KitcoKitco
 

Gold and the Gold Stocks

 

By Howard Katz

Aug 11 2008 1:22PM
www.thegoldbug.net

   

The past month has seen a large disparity open up between gold, the metal, and the gold stocks. For example, the HUI closed on 8-8-08 at 334, the same level it was at shortly before the sub-prime crisis of last year and at which time gold was $660. And yet gold itself closed on 8-8-08 at $860. That is, gold has gone up by $200 over the past year, but the HUI, representing the gold stocks, is at the exact same spot.

This is a frustrating and difficult situation, and one’s first impulse is to complain that the universe is unfair. After all, it seems to be a matter of mathematics. As the price of their final product rises, the gold stock’s earnings should rise (at a faster rate). Math says that the gold stocks should go up, but they are not going up.

The important point to note is that such logic-defying events are fairly common in the financial world. There are many such economic pairs which ought, in logic, to move in synchronization with each other. This indeed was the plan behind Long Term Capital Management, to take such corresponding pairs, wait for a discrepancy and then play the discrepancy to get smaller or disappear. You know what happened. The discrepancies got wider; LTCM went belly up and lost $4 billion. Although all such discrepancies are ultimately resolved, it usually takes a lot longer than anyone expected, and many people lose money along the way. A good example is silver versus gold during the 1970s. For most of the decade, gold moved ahead, and silver lagged behind The discrepancy got wider and wider. It took until 1978 before silver woke up and then spent a fantastic year-and-a-half catching up with gold.

In short, if a discrepancy is opening up between gold and the gold stocks, the lesson of the market is that one must respect the mood of the market. Give the discrepancy its head and let it run as far as it wants. Don’t tell the market what it ought to do. Let the market tell you what it is going to do. When the discrepancy is so wide that the market wants to turn and correct it, then the market will tell you via the standard technical signals. It will not be hard to recognize. The problem will be to have enough patience and to keep perspective so that you can be ready when the time comes.

Last week was a dramatic time for both the metal and the stocks. The HUI, the XAU and gold itself formed giant head and shoulders tops. If these tops are all valid, then there is going to be a serious decline in the precious metals sector.

At the same time, this would be a bit difficult to believe because the U.S. dollar index looks very bearish in the long term charts. The up move in the dollar of last week was due to a single news item to the effect that Barack Obama favored a stronger dollar.

Of course, as we know from listening to Henry Paulson (and many before him), a political figure can favor a stronger dollar without doing anything to bring it about. The U.S. dollar was weak last summer when the Fed funds rate was 5¼%. Since then Bernanke has cut over 3% from that number, putting the dollar at an enormous disadvantage.

Bernanke has stopped easing, but he has not started tightening. However, even if he does, there are three problems.

  1. There is a world-wide move toward tightening. The U.S. would have to tighten more rapidly than this world average. If it tightened at the same or a slower rate, it would provide no support for the dollar.

  2. There is a normal lag of about 6 months between a tightening move by a central bank and a rally in that nation’s currency. The radical Bernanke easing of last autumn/winter is going to lengthen that time considerably.

  3. It is very rare for a President to take an active role in monetary policy. Reagan was the last one to do so. Most Presidents do not have a clue what it is about and simply leave the decisions to the various central bank officials. So it will probably not make any difference who is elected in November or what his views on the dollar are (assuming they are sincere).

Analysis of my indicators on the dollar tells me that this dollar rally has gone about as far as it can go. (You may want to check the 8-8-08 issue of the One-handed Economist to see this analysis.) But of course a fall in the dollar means a rise in gold.

Therefore, over the short term we can look for a rise in both gold and the gold stocks, and these rises will act as returns to the necklines of the various head and shoulders tops. It is the quality of these returns which I consider important.

Since March, gold has acted well. It has basically held its range (850 to 1000) in the face of a dollar rally. The gold stocks, however, have shown weakness. Assume that this process continues and that the HUI and XAU make classic returns to their necklines. However, in the same period assume that gold can climb above its neckline. This will indicate that the stocks are weak but gold is strong.

Any way you look at it, crucially important events will unfold in the gold markets over the next few weeks, and these events will have an enormous impact on the financial markets. You are invited to visit my blog at (www.thegoldbug.net) (no charge) for social commentary and to subscribe to the One-handed Economist ($300/year) for hard forecasting of the markets.(For all new subscriptions, a copy of the 8-8-08 issue will be included at no extra cost.)

I think you will find it a profitable relationship.

Howard Katz

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Howard S. Katz was one of the early gold bugs of the late ‘60s and ‘70s, turning bullish on gold in 1965.  His favorite gold stock, Lake Shore Mines, went from $3/share to $39/share over the course of the seventies (sold at $31).  Katz turned increasingly skeptical about gold as it mounted its final rise in 1979, and he called the top after the close on Jan. 21, 1980 (with gold at $825.50/oz.).  Katz traded gold in and out during the ‘80s and ‘90s and once again turned long term bullish in Dec. 2002.  His thoughts on commodities, stocks, bonds and real estate are available in a letter entitled The One-handed Economist and published every two weeks giving specific advice on trades in stocks and futures.  This letter is available (both electronic and paper copy) for $300/year with a 3-month trial for $100.  Send to: The One-handed Economist, 614 Nashua St. #122, Milford, N.H. 03055.  (Include both electronic and mailing address.)  Mr. Katz’s blog is available weekly (no charge) at www.thegoldbug.net.