<Correction: all comments referring to Monday were intended to mean Tuesday; changes have all been made>

There was lots of second-guessing going on this past week as gold shares dove faster than Al Gore's latest popularity polls. The volatility is likely to continue. But the bears' vindication isn't.

The louder the gold bubble crowd is, the more confident we grow that this bull market is still young. I won't waste your time with arguing whether there is or is not a gold bubble, since we dismissed it as fodder for the developing bull market just last week.

Don't Hold That Punch!
However, we would contend that analysts calling it so fall into one of either two categories, assuming they've been around long enough for at least one:

1. Those who missed calling the tech bubble for what it was, and/or
2. Those that missed buying the bottom in gold

Of course it's important to know their record, particularly if they claim to be some sort of authority on the subject of bubbles, a theory we can apply to only paper by the way if we want to avoid sounding, well, ironic. We don't define a bubble by how fast stocks go up or down, but by how far they are from reality, if you will. And it is important to think outside the box if the goal is to determine reality.

At any rate, sharp wild corrections will naturally follow sharp wild rallies. How far could a stock, which has tripled, correct and then continue on in a bull market rendering an otherwise scary correction in the moment irrelevant, with hindsight?

I don't know. Some would say up to two thirds of a move might be retraced in cases such as this, applying some variation of Fibonacci analysis. Some would say that the correction should at least tap the 200-day moving average.

We don't forecast corrections, though we do assess them and try to warn our clients if their likelihood increases. We try to predict bull and bear markets, or trends. As far as our outlook is concerned, moreover, we're not so sure this correction will be all that long, particularly since it has been so fast, and since our near term outlook for the dollar and gold prices is still as bearish as our long term outlook.

I think this kind of volatility is only going to grow. The action in Tuesday's session was bullish for gold shares, and could portend the end of the swoon that began last week. All of the major gold indexes registered a familiar one day reversal; one of the kinds of behaviors that has been extremely reliable in signaling the end to many corrections as well as the end to many rallies, particularly in the short term. Tuesday's behavior was classic. Most of the shares whose charts we read all saw a spike in volume after a gap down on the open; share prices tapped support just under the last highest low in the intermediate sequence and, if experience serves correct in my interpretation, suggests this move just defined the low end of a trendline. Almost every gold share we monitor carved the same signature on the chart. Follow through will be important, more so to short term traders, but the conviction of Tuesday's rally even as the Dow continued to unravel is already a good sign, from the bullish viewpoint.

On May 31st we wrote to our clients (in Subjective Values) that gold shares were fully valued in the short term, specifically at $330 gold, yet undervalued in the long term relative to our outlook for gold prices. We used Newmont as our case study and calculated that at $300 gold, the shares are worth $28 if priced at their average multiple of cashflow over the past five years, but at a conservative 8 times (operating) cashflow they are worth only half of today's market price, or about $15 per share. At $400 that range grows from $25 to $46; at $500 gold we calculate Newmont's shares could be worth from $38 based on eight times cash to $71 per share based on 14.6 times cash - its five year mean.

(The report is available to subscribers. See our Subscription Page for details).

Thus, if you're bullish on gold, and can't decide if it is better to sell or hold your gold stocks, the questions to ask are: how long will it take for the price of gold to get to the $400 - $500 range to reflect better value for my shares? And, in such circumstances, what is the more valuable currency to hoard: a gold share or the dollar?

Should gold prices break through $339 they'll have completed a near perfect five year double bottom. Our confidence is high that 1999 was the bottom in this market for some time, perhaps ever. I know that sounds bold, but it's not really.

During late 2000, after a one-year decline in price from a post Washington Agreement buying spike, the same analysts calling this market a bubble today saw gold going to $180. The reason we argued, at the time, they were going to be wrong was that the conduits that helped sustain the monetary boom had been impaired. Whether the Fed targets asset prices or not, the fact remains while asset prices go up, the dollar carries an investment premium that enables a check on the prices of goods and services, and in turn buffers value of the currency. To the extent they try and influence this premium we could say they control, export, hide, or sustain the inflation.

Inflation is not prices. It isn't a change in prices. It is a "process" that results in too much money first, and debasement second. The way in which it accomplishes this is more varied than Marx's imagination. But it always is a process that affects (usually dislocates) individual valuation judgments within an economy. Interfering with the mechanism of prices, which Adam Smith called the invisible hand, is only part of the story, and only the beginning of it at that.

The rest of the story lies in what happens to the economy's capital structure, and then to its currency once the investors propping up its value realize how long it will take to heel the resultant dislocated structure. In other words, how long before real profits come back (Ed Bugos).

Flash From The Past
When the tech bubble first popped, we realized right away that the US current account deficit was in danger of halting the dollar's ascent. The gruesome fate of the stock market suddenly made the current account deficit seem unsustainable. But many analysts at the time still largely questioned our objection to a deficit that had been sustained for as long as their careers probably spanned.

By late 2001 it was apparent to most of Wall Street that interest rates were going to stay sticky despite the fall in commodity & asset values, and the government's deteriorating books weren't going to help matters there. Even if rates could lower, and they did in the short end, this we argued would only further dislocate the economy's structure. We argued that stock prices would not benefit, and that profits weren't likely to come back until the economy was allowed to heal itself laissez faire like.

In the meantime, the bear market on Wall Street meant that analysts had to start thinking differently about where earnings would come from now that stock prices weren't going up every day, and companies couldn't report windfall investment gains as well as other shams without getting caught.

A few months ago we wrote about the crumbling pillars of dollar policy, another conduit that has enabled a check on prices (or control of the inflation), though this one is deliberated to certain ends. In this case we've sensed a division in the team that has traditionally run economic policy, specifically, the US President, Chairman of the Fed, and Secretary Treasury. Clinton's complicity in this union was an important element supporting the US strong dollar policy. But equally, Bush's apparent disloyalty to this team in mismanaging the nation's fiscal ledger, and proposing his new not so free trade doctrine, are factors that undermined it, and consequently may have impaired the Fed's ability to manage interest rates.

America's former "freer" trade position was a bullish factor for the dollar (or dollar denominated assets to be precise) to the rest of the world, and helped its standing as an international reserve currency. That's because Greenspan knows there is a market that determines what is money, and I believe this is why the EU understands the importance of freer trade itself today?

The point of the brief historical recap is that we've argued for an inflation breakdown (breakout to most people) ever since 2000, and nothing has happened in the past week to change that outlook, so we won't be getting bearish on gold anytime soon.

In fact, the markets have moved closer to this inevitability, even as we write. The dollar is three points from reversing a primary bull market, and gold prices are $18 from beginning a new one. Wall Street's bear market is still decisively on. Since most investors continue to remain bearish on gold's longer term prospects, and bullish on the broad market, of course the noise from that camp will be louder during each correction in gold shares, and rally on Wall Street.

And although gold shares did trade a little ahead of themselves, who are we to say if they will stay ahead of themselves or not. I know I'm not smart enough to guess how smart everyone else is. But we do think that if gold prices complete the five year double bottom we see developing on the chart, technically they are likely to aim for $425.

I'm a technician because it works when my brain doesn't. But if you're not, it ought not to matter because the fundamentals seem even more bullish than that tepid target.

Valuation Is A Process
...just like inflation is. It takes a market to determine value and the market may change its mind tomorrow about the value of something. In our kind of monetary system, most any determination of value will depend on how the inflation alters our valuation judgments tomorrow, relative to the recent past.

If for instance, the major stock market averages recover into the summer, one could say that the inflation is working to help bulls revalue the dollar. If the foreign owners of wealth in the US decide to invest their liquid proceeds in either real estate or directly into long term fixed projects, as opposed to repatriating them, one might be able to say that the inflation has been worked to underpin the dollar.

Any number of scenarios could evolve to save the dollar before it cracks 108, which is the level that would confirm our analysis. But the conduits, or tools, which have made life so easy for policymakers in sustaining the inflation & purchasing power of the dollar over the past decade, are now working against them.

When I meet with old mining gray hairs at the soup kitchen they tell me that it's not over; that the government can sustain the value of the dollar relative to gold in particular. In my opinion they've underestimated the market. Their eyes may be on the "crisis" ball that bounces around unpredictably, save to the privileged few puppet masters.

I believe the bull market in gold is part of a healing process that will end once the vast majority of investors understand why gold is money. I see the market rejecting the government's models for the economy throughout that process.

The Sky is Falling... It's a Bubble
The process of revaluing gold is still young. We haven't even seen the point of recognition.

Instead we hear warnings from the professional investment community about the danger of gold bubbles who sound like Chicken Littles running around telling us the sky is falling just when the sun is rising.

Their timing is impeccable, though it is the same thing they've been saying all along. It's just more perceptible this week because gold shares are down nearly 20% by the average index (before Tuesday's close).

The technical resistance points that controlled the 5 year bear market in gold shares were blown away last month, particularly those pertaining to the shares of producers that aren't hedged.

Obviously, if gold prices are still in a primary bear market and the dollar is still defined by a primary bull market sequence, gold equities probably got ahead of themselves by jumping into a new bull market with both feet. In our view that was just the first punch. The question in determining the value of a gold share is not what will happen with India, or Iraq, or North Korea, it is what will happen to the dollar, and thus gold prices?

For in the end, a gold company's profits are determined largely by the price of gold.

Consumer demand for Jewelry can fall all it wants. Bearish analysts say that India is an important consumer of gold and that the higher gold prices go, the less gold will be bought in India. I would argue that while Jewelry demand has been an important component underlying gold demand in the nineties, investment demand is likely to replace it in the new decade, even within India at some point, but especially around the globe.

If we weren't counting on investment demand to make a secular recovery in the gold business, there is no way on earth we'd be so bullish on gold prices.

However, to the extent that new enthusiastic shareholders of gold mining companies haven't factored the rising risk premium that all stocks are increasingly having to contend with, into gold shares, this sector can fall along with a major stock market collapse at first, depending on its nature (severity), and depending also on how gold prices and the dollar react to it. Tuesday's bullish foot prints in gold shares on a reeling Dow is reason for optimism.

If the market factored in a $330 gold price a few weeks ago for most gold shares, it is factoring less today. But at that point where Wall Street's demise cracks the dollar's primary support at 108 (for the dollar index), and gold prices bust through $339, it is likely that gold shares will be undervalued, even in the short term.

The case for $180 gold will appear as it does in every correction we've had so far but it is going to require new highs in the value of the dollar against other currencies, as well as relative to the commodities that have been made scarce by the policies supporting the dollar over the past several years. But there is little indication, technically, that the plausibility of a recovery in the dollar's primary bull trend is anything other than... maybe we get a bounce off support before it hurls towards 100.

Deflation is a pipe dream. I mean that scientifically. Some prices will fall. But anything worth more than the currency it is denominated in is likely to rise in value relative to it, as a result of the atypical protracted bust side of the prior 20 year long monetary boom, and the nature of our monetary system. This is particularly true to the extent that a market still determines what is money.

And it is true so long as the Fed exists. In fact, it has been true as long as the Fed has existed. And it is why the gold business is a growth story.

So why would we sell our modest 30% allocation in gold shares because of a little bit of volatility?

We would if they became overvalued relative to our outlook. But since we expect gold prices to make it through $339 and head towards $425, sooner than most think, we feel they aren't.

If we are wrong about our targets for gold prices and the deflationists get their $180 gold then gold equities are indeed overvalued today. Being wrong about that obviously means we disagree with that outlook. Still, while this correction could grow deeper for gold shares, it would require either a crash in the Dow, or a significant recovery in the dollar's value... an outcome that recent action on Wall Street appears increasingly likely to prevent.

Ed Bugos