless they could see that gold was out-performing the S&P500.

Of importance at this time is that gold has moved sharply higher relative to the S&P500 Index over the past fortnight. If gold's out-performance continues then the investment demand for gold-mining stocks should increase.

Gold tends to be a top performer when the financial environment is becoming less liquid, so the recent strength in gold relative to other investments is undoubtedly related to reduced liquidity within the financial markets in general and the credit market in particular. Gold should also benefit in a big way from the actions that will inevitably be taken by the US Fed and its central banking cohorts to counteract the reduced financial market liquidity. Note, though, that it would not be unprecedented for gold stocks to trend lower for an inconveniently long time while the financial backdrop was becoming increasingly 'gold bullish'. During the second half of 2000, for instance, the HUI moved relentlessly lower for a few months while the stage was clearly being set for a major gold bull market. It will therefore be prudent to use price action as a filter.

As mentioned in last week's commentary, the HUI's pullback from its 20th July peak should be essentially complete IF an intermediate-term rally has begun. This means that the HUI shouldn't close below the mid-330s if things really have turned for the better, although the ultimate area of support for our bullish outlook is the cluster of lows at 317-320 (refer to the following HUI chart for details).


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