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Gold Sector Outlook Strategy Update

By Louis Paquette, Contributing Writer and Editor of the Emerging Growth Stocks Newsletter
July, 2002

Gold stopped dead in its tracks right at the 'significant resistance' level I recently pointed out in my last issue and continues pulling back to the $311 -- $315 range. For a while there, it was able to establish a base at $316 but it broke down on the last trading day of June. Amid almost daily announcements of corporate accounting scandals and a tumbling US dollar and stock markets, gold just couldn't make it to new highs. The inverse relationship between gold on the one hand, and the U.S. dollar and stock markets on the other, seems to have at least temporarily become uncoupled.

This has to be extremely discouraging for gold bulls. If gold prices can't go up with all this happening, just imagine if the negative news out of Wall Street were to pause for just a few days, and US dollar were to stop falling. What then? Here's what I believe is happening:

1 - For one thing, prices for gold and gold stocks got ahead of the fundamentals by the time gold peaked right around significant resistance at $327 in May. Sharp moves in either direction, sooner or later, always eventually beget retracements.

2 - As stated last issue, gold has entered a period of seasonal weakness that typically lasts through to September. Don't take this too seriously as extreme factors can easily override the trend or at least modify it. But all things being equal, we could easily see a month or two of more pain according to the pattern. This may actually be a good buying opportunity.
See: http://www.spectrumcommodities.com/education/commodity/charts/gc.html

3 - Technically - the trend line that was broken at $316 was a sharp one. Holding it would have implied much higher prices in the near term that current day fundamentals just couldn't support yet. This correction serves two purposes - it gives the fundamentals some time to catch up to the higher prices, and in the meantime, to 'shake-out' all the newcomers to the party and other 'weak hands'.

IMO there is better support at $310 right through to $300. The longer-term positive trend won't be reversed until these are violated to the downside. If $300 were to be broken, I would be surprised. Even then, commodity prices can do that just for a brief time to shake out as many participants as possible. Last October/November was such a time. My guess is, in the absence of any extreme news either way, the price maintains itself within the longer term, more gently sloping price channel shown in the chart above.

So the bottom line on gold is that I believe the gradually improving fundamentals need to catch up to the price. I don't know how much longer this will take, a few weeks or even months. But I believe that inverse relationship between gold and the other capital markets will once again be restored. Just as Rome wasn't built in a day, and prices never go in a straight line, I believe a longer term bullish trend remains in place.

Of course the major wildcard is the direction of the US dollar and major stock market indexes going forward. All of these have broken through successive support levels, with stock indexes at various stages of testing the major 9-11 lows. This is a major inflection point. While long-term, there may be more downside, a 'summer rally' bounce could be in order here. Then again, some seriously bad news could cause the indexes to break the 9-11 lows and keep falling.

I think what might be helpful at this point in time is a review of what a full fledged bull market in gold looks like. Then we can stand back and get a better feel for where we currently are in the cycle and a better idea on what we should be doing right now.

The Four-Stage Bull Market Cycle

1 - 'Disbelief' is how I would characterize the first stage. I suppose one could argue this is more of a bottoming phase than the actual bull market. Anyway, this is when the price of the metal stops making new lows, the fundamentals have either stopped deteriorating, or actually gradually started improving - even as sentiment remains almost universally and decidedly negative. Somehow though, the highest quality senior and intermediate unhedged gold producers begin to slowly drift higher ahead of the bullion price, almost foretelling the improvement in metal prices that is to come. That is exactly what took place beginning in late 2000 through the end of 2001.

2 - 2002 is the year of the 'Recapitalization Boom' stage. Stock prices soar from extremely oversold levels and the exploration sector can finally refinance again. They've eliminated excess debt - raised additional cash now and are already beginning to deploy it in the field.

3 - Which leads to the 'Exploration Boom' stage. It's actually beginning to get underway already, and will build in momentum along with additional price gains in gold, and continue as long as prices stay strong. By this time this year, this stage should be well underway.

4 - Do enough exploration and inevitably the "Discovery Boom' stage results. Now this is when the action really gets exciting. This is when previously two-bit penny stocks can end up going to $10, $40, conceivably $100 or more if you were to hit the bull's-eye. The beauty though, is given a couple major discoveries - and they all go up in price. This is the age of 'The Area Play' when one discovery can also cause the stocks of a dozen or even 40 other neighbouring claimholders to make gains in the multiples.

Assuming stage two i.e. 'Recapitalization' began approximately six months ago, we can approximate that we are still only in the first half of the game. And given stocks deliver their best gains in the latter stages of a bull market, we should hold right now (notwithstanding the odd trading opportunity when prices get way ahead of themselves).

Louis Paquette is an independent research analyst based in Vancouver, British Columbia. Louis is a regular contributor to Investor's Digest of Canada, Bull & Bear, The Money Saver, and is on the Cambridge House Investment Conference circuit. EGS is available through direct subscription, or at Baystreet.ca and Infomine.com, and his specialties are finding value and growth situations sector analysis and market timing. In the past year, EGS has turned bullish and bearish at profitable intervals in the Technology, Energy, and Gold Mining sectors.

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