Market Observations with Chris Puplava

Chris Puplava

Gold & Gold Stocks Setting Up for a Strong Second Half?

By Chris Puplava, July 29, 2009

Back in February an article was penned in which the case was made for a period of underperformance in gold relative to the general stock market (Gold, Is the Future Still Bright or Fading?). In this article a case is made for a strong second half for both gold and precious metal stocks.

Gold Technical Indicators Oversold

Over the last year I’ve developed two indicators to help identify major tops and bottoms in gold. As seen below, major tops have been witnessed when the FSO Gold Technical Indicator #1 is north of 2, and February’s reading of more than 4 led me to believe that gold was due for a correction. Readings north of 2 and especially north of 3 are often followed by significant corrections in gold, with the prior occurrence seen in early 2008 when gold first neared $1,000. After that overbought condition gold fell more than $200 over a multi-month correction. A similar occurrence was seen in 2006 when gold jumped to over $700 an ounce for the first time since the 1970s bull market. That overbought condition resulted in a sharp sell off in gold and more than a year long consolidation before gold moved higher. In contrast to the last two readings of the indicator north of 2.0, the overbought condition in February resulted in a moderate pullback with a multi-month consolidation to work off the overbought condition. A market that works off an overbought condition through a consolidation rather than a correction is a sign of strength as it indicates that the bears could never really gain the upper hand and drive prices lower. This is what was seen in gold after the February reading north of 4.0, the most overbought reading seen in 26 years, where gold simply consolidated rather than stage a significant correction. The FSO Indicator #1 is approaching -0.5, with readings in this vicinity often marking major bottoms in gold over the last decade.

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The more intermediate indicator, FSO Gold Technical Indicator #2, is also nearing a level that has marked prior bottoms. The last time the indicator reached these levels was back in September when gold was in the $700s, with gold over the course of the following months staging another assault at the $1000/oz mark. The current reading may be signaling a coming advance in gold in the weeks and months ahead.

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Seasonal Pattern

Further support of a likely advance in gold in the second half of the year in addition to the FSO gold indicators is that gold is approaching its strongest months of the year. So far this year gold has been tracking the seasonal pattern seen over the last eight years, though with greater volatility. Below you can see the 2000-2008 average seasonal pattern in gold along with the current year’s path, with both normalized to 100 at the start of the year. Typically an intermediate peak in gold is seen in July followed by a correction into August that sets up a significant bottom in gold before it stages its greatest advance of the year.

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Like gold, the AMEX Gold Bugs Index (HUI) has been tracking fairly closely its seasonal path this year, also with greater volatility. Typically the HUI makes an intermediate low in late July to early August and rallies into late September, followed by a correction into October and then a strong move to finish the year. If the HUI continues to track its seasonal pattern it may be putting in another significant low before a rally into the fall.

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Gold Stock Breadth is Bullish

Further support for a possible rally in gold stocks over the coming weeks and months is that the breadth of stocks in the Market Vectors Gold Miners (GDX) exchange traded fund that are below key moving averages are at levels that typically mark bottoms. For example, the percent of stocks within the GDX that are above their 20 day moving averages currently rests at 22.6%, while only 12.9% of GDX issues are above their 50 day moving averages. With the number GDX issues above their 20 day and 50 day moving averages at oversold levels that have marked prior bottoms, gold stocks may be set to stage another advance in the coming weeks and months.

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The USD, Setting Up for Retest of the 2008 Lows?

Perhaps another key element to a significant rally for precious metals in the second half of 2009 would be a break in the USD Index below the May lows to set up a retest of the 2008 lows. After peaking in March of this year the USD Index has been in a defined declining trend and is currently battling to hold above 78. Looking at the relative strength index (RSI) shows that USD Index may be nearing an important juncture as the rising RSI trend line (green below) is approaching the declining trend line (red below) that has been in place since the momentum peak in August of last year. Since then there have been two prior periods of the RSI rising to meet the declining trend line, and breaks through the rising green RSI trend line have marked intermediate tops in the USD. We are at a third occurrence with resolution likely to play out soon as the USD is currently testing the declining RSI trend line and a break through to the upside would be bullish and may signal that the declining trend in the USD since March is over. However, a break through to the downside of the rising green RSI trend line and a break below the late May lows could signal the USD is continuing its slide and set up for a retest of the 2008 lows.

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Source: StockCharts.com

One sign that tends to support a break in the USD to the downside is that the 50 day moving average is now below the 200 day moving average. This is the third significant breach of the 50 day moving below the 200 day moving average this decade, with each marking cyclical bear markets in the USD within the secular bear market that began in 2002.

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Source: StockCharts.com

A look at the season pattern for the USD Index was done in order to further determine where the USD may be heading in the second half of the year. Unlike gold and the HUI, the seasonal pattern for the USD is not as well defined where the USD Index in some years stages an impressive second half rally while in others it stages a significant decline. What was seen when looking at individual years was that the USD Index tended to follow either a bullish or bearish seasonal path for the year, with the path typically decided in April to May, with very few years showing undecided direction. From 2000 to 2008 there have been four bullish years in the USD Index and five bearish years.

Below is the average seasonal path of the bearish and bullish years in the USD Index normalized to 100 at the start of the year. You can see how the bearish and bullish seasonal paths in the USD Index do not really part ways until late April and into May. From there the USD Index either trends higher or lower through the rest of the year.

As seen below, the USD Index this year is tracking closely the bearish seasonal pattern in the USD and may be setting up for a short-term bounce into late August before resuming its decline.

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What was also done was looking at the current year’s pattern in the USD relative to the average path of 2002-2003, when the reflationary efforts of the Fed were beginning to take hold and the stock market was putting in a bottom, which may describe the current environment. If the USD Index continues to follow the path of the 2002-2003 average, a period where reflationary efforts were beginning to gain traction, then we can expect a sharp sell off in the USD during the second half of the year which would be bullish for both gold and gold stocks.

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Summary

Gold and gold stocks may be setting up for a strong second half of the year, and may have or may be putting in a significant low. Gold and gold stocks currently have many bullish supports that would suggest a rally is in the cards. The long-term and intermediate-term FSO Gold Indicators are both at levels that have marked significant lows, the seasonal pattern in the second half of the year is favorable for both gold and gold stocks, and breadth measures rest at levels that have marked prior lows. Perhaps the greatest key to the next move in both gold and precious metals is the USD Index. A break below 78 would signal a likely powerful move in precious metals while a break above the June highs of 81.38 would signal that precious metals are likely to further correct as the USD would be signaling its declining trend since March is over, with a potential renewed advance higher. With the declining trend line in the USD Index approaching the key 78 level, we may not have long to find out whether the USD is going to continue to head south with precious metals likely advancing, or the opposite. Resolution either way will be signaling whether gold and gold stocks have a bullish second half of the year run, or further consolidation.

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Source: StockCharts.com

Chris Puplava

© 2009 Chris Puplava

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