Has Gold's Corrective Phase Begun?

by: Przemyslaw Radomski, CFA

A growing number of countries see a weaker exchange rate as a way to lift their economies. They want to export their way out of trouble. This war is over the ability to export to other nations and about keeping your own citizens employed during a period of an extended slowdown in global demand. Nations will either vault forward or fall behind, so they are trying to protect their own turf, a worrying signal that all is not well with the global economy. Countries tend to be less bothered about a strong currency in good times.

With further quantitative easing in the developed world, the appeal of hard, unprintable currencies like gold and other commodities will continue to shine. Given the budgetary jam U.S. leaders find themselves facing, they understand that one of the few options they have is to boost American exports by devaluing the dollar.

All this in the long term will be very good for gold.

Speaking of gold, the very long-term gold chart shows that gold moved up to the upper border of the very long-term trading channel. Last week’s stated target level was breached only temporarily. Although at first sight, Friday's intra-day action might give a different impression, it seems as though gold’s fervent rally may have cooled.

Click to enlarge:

Click to enlarge

Charts courtesy of Stockcharts

Thursday’s decline from intra-day highs is an indication that the corrective phase may have begun, mainly because of the size of the decline and the fact that it was accompanied by huge volume The obvious question now is how low will gold’s price go? Generally, specific targets fall in the $1,235 to $1,300 range. The good news is we have the strategy to determine which target will hold this downturn.

In recent weeks, gold’s price rise has been very much U.S. dollar-driven. As we discussed earlier, once the USD Index reaches a local bottom, likely in the 77-level range, gold prices will probably decline. This is precisely what we have seen in the last few trading days and it will be important to monitor the correlation matrix when gold’s price approaches the target levels defined above to see which market is best aligned with gold at the time. This will allow us to better anticipate the likely turnaround.

So, should you put a small part of your capital betting on lower gold prices in the short run? Generally yes, but we don’t' think that using any other instrument than options (or similar) is a good idea right now.

Disclosure: No positions

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This essay is based on the Premium Update posted on October 8th, 2010