When Will the Gold Correction End?

Last week almost every index and market, except the dollar index, fell after the Federal Reserve raised interest rates and admitted in its accompanying statement that there is indeed inflation. Bulls of all stripes got hit hard, while the consensus coming from CNBC and the financial press seems to be, yes there has been inflation, the Fed recognizes it, and is now going to put a lid on it. Commodities have now topped out and oil is going to come back down.

In other words, Alan Greenspan is on the job and everything is going to go back to normal. Much of the selling we saw last week in gold and commodities was driven by just such a mentality. Gold bugs who sold did so in fear that the Fed will now raise rates aggressively and make the dollar enter a new bull market, thereby putting an end to the gold bull market.

I wish things were that simple. The Federal Reserve creates inflation. The inflation we are seeing in the economy has not been caused by an overheating US economy or by China, but is the result of the Federal Reserve's monetary policy.

Alan Greenspan has a way of overdoing things. He tends to raise rates until there is a crisis and then he panics and lowers them too much, which results in a bubble being created somewhere in the economy.

According to the ISI Group, a New York economic-research firm, "It seems likely" that the Fed is about to create another crisis. "If a company or country is a weak link, that combination of higher interest rates and reduced economic activity just tips them over," says ISI economist Nancy Lazar.

When the Fed raises interest rates "trouble usually follows." According to the Wall Street Journal, "In 1987, the stock market crashed. In 1994, Orange County went bankrupt and Mexico devalued its peso, ravaging its economy. In 2000, the Nasdaq Stock Market bubble burst. And weak links are everywhere – from the current deficit, which could spur a sharp drop in the dollar and subsequent rise in gold and spike in interest rates – to bubble-like housing prices in parts of the United States."

Greenspan is almost always either wrong about the economy or way behind the curve. Back in 2000 he claimed he was going to create a "soft landing" in the economy. Instead he raised rates so fast that the stock market collapsed. He then feared that we were about to enter a deflationary disaster and brought rates to an artificially low level in a panic.

Although those rate cuts helped to hold up the DOW, they fueled bubbles in the bond and real estate markets. The low rates also exploded the current account deficit and fueled a bear market in the dollar. The artificially low interest rates fueled too much money creation in the economy which is the cause of the inflation you are seeing now.

People who think the Federal Reserve is all of a sudden going to be able to press a button and bring the economy back to normal while making inflation vanish are engaging in wishful thinking. But it is exactly this type of thinking that drove the selling in gold and buying of dollars last week. Those people reacted to Federal Reserve statements and CNBC fawning of Alan Greenspan.

In reality, the Fed is trapped in a box. It is way behind the curve when it comes to inflation. Short-term interest rates are now at a lower level than the rate of growth of the consumer price index. However, in order to get ahead of the curve the Fed would have to raise rates so high that it would create another crisis.

That crisis would come in the guise of a collapse in real estate bubble markets and current account deficit funding problems, which would result in a full blown dollar crisis. It would cause much bigger problems than inflation and at the hint of a crisis Greenspan would stop his tracks.

The end game has not changed. The end game is an eventual fall in the value of the dollar. A blip of raising interest rates won't end the trend of the current account deficit. As Greenspan claimed six months ago, the only answer to the current account deficit is a lower dollar.

Don't react to short-term news. If the Fed lowers rates don't rush and buy stocks. Remember back in 2001 when the Fed first started to lower interest rates and CNBC said that the market would now go up, because it "always does" when the Fed lowers rates. Well, the market fell for another 18 months.

Likewise don't rush out to sell your gold stocks just because the Fed raises interest rates. Don't react to what the Fed does. Keep your eyes on the larger trends. That is how you make money, not by jumping in and out of markets based on individual news items.

Personally what I do is focus on the large macro trends and then profit in the sectors poised to benefit from them by looking for company specific growth stories for investment ideas. I then use technical analysis to pin point my entry and exit points.

As far as gold goes what I try to do is buy when gold is trending up and sell out when the gold uptrend starts to falter and then buy back on dips. To follow the trend the most important thing I watch is the XAU/gold ratio. Gold stocks tend to lead gold so when the XAU gold stock index outperforms Gold the gold trend is bullish. Likewise when Gold outperforms the XAU, usually a top is being formed.

Following this ratio led me to buy gold stocks in August and sell in November. Once I sold I planned to buy back in following a correction and did so two days within the February low.

After I bought I said, in a members bulletin, that I expected the gold stocks to rally and then spend 5-8 weeks going sideways, after which they would breakout and start another large bull run.

I viewed the current action in gold as being very similar to the action we saw in the first quarter of 2003. Back then, gold and the gold stocks had a large correction in the first quarter, after which the gold stocks rallied up to their highs and then dipped a little before breaking out and rallying into the end of the year. During this final dip though, the price of gold fell much harder than the stocks did, which brought a bullish breakout in the XAU/gold ratio.

I have been - and still do - expect something similar to happen in the coming weeks. After this current dip comes to an end if the gold stocks outperform gold on the next rally then the XAU/gold ratio will breakout once again. Such an event would herald the launch of wave 2 of the gold bull market. It would be caused by gold stocks breaking out of their 2 1/2 year highs ahead of gold making a new 52-week high.

Much work has to be done till we can get to that point and this current dip in gold is probably a part of of that process.

I saw clear warning signs that this dip in gold was coming. On February 14th I sent out a members bulletin stating that "gold is about to pullback and consolidate its recent gains. I'm not sure if the gold stocks will pull back much or if they'll just go sideways in a very narrow range (2-3%) while gold pulls back."

What caught my attention was the fact that gold started to rally ahead of the XAU and the commercial gold futures traders had once again built a large short position. During this final surge in gold, commercial futures traders opened up an additional 41,943 short contracts to make their position 147,491 net short. Each major top in the past 4 years has come with commercials short net 150k-170k contracts. Major bottoms have come when they have been net short 30-90k contracts.

I had targets of 430, 425, and the 420 on gold and listed 97 and then 94 as levels at which the XAU would likely hold.

Well, gold has fallen to 425 while the XAU closed Friday at 92.97. So far during this correction, the stocks have been falling at a faster rate than gold.

What this means is that gold likely has further to fall. It should hit 420 this week and will likely even take out that level. On the positive side, the commercials have started to cover their short position. As of last Wednesday, they were 125,978 contracts net short, covering around 25,000 contracts over the previous week. However, they probably need to do more covering. They were only 48k contracts net short at the February low. They don't need to get to that level, but they certainly need to be less than 100k contracts net short. That means we should see gold at least dip below 420 before we see gold bottom.

The good news is that the stocks will firm up ahead of gold, telling us that the bottom is likely in. At some point the gold stocks will stop dropping, while gold will continues to drop. This may come with a large gap down in gold one morning and then an intraday reversal in the gold stocks or it may simply come with a day in which the gold stocks firm up in the afternoon while gold has one final 5 point plunge.

After the next bottom, I expect the stocks to act much in the same way they did before they broke out in 2003 - they should go sideways and start to outperform gold, leading to a pivotal breakout of the XAU/gold ratio.

It is this breakout of the XAU/gold ratio that will be the FINAL and most safe buying opportunity. But this dip here will be an excellent opportunity to average in at low prices. By buying here and then later on the XAU/gold ratio breakout one can have a large gold position that will rise in value on the next leg up in gold. You buy the dips during bull markets.

To find out what gold stocks Mike Swanson holds and plans on buying subscribe to his free Weekly Gold Report at http://wallstreetwindow.com/weeklygold.htm

March 28, 2005

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