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Optimistic Outlook after Two Years of Failing Rallies

Gold/silver stock indices experienced another severe correction (averaging 17%) from the top set in early November. As a result, there is the threat of returning to a trading range which has exhausted most precious metals investors for the past two years.

The good news is that the upside breakout that occurred in September is still in effect, and the $HUI Index would have to fall and remain below 375 for a few days to negate the breakout. The bad news is that indices are just 3-4% away from pivotal points where many stop orders could be triggered. The level of fear and frustration is so high among smaller investors that it is possible that many will once again sell at an inopportune moment.

A more dreadful picture emerges for the S&P/TSX Venture Composite Index which consists mainly of metal mining and oil and gas companies. After doubling two years ago, the index has been and remains range bound. It spends months climbing slowly and then gives up all of its gains in just a matter of weeks. And this is happening while oil and gold are near all-time highs?

Is gold going to proceed higher and pull lagging gold stocks along? Or are the gold stocks predicting upcoming weakness in the yellow metal?

The latest round of selling on all equities including gold and silver stocks was related to the investors' perception that the Fed, seeing inflation numbers creep up, will not be aggressive enough in lowering interest rates.

In reality, it is becoming clear that the central banks' attempts to stabilize the financial system are failing. The banks are not taking advantage of the discount window and the recently announced $40 billion auction of cheap funds is nothing but a drop in the bucket. The Fed has no choice but to continue to lower interest rates and inflate. We have a slowing US economy in an election year together with falling prices on the most important asset for American consumers - housing. Combine that with increasing uncertainty in the financial markets, a weak banking sector and a stabilizing USD, and there is no doubt left that monetary inflation - increase in money supply - will continue.

We are marching on a path toward stagflation and as a result the fundamentals for gold remain very bullish. Investment demand is getting stronger and stronger. Over the past year, StreetTRACKS Gold ETF alone added 167 tonnes of gold, a 37% increase compared to the previous year, while gold is up 27% over the same period. India, China and Russia have all substantially increased their gold purchases in 2007.

What is in for gold? Technically, the metal is currently consolidating its gains. This is not surprising as it has just hit a psychologically important level of $850 and it may take some time before a breakout higher becomes likely. Consolidation in gold coincides with the highly anticipated rebound in the US dollar.

Eventually, the dollar is likely to reach 79 or even 80. If this happens in the near future, gold could easily test $750 and $HUI fall to 350-360. From that point on, we think that upside in the dollar and downside in gold will be minimal.

For the US Dollar Index, the level of 80, which used to be a multi-year support, is likely to become an important resistance level. It is possible that we will not see the greenback above 80 for a long time to come.

Many gold and silver stock investors tend to focus solely on the action of gold and the US dollar. Equally important, however, are costs related to mine development and production, which have often been rising as fast as gold itself. The net effect on gold stocks has been nothing other than the hype created by investors who link gold and the dollar together with gold stock profits. And once reality sets in, it becomes evident that profits for most producers are stagnating or even falling while new mine developers are faced with prohibitive capital expenditures. This is the principal reason why every rally in gold stocks over past two years has been met with formidable selling pressure.

Energy expenses often make up about one third of total operating costs for many mines, especially open pits. As gold underperforms oil and base metals, gold miners cannot expect a substantial improvement in operations. As it is clear from the chart above, the gold/oil ratio is in a downtrend, meaning that cost pressures remain.

There are some encouraging signs on the horizon. The US economy is undoubtedly slowing, while the Organisation of Economic Co-operation and Development (OECD) revised down expectations for 2008 economic growth in almost every country around the world. One of the first symptoms of slowing growth is the current decline in base metal prices.

In this environment, it is doubtful that oil prices will rise any further. On the contrary, speculative demand will subside and oil should level out or even fall. This will cause a long-awaited stabilization in mining/development costs. We believe this will happen in the coming year, and gold stocks will regain their leverage against gold and outperform the metal to the upside. This is not the time to let fear take over. Those investors that stay patient will reap bigger rewards since the longer the consolidation period lasts, the stronger the next advance will be.


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