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Gold Action #426

Dr. Clive Roffey
Jul 24, 2006

There are two main talking points in the market this week. First the Israel / Hezbollah war and second the volatility of the gold market. I must admit to a wry smile when various TV commentators believe that it will be a short war. Come on, it has been going for 5000 years and there is no sign of an end. The Israelites and the Hittites went at it, then Alexander and Darius confronted each other, the Crusaders and Saladin locked horns. The whole region has been a hot bed of continuous battles for centuries.

I believe that the main point of the current conflict is the disarming of Hezbollah. I do not understand how any self respecting government can allow a military splinter group to attack another country without taking any action themselves to control the radical elements. Disarmament is the key to this story. The US, Europe and Israel want Hezbollah to disarm and become a legitimate political entity within the Lebanese government whilst Syria and Iran need them to remain as an armed opposition to Israel. It is simply another story of vested interests with the poor public in the middle.

The UN has passed resolutions calling for the disarmament and proposed a peace keeping force to ensure this. What a joke. They already have about two thousand 'peace keepers' in southern Lebanon that have been powerless to prevent the recent events. It appears that life, like talk, is cheap.

Bernanke's report coupled with the mood swings of the war has produced the most violent volatility in the gold market for some considerable period of time. Moves of 5% per day have been the norm as the gold price gyrates up and down. But this is fast drawing to a close and a new trend is ready to emerge. The run up to $725 was way overbought and the sudden collapse to $540 way overdone. The gyrations around the $630 pivot are dampening down and a move back above this pivot point will confirm a resumption of the long term upside bull trend.

My Elliott analysis continues to indicate further upside potential for gold to again attack the $750 level. I do not see the current fluctuations as precursors to a new bear trend. The shares have not yet started their true bull market run and need to play catch up. They are unlikely to do this on a falling old price. It is essential to watch the shares in conjunction with the gold price as the share data often gives a far clearer picture.

The Dow bounced up underneath the main resistance line at 11 100. This is a key level for the immediate future of US equities. If the DJIA fails to penetrate above this resistance and falls under the support at 10 500 I will be forced to scream..... "major bear market". I have several times detailed the B wave split that is evident in the US indexes with the S&P looking like a zig-zag, the DJIA having the double top and the NYSE the irregular top. These separate B waves appear to be complete and all that is needed now is confirmation of the start of the massive C wave sell off. Be very careful with global general equities.

In the meantime the rand price of gold hit R149 000 a kilo. That is a massive price level considering that most of the South African mines break even at around R100 000. I have had a long term target of R175 000 and at that level the profits will be enormous. So that any crazy selling of JSE gold stocks out of the US, such as is occurring at the moment, should be quickly taken up by astute investment houses.

Like most people, I hope this war comes to a quick end and that Hezbollah disarms and becomes a legitimate political entity that focuses on the positive attitude of growing its own country and not the negative philosophy of destroying another. But I doubt whether that will happen.

Uranium stocks have been the subject of considerable hype over the past two years. They are supposed to be the new and easiest way to make money in the markets. But judging by their recent performance these claims are somewhat over exaggerated. I have produced a new commentary "Uranium Stocks" as a sister publication to my "Gold & Silver Penny Stocks". 'Uranium Stocks' will be a monthly free addition to "Gold & Silver Penny Stocks" subscribers. Anyone interested in the first free issue can email me at croffey@mweb.co.za.

I have previously detailed this diagrammatic representation of the relationship between the economic and gold cycles. Just after the start of a new long term economic cycle inflation rears is head. About a third of the move up the cycle astute investors start to buy gold as a hedge against inflation. As the economic cycle develops the inflation grows and gold acts in its tradition role as a safe haven from increasing prices and falling value. Stock markets boom in the spotlight of economic growth and paper promissory notes are the most desired investment. But towards the top of the cycle, and at the turning point when economic growth has ended, a region of uncertainty develops in which a distrust of paper investments becomes evident. Gold has not yet reached the top of its cycle and continues to appreciate as investors move away from paper into solid assets. There is a misconception that gold needs inflation to run. At the top of the economic cycle it is the flight from paper that drives to move to gold and not inflation.

This is a diagram illustration of a typical gold share bull cycle. All new bull markets commence in an aura of skepticism as the negative psychology of the previous bear market continues to pervade investment attitudes. The first leg is born in disbelief and share prices appreciate due to growth that is directly related to the current earnings of the large gold producers. The high cost mines and the exploration companies do not feature in this part of the cycle. After the 1-2 correction the market moves to a new high and suddenly a fundamental realization that a new growth phase has started sets in.

Wave 3 is the major growth phase and fundamental analysis focuses not so much on the current earnings of the mines to justify investment but on the potential future earnings as the gold price is expected to continue rising. Projected earnings are the watchword and this becomes the driving force behind the sudden change in attitude to the higher cost producers. This is the phase in which the more marginal mines start to move. Wave 3 often extends as it sucks even the stolidly doubting fundamental analysts into the future growth and earnings vortex. Ultimately the market becomes overheated and corrective wave 4 sets in.

But this correction only lasts for a while before the bull trend resumes and moves into its final euphoric blow off stage in which making money in this market is the easiest game in town. Traditional values such as earnings, profits and dividends go out of the window. Current earnings are discarded as old hat and the total focus of analysis is on future earnings based not on production but on the gold reserves in the ground that have suddenly become a hugely valuable asset in view of the elevated price of gold. Re-rating of reserves adds millions to exploration, resource and royalty company balance sheets. The large producers are dishing out substantial dividends but this is disregarded in favour of the future earnings that are associated with the reserves. Companies with large reserves are the most sought after investments. Penny stocks with mining rights appreciate exponentially. Every man and his dog is a gold expert and everyone knows some secret data related to gold reserves. We are back to the era of the NASDAQ bubble!!

You don't believe me?? Wait and see. At this stage I believe we are just entering the growth section of the cycle at the start of wave 3. This gold share market has not yet started its runaway catapult. The penny stocks are building massive bases that will be triggered in the near future.

One of my reasons for discussing this cycle is to address the conundrum of the Rand. I expect some short term weakness to continue over the next six months and view the current dip under R7 as a serious selling level. But in the long term from 2007 to 2010 I am looking for a much stronger currency down to at least $4 to the Rand on the back of a significantly higher gold price. This will impinge on the Rand price of gold and effectively put a cap on this runaway situation. I believe this potentially negative effect will be more than offset by the sirens call of the value of reserves.

This is the GoldColony index of 50 junior mining stocks that have miniscule production and are primarily exploration, royalty and development stocks. They are the index of the wave 5 euphoria movement. For three years the index failed to move even though the gold price appreciated 50% from $300 to $450. But once above $500 these stocks started to kick in as their reserves became more attractive. The index has doubled over the past year as gold moved above $700. The current churning is directly associated with the machinations of the gold price but the long term prospects for this index are extremely bright. If this is the case it implies a much higher gold price. This index will not appreciate unless the gold price moves. In addition there appears to be a floor around $500 above which the reserves are of interest. The closer gold drifts back towards $500 the more dramatic will be the collapse of this index. But I do not anticipate this happening. This index will continue to accelerate the further the gold price moves above $700.

It is interesting to note that Mark Wellesly-Wood the CEO of much maligned Durban Deep has recently revised the value of their gold reserves upwards by 30%. This is the first shot across the bows of the reserves debate. It is interesting to note that the large gold producers are finding it increasingly difficult to find economic gold reserves to replace the mined resources. The whole emphasis going forward will be on reserves.

A higher gold price will not just reflect the metal's value but it will have a profound effect on the movement, evaluation and attraction of the various categories of gold mining shares.

The XAU gold index is also showing the possibility of a head and shoulders top with the neckline at 125. But there is also the possibility of a reverse head and shoulders with a neckline at 150. I know this data is contradictory but it does advise some degree of caution until the index pushes back above the 150 level to confirm the bull trend.
The FT Gold index is of concern. It has a potential head and shoulders top pattern with a sell divergence on both its MACD and RSI. A break under the neckline would be nasty for the gold shares. This will negate if the index moves above the 250 index level. But it does signal caution in dealings with gold shares at this point of time.

Jul 22, 2006
Dr. Clive Roffey
South Africa
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"Gold Action" is a fortnightly commentary on global gold and precious metal markets produced by Dr. Clive Roffey, Johannesburg, South Africa, a leading professional independent commentator on gold markets since 1969.

'Gold & Silver Penny Stocks' is the sister publication to 'Gold Action' and is produced by Dr. Clive Roffey; croffey@mweb.co.za

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