Gold Rally Fails. Will a Big Drop Be Next?

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 |  Includes: GDX, GDXJ, GLD
by: Daryl Montgomery

On May 11th, gold closed at a new all-time high above $1200. I was at the Hard Assets Conference in New York that day and I was probably the only person in attendance that was not enthusiastic about the yellow metal's short-term investment potential. Now, only nine days later, it looks like the breakout has failed.

GLD, the largest Gold ETF, had reached a high around $120 in early December of last year. So far in this recent breakout it traded up to only $122.23. GLD closed at $116.63 yesterday, convincingly dropping below the high from late last year. GLD is now likely to test its 50-day moving average, which is currently a little below $113 and rising. So far, there is no serious damage on the technical indicators, but this could take place in short order as occurred with stocks before the crash on May 6th.

When trying to determine what gold is going to do, it is a good idea to look at mining stocks. These almost always lead the metal both on the way up and the way down. Interestingly, GDX, the gold and silver ETF for the major mining companies, failed to make a new high and break out in the days around May 11th. This non-confirmation was disturbing at the time and is even more disturbing now. GDX almost touched its 50-day moving average in the almost $30 drop in gold prices yesterday. The more volatile GDXJ, the junior miners ETF, convincingly sliced through its 50-day and closed well below it. The technical indicators on GDXJ are starting to look quite sickly. The juniors are clearly breaking down and it makes sense that they should lead the way for the complex. If so, bullion itself could be in a lot of trouble soon.

Investors should remember that gold sold off substantially in the fall of 2008, although not nearly as much as most stocks or other metals. Junior mining stocks were as devastated as the financials and had some of the biggest drops of all. If we are entering into another global financial crisis, gold may once again fail to live up to its safe haven reputation. This situation can arise once again because the central banks cheaply lease their gold to the big banks and hedge funds. When the trading houses are desperate for cash because they are having difficulty selling their assets, they can lease gold and sell it on the open market immediately. This sudden supply being dumped on the market overwhelms safe haven buying and suppresses gold prices. If we have begun global Credit Crisis #2 because of the problems with the euro, investors will once again have access to bargain priced gold. It's at that point that investors should stock up.

Disclosure: No positions.