Has Gold Bottomed?

It looks as though gold is getting ready to make a comeback and once again move higher. After a violent decline of over two hundred dollars in the price of an ounce of gold, it appears as though we have finally put in a short term bottom. The result of this downturn has created incredible buying opportunities in gold and, especially, in gold stocks.

One of the indicators that I like to follow is the GOLD/XAU ratio. Written about in an earlier blog, this indicator has proven itself in indicating good entry and exit point for gold stocks. Not since late 2000 has this ratio shown such an unequivocal buy level. As shown on the XAU performance chart below, the result of buying into gold stocks in late 2000 would have yielded a return of over 95% by early 2002.

Historically, gold stocks tend to lead the trend of the price of gold. What we are seeing now is no exception; while gold stocks broke through their descending trend line last week, we are only seeing gold beginning to do the same.

A vicious turnaround brought gold down from its July high of $989.60 to a low of $777.70 in mid August. That represents slightly over a 21% drop in the price of gold and a deeply oversold level for the MACD indicator. By definition, a correction is defined as a drop of 10% to 20% over a very short period. As such, the price movement we have witnessed over the last two months fits perfectly into this definition of a correction and is not, as some may fear, the beginning of a bear market for gold.

The correction was brought about by a strong rally in the US dollar. While the US dollar was heavily oversold and was due for a swing back in its price, its current level now seems over extended. It is inherently difficult for most gold bugs to ‘buy’ the dollar, as it holds no true intrinsic value. Some argue that it represents shares of stock in the United States of America, Inc., as it were. If this was the case, it would be a screaming SELL! As a company, the US would be considered to be poorly managed and heavily in debt to the point of bankruptcy. As such, it is difficult to see any fundamental reason why the current US dollar rally has any sustainable legs.

Gold, on the other hand, does have fundamental strength to justify a higher valuation. Most significantly, gold has a finite supply of which there is currently decreasing. According to the latest World Gold Council report, the total gold supply has been decreasing since the third quarter of last year. As of the Q2 of 2008, the total gold supply has decreased almost 16% since Q3 of 2007.

All the signs seem to be pointing to the fact that we should be accumulating gold at this price. If, however, more convincing is needed, we keep a close eye on this week’s closing price of gold. It should be closely watched, as it also coincides with the month end’s closing price. This will be a telling indicator as far as what to expect for the near future.

-by D. Malcolm