Ongoing Precious Metals Correction - Two Scenarios

Includes: GLD, UDN, UUP
by: Boris Sobolev

Five weeks have passed since the recent correction in the gold market commenced. Gold lost 10% in this time period, while the precious metals stock indices fell by 16%. Over the past two weeks, precious metals stocks stabilized ($XAU even climbed by 1 point). Is this a temporary breather before more downside or did $1075, set one week ago, mark the bottom?

If we are in the midst of a short term correction similar to those that occurred in December 2005 and November 2007, then in the next couple of weeks, gold is likely to find support and should commence its rally to new highs, likely to $1300-$1400. This scenario, from our point of view, is most probable. It will remain our preferred scenario if gold will be able to hold the main (black) uptrend line in January and not close below $1025.

If the black uptrend line and the $1025 level do not hold, this will mean that the high of $1225 set in early December was an intermediate period top and that gold has entered into a multi-month consolidation.

From a technical perspective, gold is approaching a short term oversold condition while its counterpartner, the US dollar, has reached overbought readings. In addition to the fact that the $USD has entered a level of heavy multi-month resistance, including resistance posed by the 200-day EMA at $78.4, it has also reached a zone of a multi-year resistance at 80.

Additionally, in the past few weeks, there have been major changes in the US dollar futures markets. Commercial hedgers have quickly switched their large net long positions to net short positions – now close to all-time-high levels. Large and small speculators have moved to an extremely high level of net long positions.

At a minimum this means that the time for profit taking should be very close for the US dollar.

Continuing growth in inflation expectations and the stability of the S&P 500 in the context of the growing US dollar also supports the point of view that the dollar rally is only a short term rebound from oversold levels and is going to stall in the near future.

At the same time, the situation with the overly optimistic sentiment on gold has improved. Public opinion on gold has finally dropped sharply in the past couple of weeks. The Hulbert Gold Newsletter Sentiment Index (HGNSI) also fell very substantially on December 21-22 from 53.8% to 10.9%.

Such moves in sentiment are typical for a bottom building process which could last well into January. The one notable cause for worry in the sentiment picture is the stubborn bullishness of the Rydex mutual fund precious metals traders. This indicates the potential for trader capitulation in the coming days and weeks.

We will view additional weakness in gold and precious metals stocks as an additional buying opportunity.

Disclosure: None