Now remember another one: “Don’t fight the Fed.”

Well, what happens when the Fed fights the trend, as it has been recently?

Which axiom to believe?

Historically, the Fed loses that fight until the trend is ready to turn back around. Admittedly, the central bank’s inflationary policies will likely help this occur at a higher nominal dollar value than otherwise.

Nevertheless, the historical odds favor the trend over the Fed when these two maxims collide.

But putting aside my autistic wisdom for a moment, let’s consider what the Federal Reserve is doing for the trend in gold prices — a trend, I am loathe to inform you, which it is not fighting.

Let me sum it up by reminding you that the trajectory of this bull trend shifted north when Bernanke took the helm of the Federal Reserve System, and that the policies pursued by the Bernanke Fed have confirmed the investment thesis driving the bull market in gold. As one pundit recently noted during a Bloomberg interview, “You gotta go with the inflation theme…it’s the only thing still working.”

After upping the size of its new Term Auction Facility from $60 to $100 billion last weekend, the Fed revealed another innovative tool that might help it manage liquidity in the banking system.

The new facility, the Term Securities Lending Facility (TSLF), will offer up to $200 billion in Treasury securities to primary dealers in exchange for a wide variety of collateral the Fed has never before accepted, including private-label mortgage securities. It also eased swaps with other central banks.

The controversy is that although the Fed has been allowed to accept mortgage-backed securities as collateral since 1980, it has never outright bought them, and only recently enacted legislation that allows it to actually monetize them — which means buying them without having to sell other assets.

Gold bugs have followed the Fed’s legislative changes with interest. This move should not surprise any of them, but it does hold a special significance in its long-term implications, and for gold prices.

And even though the Fed hasn’t expanded bank reserves or the monetary base much since August, it is helping the banking system postpone an increase in reserve demands triggered by criteria built into the Basel II framework, a generally accepted model for capital adequacy standards. By boosting the quality of bank reserves, even if temporarily, the Fed hopefully won’t need to increase the quantity of bank reserves, which have been sufficient to fuel an $800 billion expansion in the broad U.S. credit aggregate, MZM, since August. That is 11%, or 15% year over year. The highest rate since 2002.

That is a bullish recipe for the precious metals. There is nothing more bullish for gold than a situation in which the central bank refuses to acknowledge that it is pouring gasoline on a raging fire.

Forget the dollar and oil. Those were just interim preoccupations.

The real bull market is about to stand up.

If gold prices are going to continue to drive through $1,000, they are going to do it because the central banks are all inflating madly at the worst time. This means that a good old-fashioned bear market on Wall Street is sufficient to keep central bankers’ collective pedal to the metal and sustain the gold bull.

So far, the precious metals stocks have bucked the general stock market trend since August.

This is as it should be, and it is impressive because, by most counts, gold stocks are quite expensive relative to today’s gold price. But investors are complaining about the underperformance of those stocks relative to gold, and also about the lackluster performance of their junior mining assets, which haven’t participated in the precious sector rally at all since August — when the current leg started.

There are a few explanations for this.

Perhaps John Embry said it best at a gold conference in Vancouver, British Columbia, recently, when he remarked that gold shares sometimes act like a bet on gold, but sometimes they just act like plain old shares.

We should leave it at that.

However, that is not like me.

Historically, I have found that gold shares are susceptible to market declines, except occasionally during a major bull market advance in gold, when they tend toward counter-cyclicality — the more so as the bull market progresses. They will still fall during stock market panics, as all shares do, but they are likely to come back harder and hold their trends better. Still, since 2004, I’ve held the position that, as an asset class, gold shares would not outperform gold prices for the remainder of the primary leg.

I continue to think that, with the qualification that we are talking about the average gold stock.

Junior markets are wired differently. They do not correlate that well with the underlying commodity trend in the first place. In my experience, they correlate better with market attitudes toward risk.

Junior and small-cap markets have never fared well in a general market meltdown, because they are typically risky assets, and in a selling panic, the crowd is averting risk.

The larger-capitalization precious metal producers are different. The reasons for this are sound. But as a rule, speculative assets do well when the gambling environment is friendly.

However, within the small-cap resource sector, there will invariably be exceptions. Many of them are cheap now, and the supply fundamentals for gold are tightening.

Production from many gold-producing regions of the world is currently constrained by power shortages, and rapidly inflating development costs are causing the postponement of several otherwise promising development projects around the world.

Meanwhile, gold producers need reserves!

The large-cap producers are on the hunt for sound mining assets.

And they aren’t going to be discouraged by a 20-30% drop in gold or stock prices.

I’m lining up several potential takeover targets for my new report right now. These include small-cap gold miners that have either just finished developing a new mine or soon will be, or whose assets are otherwise overlooked. And we’ll be publishing option strategies to profit from swings in the large-cap miners, too. Regardless of which way the markets go, I’ll show you how to profit from trend changes…

Regards,

Ed Bugos
March 19, 2008

Hidden Gold Shares Will Play Well in Down Markets was originally featured in the Penny Sleuth.