Trader’s Narrative

Not surprising after the extremely negative sentiment in the US dollar index, the greenback has staged a modest rally. In response, gold has wilted. Here are few perspectives on what may be next for the precious metal:

Elliott Wave International
Arguing for the bearish case, is Robert Prechter of Elliott Wave International. He writes that since 1913, as shown in the chart below, the purchasing power of the US dollar has eroded by 96% (great job Fed!). If gold had simply offset this loss in purchasing power, it would have to have increased 25 times. But instead gold has multiplied in value by 50 times. Therefore, Prechter argues, it is 50% ‘overvalued’.

This is a strange sort of argument because most gold bugs would say that gold’s strength, the very fact that it has gone up so much, reflects positively on the precious metal. Prechter has had a very hot hand lately in timing the stock market so I’m willing to listen to his argument even if it sounds a bit odd. It appears that he implies that gold’s only sensible ‘value’ is to be the anti-dollar. However, I’m not sure that’s a valid point because as far as I’m concerned, gold is just another commodity with all the inherent susceptibilities to manias and panics we ascribe to other more traditional markets like stocks.

While I’m reticent to embrace this line of thinking, I do agree with something else that Prechter wrote recently about gold:
Continue reading ‘What’s Next For The Gold Bull?’

Proving the old technical analysis adage true that the more a level is attacked, the higher the probability that it will break, gold recently broke through the $1000 ceiling and closed at a new, all time historically high price.

While this got a lot of attention in the media, gold sentiment remains relatively subdued in response. Since gold is the haven sought by dollar bears, the big question is whether this important technical move is a result of weakness on the part of the US dollar or whether it is secular strength from the gold market pure and simple.

The simple way we can look at this question is to strip away the effect of the US dollar by dividing the price of gold by the US Dollar Index, as the chart below shows:

With US dollar sentiment at historic lows, the dollar continues to be about as popular as a leper. In contrast, the yellow precious metal continues to be the belle of the ball. Today it closed at a new, all time high at the Comex. The December futures contract closed at $1045, decisively higher than even the intra-day high in March 2008 (when the fall of Bears Stearns lead to a panic).

Here is a short video covering the recent move and a look ahead at what’s coming up at the hard right edge of the chart (make sure to watch till the end for a bonus):

It wasn’t too difficult to anticipate a successful break above the hitherto challenging $1000 level. An analysis of the investor sentiment in gold revealed a mostly bland response to its advance this time around. Unlike previous rallies.

As well, gold’s seasonality was the wind at the back of its uptrend. However, as you’ll notice from the seasonality chart in the previous link, a pull back is to be expected for gold in October. At least, that’s what has been average historical pattern.

Checking in with the K-Ratio (the ratio of the price of gold to the Philadelphia Gold Bugs index), we see it in neutral territory:

This recent move helps to cement the long term uptrend for gold, however it isn’t smart to chase it higher. Once a decisive break through tough resistance like this is made, it is typical to see a pull back to that level again as it acts as support. With the seasonality weakness about to kick in, that’s what I’d expect to happen. So keep watching this market for a good opportunity.

Also keep in mind that there are many ways to play this. You don’t have to buy gold futures or the Gold ETF (GLD). There are many highly leveraged mining companies that provide a fantastic proxy for this precious metal. The K-ratio still has room to move higher, which means that relative to gold, gold equities are not expensive.

Finally, the bigger picture is the slow decline of the dollar. I expect a rally in the US dollar, especially as the sentiment is so extremely pessimistic. But the long term trend is clear. There are some rumblings in the background that oil producing Middle Eastern countries, along with China and Russia are working together to stop pricing crude in US dollars. As well, the Reserve Bank of Australia wins a gold star for being the first among industrialized nations to start on a tightening cycle.

With the second year anniversary of the 2007 market top coming up in a few weeks, here is a video which points out that the S&P 500 index’s date with destiny is also marked by two major technical forces:

The reason for a correction are piling up. We’ve already talked about sentiment and Lowry’s expectation of a correction. This is yet another reason to rein in any bullishness (at least in the short term).

While this rally has gone on longer than even the most optimistic bull predicted, don’t forget, we are still mired in a secular bear market. As the video mentions, we have yet to put in a higher low to denote that we have a change of trend.

While everyone’s attention was on a head and shoulder pattern completing on the Standard & Poors 500 index, another head and shoulder formation was taking place in gold. As the magical $1000 marker acted as strong resistance several times, a consolidation pattern emerged below it.

Here’s a good video update of the recent price action. Click the chart below to watch the video:

While head and shoulder formations are usually considered to be reversal patterns, they can also act as continuation patterns. This is less common and fewer technical analysis students know about it, which makes it more likely to complete. As we’ve all noticed by now, the head and shoulder formation in the equity indexes was noticed and watched closely by everyone and their uncle. Which is why it turned into a bear trap.

The other possibilities are that we could get an irregular head and shoulder pattern. This is a variation where the shoulders are not symmetrical. For example, we could have two shoulders form in the right hand side. The whole pattern would still be valid but it would take longer to play out.

Also, we could see a sideways trading range which would then suggest a large cup and handle pattern instead. Either way, if the price of gold continues to trade within a short distance from the $1000 resistance, the probability of it breaking up increases.

Finally, we can look at the K-ratio to get a sense of the gold market. This is a ratio of the gold equities compared to the price of gold itself. It was first proposed by the technical analyst Jay Kaeppel and I estimate it by using the Philladelphia Gold Index (HUI) and the futures price of gold - instead of the original formula of Barron’s Gold Mining Index and the Handy & Harmon price. There is a minor difference in the two but the important thing is keeping things consistent by picking one method and sticking with it:

According to the K-ratio, the best time to buy gold stocks was in late October 2008, when they were almost as cheap as they were back in 2001. Of course, we now know the 2000-2001 era as a generational opportunity to buy gold - just as the majority were preoccupied with the technology sector. You can also see that the 200 rate of change for the ratio was confirming the buy signal. Right now they are both in neutral territory. This presents a bullish opportunity because if the price of gold breaks through the long term resistance, the K-Ratio still would have room to move up before becoming overbought.

Last Call
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