“One of the big differences between the current situation and the situation in early October of 2005 is that in October of 2005 the US$ had been trending upward for 9 months and was close to an intermediate-term peak, whereas the US$ is currently (in our opinion) at the tail-end of an intermediate-term decline. Putting it another way, the US$ has considerably more upside potential now than it had in October of 2005. In fact, we think the US dollar can currently be likened to a beach-ball that is getting pushed further and further underwater. The pressure being applied by speculative selling may continue to force it lower in the very short-term, but at some point in the not-too-distant future it will catapult upward. We therefore continue to perceive significant downside risk for gold and substantial downside risk for gold stocks associated with a US$ recovery.

The downside risk for gold stocks is much greater than the downside risk for gold bullion, for two reasons. First, the gold-stock indices recently became extremely ‘overbought’ relative to gold bullion. Second, US$ weakness has been one of the propellants of the global stock market rally, so the initial phase of the US dollar’s next upward trend will probably be associated with parallel declines in the gold market and the broad stock market. This could result in gold stocks being simultaneously hit from two directions.

Outlook

Gold bullion ended last week at a new multi-decade high while the HUI finished the week about 2% below its 11th May-2006 and 21st September-2007 peaks. This is a bearish divergence because the stocks typically lead the metal at important turning points, although it clearly wouldn’t take much additional strength from here in the gold-stock indices to eliminate the divergence.

Regardless of whether the HUI is in the process of completing a major double top or is immersed in an intermediate-term upward trend that will take it much higher over the coming months, a sizeable pullback is likely to occur over the next few weeks. As previously advised, history tells us to expect the HUI/gold ratio to trade at least a few percent below its 40-day moving average prior to the next short-term bottom. If this happens over the next few weeks and gold concurrently pulls back by around 5% then the HUI will drop to the 340s.

The sort of pullback described above is the most likely short-term outcome even if the overall upward trend is going to remain intact.

The risk is that a top of longer-term significance is currently being put in place. This possibility doesn’t mesh with the current fundamental backdrop and is therefore not the most likely intermediate-term outcome, but the fundamentals could change and therefore need to be continually re-assessed. Just to quickly recap, the main fundamental drivers of the gold price are credit/yield spreads, nominal interest rates, inflation expectations (the expected rate of purchasing-power loss), and currency exchange rates….”

Says Steve Saville at Speculative Investor.

Comment:

Well, this has been my thinking too (I think the Fed Reserve’s future rate cuts this year have been priced into the dollar already), but the sharpness of the decline following September’s cut took me by surprise. So much so that I am no longer sure of my dollar reversal theory.

I worry that should the credit problem unravel further and show signs of hitting the banks even more, there will be a run on the dollar.

What to do? When in doubt, do nothing — especially nothing that is too fast or too drastic. Think incremental. Take metal/foreign currency profits in increments on dollar strengthening but be prepared to do a 180 degree pirouette and buy back when the dollar moves against you.

This makes you, of course, a speculator and a trader.

Neither activities terribly good for the economy or the social fabric.

But you are absolved from guilt. When the big fish trade, the little fish have to as well. For several years now, buy and hold has been a bad strategy except for the sharp of wit and the deep of pocket. For the rest of us, guessing the short term movement for buying opportunities, and knowing the long term trend for knowing what to buy has been the best strategy.

The trend for the dollar is down. But right now, we might be at the end of a midterm decline.

On the other hand, there is a  wild card —  the credit crunch…..

Nothing like stumbling  on the rairoad tracks with your belongings in a bundle and trying to second guess the speed of the train bearing down on you.