Overstretched Gold Stocks Due For A Pullback

Includes: FXI, GDX, GLD, TLH
by: Clif Droke

Gold mining stocks have rallied too far, too fast in recent weeks.

Technical indications suggest a corrective pullback is in order.

Dominant intermediate-term rising trend will remain intact, however.

Gold and gold mining shares continue to be one of the top-performing assets this summer as global growth fears abound. And yet a case can be made that gold stocks in particular are becoming vulnerable to a potentially sharp corrective pullback. In today’s report, I’ll explain the reasons for the increasing vulnerability of gold stocks to short-term selling pressure. However, while the probability is high that we’ll see some sort of “correction” in the XAU index this month, the dominant intermediate-term rising trend for gold shares is expected to remain intact.

Trade tensions continue to support precious metals as the gold price continues to hover around the $1,500/oz. level. Gold’s recent 4% rally last week also marked the first time since April 2013 the metal has managed to exceed $1,500.

Gold Continuous Contract

Source: BigCharts

Continued worries over the state of the global economy have driven shares of many China companies to year-to-date lows. It has also led to a troublesome increase in U.S.-listed shares making new 52-week lows on both the NYSE and the Nasdaq. The turbulence which equities are now subject to is forcing many participants into the safe havens of gold and U.S. sovereign bonds, both of which have dramatically outperformed stocks in recent weeks. Shown here is the iShares China Large-Cap ETF (FXI), which provides an idea of how poorly China ADRs have performed lately. Due to the trade war focus, there has been an inverse correlation between the direction of China stocks and the direction of the gold price.

iShares China Large-Cap ETF

Source: BigCharts

Another sign that the demand for safety is very high right now can be seen in the following graph of the iShares 10-20 Year Treasury Bond ETF (TLH). This chart compares TLH, my favorite proxy for T-bond prices, with the gold price. It shows just how strong the fear among traders has been in recent weeks. And yet for all the demand for government bonds, gold is still clearly outperforming Treasuries as can be seen in the chart below. The out-performance of both assets serves as a further reflection of the unrestrained fear and uncertainty generated by the recent acceleration in the U.S.-China trade war.

iShares 10-20 Year Treasury Bond ETF

Source: BigCharts

Yet another indication of how much gold is in demand right now can be seen in the latest data for gold ETFs. Holdings of the world’s largest gold-backed fund, the SPDR Gold Trust (GLD), rose by almost 2% last week. They’re also up by some 7.3% in the year to date. Precious metal ETFs also saw the fourth-largest inflows in history last week, according to Bank of America Merrill Lynch, based largely on investors’ fears of a global slowdown.

Aside from gold bullion, one of the hottest markets right now is the shares of U.S. and Canadian-listed gold mining companies. Gold stocks have lived up to their billing as a way to leverage a gold bull market, with the PHLX Gold/Silver Index (XAU), the industry benchmark for the miners, having risen some 32% in the last two-and-a-half months. The XAU has also been driven higher by investment fund demand as hedge funds and money managers are chasing one of the few upside momentum trades of the summer. Yet the XAU's runaway rally of recent weeks has also caused it to become distended from its widely watched 50-day moving average, as can be seen in the following graph.

PHLX Gold/Silver Index

Source: BigCharts

This naturally begs the question: Are the gold stocks in danger of becoming overheated? On a short-term basis, the gold mining stocks are indeed in danger of becoming overheated and overextended from a technical perspective. Too many actively traded gold shares have become overstretched from their 50-day moving averages, which is one of the classical definitions of a market that’s vulnerable to a sharp pullback.

Another sign that the gold stocks are in danger of a corrective dip in the immediate term can be ascertained by the slowdown in the 4-week rate of change (momentum) of the net new highs among the actively traded mining shares. The new highs and lows are my favorite way of gauging the demand for gold stocks. The relentless tendency for many small-cap, mid-tier, and senior mining shares to make new highs in recent weeks has allowed the XAU index to maintain a rising path. But a small-but-growing number of gold stocks (mostly those with large exposure to copper mining) are beginning to make new quarterly lows. That’s one sign that a measure of internal weakness has entered the broad mining stock market. And while this isn’t enough reason to sell the miners, it’s certainly enough of a concern to keep bullish gold stock positions on a fairly tight leash right now.

Shown below is the 4-week momentum of the new highs and lows of the 50 most actively traded U.S.-listed gold mining shares. As you can see, this important measure of the market’s internal momentum is still in a rising trend and is bullish. Yet there is a definite slowing of the rate of ascent and also the threat that gold stock internal momentum may soon turn lower. If at any time in the coming days we see a lower peak being established in this indicator it will be time to raise protective stops even higher and take profits on some of the biggest winners among individual gold stocks in your portfolio.

Source: NYSE

Despite the growing possibility of a corrective pullback in gold and the gold mining stocks, the continued risk of an ever-growing trade war will serve to keep a strong bid under prices. Gold’s intermediate-term (3-6 month) demand will also be assured by continued weakness in China stocks as mentioned above. And while I expect a test of gold’s 15-day moving average this month, gold’s dominant intermediate trend should remain intact based on global safety concerns. Gold mining stocks should also continue to benefit from this in the months ahead thanks to the leverage factor in the mining shares. Investors are therefore justified in maintaining longer-term investment positions in gold and gold ETFs, as well as gold mining stocks.

On a strategic note, I’m currently long gold via the VanEck Vectors Gold Miners ETF (GDX). For this ETF I’m using a level slightly under $27.00 as a stop-loss on an intraday basis. Participants who haven’t done so should also book some profit in GDX after its impressive run of the last few weeks.

Disclosure: I am/we are long GDX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.