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May 24, 2005

Are the Stars Finally Aligned for Gold Stocks?
by George J. Paulos

The Spring of 2005 witnessed a severe decline in the prices of most gold mining stocks, crushing the hopes and dreams of many a goldbug. Curiously, gold itself has been coasting along just fine near its multi-decade highs. In the investment business, this is called a divergence. Divergences are important to analyzing investment markets and are often indicators for trend changes. Let's examine the current state of the gold market and see if there is still life left within the endangered goldbug species.

The 4-year gold chart below shows an unbroken uptrend for four full years since the bottom in the spring of 2001. Gold has been comfortably above the 400-day moving average since the beginning of 2002. There is no technical evidence of a definite breakdown in the gold price, at least yet.

The 4-year chart of the XAU index representing a basket of the largest gold and silver mining stocks shows weaker technical action. The chart displays a double peak in 2004 with a lower high in early 2005. The XAU currently sits at a 1-year support level that was established in May of 2004. A significant break of the 79 support level on the XAU would be a bearish indicator for the entire sector. Note the seasonality in the XAU chart. In 2003 and 2004, the XAU peaked out early in the year, bottomed out in the spring, then rose during the 2^nd half. Spring is traditionally the weak period for gold stocks and 2005 seems to be following this pattern exactly.

Gold is not the only commodity that is under pressure. The entire commodity complex recently made a significant high as shown by the CRB Commodity Index (gold is a component of the CRB). Like gold however, the CRB is still in a confirmed uptrend. Commodity-based stocks took a hit similar to the gold mining stocks this spring reflecting overbought conditions in the early part of 2005. Once again, we see evidence of seasonality in the CRB similar to gold with notable weakness in the springtime.

Gold is priced on the commodity futures markets. These markets are somewhat different than the stock markets in that every position is in the form of a contract with a defined expiration date. Each contract consists of both a long and a short position by traders. The dynamics of the futures markets are determined by the composition and liquidity of the traders who take each side of the contract. Traders are divided into three groups; The Commercials, the Large Traders, and the Small Traders. In the gold market, the Commercials are usually short, representing commitments of mining companies and bullion banks to deliver future production at a known price. These traders are the most liquid and hold the most power in the trading pits. The chart below shows how the Commercials (in red) trade against the large and small traders. They tend to be highly short at price peaks and very little short at price bottoms. Currently, the Commercials are holding a relatively low short interest. This historically corresponds to a price bottom.

Gold typically trades in opposition to the US Dollar. Because of this, gold is often thought of as the "anti-dollar". The bull market in gold over the last few years has corresponded to a bear market in the US dollar over the same period of time. However, since the beginning of 2005, the US dollar has staged a significant rally off multi-decade lows, breaking through resistance represented by the widely followed 200-day moving average. The dollar still sits under the "last chance" resistance at the 400-day moving average so it is too early to say if this rally has long-term significance. The rally in the dollar may be the most significant factor in the decline of gold stocks because many gold stock traders take their cues off the dollar.

Since the dollar and gold are so closely related, it makes sense to study the ratio between the two. The following chart shows the price of gold divided by the US dollar index. This chart should show strength if gold performs well against the currency-weighted dollar index. Even adjusting for the recent rise in the dollar, gold is still in a powerful uptrend and is still just above "last chance" support.

Gold is considered both a commodity and money. If gold is used as money, then its value could be compared against other hard assets to evaluate its real purchasing power. The most convenient way to do this is to measure gold against the CRB index. The chart below is the gold price divided by the CRB index and shows roughly how much assorted raw materials can be purchased per unit of gold. Although gold and commodities generally move together, gold forms a nice channel in relation to the CRB. Gold has just recently hit the bottom of this ratio channel and is now showing near-term relative strength against other commodities after severe weakness early in the year. A rising Gold/CRB ratio is a bullish factor for gold stocks since it implies lower operating costs because gold is rising faster (or falling slower) than raw materials.

Another useful ratio compares the gold price to the XAU gold mining index. This ratio historically trades in a wide channel. The ratio is now at the extreme in favor of the metal and appears to be turning around to favor the stocks. A turnaround in this ratio could represent either a rise in the stocks or a fall in the metal, so this is not necessarily bullish. But the odds favor a trend change soon.

On the fundamental side, gold mining companies have been hit by steadily rising costs for several years, which have diluted the positive influence of higher prices for their products. Of these costs, the primary concerns are energy and labor. Energy prices are now easing which is a net positive for all mining companies, but this situation may only be temporary. Labor is a long-term problem in the resource industry. Two decades of underperformance has left the labor pool decimated. It will take many years for the industry to rebuild the talent pool and in the mean time hot demand for existing talent will result in ever higher salaries. The cost environment for mining companies is a continuing net negative.

Currency trends are an important fundamental factor for mining companies outside of the US. Changes in the local currency relative the US dollar also affects the price that the company receives for its gold. This is because the international price of gold is always quoted and settled in US dollars. The recent collapse of South African gold mining stocks is primarily the result of the sharp rise in the SA currency (the Rand) relative to the dollar. A falling local currency is usually bullish for foreign mining companies. A continued rise in the US dollar may provide a relative advantage to companies operating mines outside the US. However, a rise in the US dollar index would not necessarily hurt US companies if the gold price does not fall.

Conclusions:

Bullish factors:

- Seasonality is positive

- Important technical support levels are being held

- Oil prices are easing which reduces mining costs

- Gold price trend is still positive

- The Commitment of Traders is currently positive based on historical norms

- Gold is strengthening against commodities

- Sentiment is at historic lows

- Higher US dollar may help foreign mining operations

- Gold price may be decoupling from the US dollar as the dollar rises

Bearish factors:

- Mining costs are still rising

- Dollar remains in a short-term uptrend putting pressure on gold

- Commodities are in a near term decline, gold usually moves with commodities

- Breakdown of nearby support levels could spell additional weakness ahead

- Gold stocks trends often lead gold price trends, but not always.

The prevailing force of bullish factors currently outweigh bearish, which makes this an appropriate time to start accumulating quality gold mining stocks. It is important at this time to concentrate on strength. Many mining stocks that were top performers during the last rally have been real stinkers on the way down. The best bets are those that have held up during this downturn. There are still negative factors that will affect different companies in different ways. Only the strongest companies are positioned to benefit from further gold price rises under current conditions. In other words, avoid junk. If there is a genuine turnaround in the gold mining industry, there will be plenty of time to play the high-risk stocks that usually outperform in the later stages of a bull market.

Gold itself is at an interesting juncture. Many analysts are predicting that gold will decouple from the US dollar, allowing both to rise simultaneously. This would mean that gold is rising in all currencies and increasing in real purchasing power worldwide. Although history says that a decoupling is unlikely, such a situation would be the highly bullish for mining stocks of all kinds. Some evidence is forming that a decoupling could be taking place, but it is still too early to say definitively. Stay tuned.

George J. Paulos
Freebuck.com

George J. Paulos is Editor/Publisher of Freebuck.com, a website devoted to wealth preservation and enhancement using alternative investing approaches including precious metals. He is also Associate Editor of The Gold Letter, a newsletter covering junior mining and natural resource stocks.

The information contained herein is deemed reliable but no guarantee is made about its completeness or accuracy. The reader accepts this information on the condition that errors or omissions shall not be made the basis for any claim, demand or cause for action. Any statements non-factual in nature constitute only current opinions, which are subject to change. The author/publisher may or may not have a position in the securities and/or options relating thereto, & may make purchases and/or sales of these securities relating thereto from time to time in the open market or otherwise. Neither the information, nor opinions expressed, shall be construed as a solicitation to buy or sell any stock, futures or options contract mentioned herein. The author/publisher of this letter is not a qualified financial advisor & is not acting as such in this publication. Investors are urged to obtain the advice of a qualified financial & investment advisor before entering any financial transaction.