For the first time this year gold prices are breaking important technical support levels and might decline below $800 an ounce before this painful correction is over. Worse, gold stocks have collapsed since July and now sit at the same levels compared to two years ago.

Gold prices are now in negative territory this year for the first time since mid-2005. That year also coincided with a U.S. dollar bear market rally that drove the dollar 12.8% higher against the euro. Still, gold finished 2005 with an 18% gain.

Major Correction Likely

The correction now underway in gold prices will probably be far more severe than the declines posted in mid-2005.

Amid a wicked U.S. dollar reversal this month commodities are coming undone.

Since peaking on July 11, the CRB Index has tanked a cumulative 19% while gold prices have declined 16% and the XAU Gold & Silver Index has plummeted 34%.

If commodities were heavily overbought heading into July, then the opposite is now true following brutal declines in just four weeks of trading. Fears of an economic slowdown in Europe, Japan and other economies has resulted in the death of the “carry trade” or buying high-yielding currencies with weak dollars to finance global speculations. As the dollar strengthens, higher yielding currencies, including gold, are likely to decline further.

Blame it on Oil and Germany

The trigger for the latest decline in gold prices is the resurgent U.S. dollar, falling crude oil prices and the latest batch of economic data in Germany pointing to a contraction of 2nd quarter gross domestic product (GDP). The latter event was pivotal since it compelled a major directional shift in foreign exchange markets to dump the euro last week.

A big drop in crude oil prices is a major factor lending support to rising stock values since mid-July. As inflationary pressures continue to ease, the market has begun to discount the possibility of a quick economic recovery in the United States later this year. Lower commodities prices act as a tax cut, reducing the coast of living and allowing consumers the opportunity to redirect more disposable income to non-energy and food items.

The dollar, of course, had been heavily oversold for months. Since peaking just north of 1.60 euro, the greenback has rallied an impressive 6.5% since early July.

In Europe, economic growth is now slowing sharply following the release of second quarter German GDP, which showed a contraction. Along with other stumbling economies in the euro-zone, the European Central Bank (ECB) is unlikely to keep raising interest rates this year – especially if oil prices continue to decline. That makes U.S. dollar assets more attractive for prospective investors since Europe is behind the United States in the economic and credit cycle.

Dollar Rally has No Legs

Fundamentally, there is nothing to support a long-term U.S. dollar rally.

Unlike 1995 when the dollar established a secular bear market low against major currencies, this uptrend will inevitably run out of gas.

Bear market rallies appear quite convincing and can muster significant strength over a short period of time. But this one has no long-term muscle. Let me explain.

In the late 1990s, the United States posted consecutive budget surpluses, enjoyed massive foreign direct inflows and low consumer prices in an environment of accelerated disinflation. No major military conflicts occurred and oil prices crashed to $10 a barrel by late 1998 amid the Asian economic crisis and the collapse of hedge fund Long Term Capital Management.

The U.S. and global macroeconomic scenario is nothing like it was 13 years ago.

Soaring deficits, two major military conflicts, a distressed consumer, rising unemployment and a bear market in housing won’t lend support to a secular dollar rally. In fact, Bill Gross, PIMCO’s bond king, predicts lower interest rates in the United States over the next several months as deflationary pressures continue to drain economic growth. Lower rates won’t support the dollar.

Remember the Credit Crunch?

The Fed is in no condition to raise borrowing costs despite high inflation. The ongoing credit crunch has not abated with overnight borrowing costs still elevated and mortgage-backed securities still clogged. Over the last 30 days the stock market is up almost 8% but most credit indices remain at the same level or lower since the Paulson Fannie Mae and Freddie Mac implicit guarantee in mid-July. That tells me credit markets are still far from stable as the economy remains fractured across key industries like housing, retail, autos and airlines.

Gold Stocks for a Song

While gold prices are likely to decline further in this correction, gold mining stocks have already been pounded much harder. That makes some of the best mines in the business highly attractive at these low levels.

One important indicator I track now suggests a massive rally lies head for distressed gold stocks.

Since 1974, the Gold-XAU ratio has been greater than 5.0 for about 15% of the period. The XAU Index or Philadelphia Gold & Silver Index is a composite of leading gold and silver mining companies. Most of the stocks in this index are large-cap gold shares.

When the Gold to XAU ratio has been 5.0 or more, like now (currently at a whopping 6.06), the XAU Index has recovered with an annualized gain of 89.6%. When the ratio has been 4.0 or higher, the XAU Index has rallied an average 27.4%. But when the XAU has traded at 3.0 or less, the index has declined an average -36.6%.

The chart above, which is quite mind-blowing if you’re a Gold-Bug, strongly points to a major up-crash for gold stocks. I don’t know when this will occur but it’s safe to say speculators will earn a bundle once it bottoms. The current Gold-XAU ratio is an extreme 5.87 as of August 7 and at 6.06 as of August 11. The last time this ratio stood north of 6.0 was back in 2001; seven years later gold stocks have soared more than 280%.

The U.S. dollar rally still has legs and gold along with most commodities will probably continue to decline.

The buck has been badly oversold for months leading up to last spring and is now embarking on a secular bear market rally. In the absence of higher interest rates to support the buck, balanced budgets or a rapid return to above-trend economic growth there is absolutely no reason for the dollar to sustain this rally beyond a few months.

The United States will not escape an economic recession, possibly a hard recession. The contraction of credit combined with deflationary forces still plaguing the housing industry are events that won’t disappear with a minor housing rescue package or a government spending bill. The real threat to the United States is deflation, not inflation, and eradicating this threat to consumption will likely result in below trend growth for at least another 6-12 months.

The dollar’s rally won’t last. Don’t abandon gold.