The Nature of the Current Gold Correction

By: Boris Sobolev | Mon, May 5, 2008
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This is an excerpt from a Resource Stock Guide Newsletter dated May 4, 2008.

A correction in precious metals that is now taking place is due to a general conviction that the Fed has succeeded in its efforts to overcome the financial crisis. A pause or even a stop in the monetary easing cycle will lead to easing inflationary pressures and a significant US dollar rally. We believe this conviction is Wrong!

The latest bull run in gold, which started in August 2007, was not due to the fears of inflation but due to a panic related to a financial crisis. Gold bull markets that are based on inflation occur during the rising long-term yield environment, similar to the 1970s and early 1980s. But that was not the case in the past nine months. Yields have been falling, but yield spreads have been rising, indicating increasing risk aversion among investors. Gold, like the T-Bills, was playing the role of a safe-haven during the times of great uncertainty.

When the Fed bailed out Bear Stearns, thus showing its strong resolve to do whatever it takes to ease the financial sector woes, the "Credit Crunch Gold Run" came to an end.

The "Inflationary Gold Run" is still ahead. Monetary inflation, which is the basis of today's financial system, takes time to transform to price inflation evident in the CPI or PCE figures, often several years. This is one of the reasons why we remain convinced that the precious metals bull market has a long way to go. Gold is yet to hit its all-time highs when adjusted for inflation (around $2,500/oz). When fears of inflation hit the Street, gold will easily reach or even surpass its inflation adjusted highs.

Additionally, gold bull markets, which tend to occur at the same time as the commodity bull markets, typically last an average of 20 years. This means that by even the most conservative estimates, there is 5-7 years left in this bull market (more optimistically, still 12 -15 years to go).

Gold's Behavior during USD Rallies

Many analysts are now making a bullish case for the US dollar. Financial media is full of dollar-bullish headlines. By association, these analysts and journalists automatically assume that gold is in for some tough times. Some even go as far as to state that gold is dead. Although, we will not dispute a general inverse correlation between gold and the US dollar, we do believe there is much more to the story.

Gold typically leads the US dollar and a beginning of a correction in the metal usually predicts a rally in the greenback. When the dollar responds and starts rallying, gold experiences a few more weeks of a severe correction, bottoming soon thereafter. Generally, when the USD is in an uptrend, this does not necessarily mean that one should be bearish on gold.

The chart above helps understand this relationship between gold and the US dollar in greater detail. The period between late 2005 through 2006 was chosen because this was the only prolonged period of the US dollar advance in the past several years.

Gold started to dive in December 2004 before the greenback made its final bottom one month later. Gold bottomed out ten weeks after beginning its decline. Afterwards, the yellow metal spent five months forming a base, after which it started to rally despite a continuing advance in the US dollar which lasted for another four months. In final analysis, the US Dollar Index advanced 15.2%, while gold gained an impressive 17% in a similar time period.

Given that there are many similarities between a correction in gold that began in March 2008 and prior corrections and since the fundamentals for the case for precious metals have not changed, we think it is reasonable to compare this decline to prior pullbacks in the yellow metal.

According to the chart above, we anticipate this correction to amount to about a 20% decline from an intraday top set earlier this year. The downside is limited at the 52-week moving average (or a 200-day moving average at $824). The lower Bollinger Band, now at $822, also provides solid support.

Although the correction is close to being over in terms of price downside, it is much harder to anticipate its timing. A rebound may be right around the corner, but a final bottom may still be a couple of months away. (In a less likely event that this correction will turn out to be as severe as the May-June 2006 plunge, gold could fall to as low as $770 on an intraday basis).

Coming back to the US dollar, the rally has been less than impressive from a technical standpoint. Moreover, we believe that this rally is mostly related to the profit taking happening on the euro and the yen, both of which reached extremely overbought levels.

Our suspicions that the $USD is experiencing just another routine rebound are backed by the following increasingly negative sentiment readings:

Both indicators show a growing interest by retail investors (who are usually wrong) in the US dollar. At the same time, Commitment of Traders on the euro are turning decisively bullish, while public sentiment on gold has fallen to the lowest level in the past 12 months - also bullish. Although all of this does not necessarily mean an imminent correction in the USD and a rebound in gold, it does limit the $USD's upside and gold's downside, supporting our analysis above.

There are more encouraging signs! It is becoming clear that the stabilization in the credit markets is having a positive effect on the small cap gold and silver exploration and mining stocks. Despite further mining-related and political troubles in Venezuela, Ecuador and Canada, small cap Canadian Venture Exchange traded stocks are beginning to stabilize. The ratio between the S&P/TSX Venture Composite Index ($CDNX) and the S&P/TSX Global Gold Index ($SPTGD) has finally broken its downtrend line providing further evidence that the worst may be over for our portfolios, although further fluctuations are likely as we enter into a traditionally slow summer "bargain shopping" season.



Boris Sobolev

Author: Boris Sobolev

Boris Sobolev
Denver, Colorado

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