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May 23, 2006

Leading Indicators for the Gold/Silver Stock Sector
by Clif Droke

What are the best combination of trend indicators for juncture recognition in the gold/silver stock sector? Are there any actively traded representatives of the precious metals stocks that can be used as leading indicators for the identification of shifts in trends? If so, what are they? In this article we'll try to answer these questions using examples from the recent past.

From a trend following approach, the best tools to use for identifying new trends in the gold/silver stock sector -- as well as spotting reversals of prevailing trends - can be found by monitoring the price action of four leading indicators: the XAU gold/silver index, the Amex Gold Bugs Index (HUI), Freeport McMoRan Copper & Gold (FCX) and Silver Standard Resources (SSRI). One of the important tools to use when following the action of these stocks and indices are the 60-day and 90-day moving averages. But just as important is to compare the action of these four in relation to the others. Doing so often yields valuable leading indications for trend reversals or trend confirmations. We'll look at some examples of how these four indicators can be used to generate useful trading signals.

In early December 2004 the XAU broke below its 90-day moving average for a period of several days. This followed a peak of 110 made in late November. During this period of time Amex Gold Bugs Index (HUI) and Freeport Gold (FCX) also peaked and broke below their respective 90-day moving averages, thus confirming that a top of at least short-term significance had been made. The rule of thumb seems to be that whenever the XAU and HUI indices along with FCX all close below their respective 90-day moving averages at the same time (after a sustained uptrend has been underway) then a top is signaled which is usually followed either by a downside correction or a lateral consolidation usually lasting several weeks.

Why is the 90-day moving average so important in confirming reversals of trend? One reason could be that the 90-day moving average combines the outlook of two very important intermediate-term cycles, namely the 30-week and 40-week cycles. (Keep in mind that moving averages isolate the half-cycle component of any given cycle so that a 20-day moving average, for instance, is tracking the 8-week cycle (40 days) as opposed to a 4-week (20 days) cycle.) But the main consideration when using the 90-day moving average is that it simply does an excellent job most of the time in reflecting both the underlying trend, bias and momentum behind a given stock or index. And when several stocks or indices within an industry or sector break below the 90-day MA simultaneously it shows that forces are at work that a trader cannot afford to take lightly.

Back to the November-December 2004 peak in the XAU. The leading indication of this top came not from the most widely followed gold stocks but from a leading silver stock. Silver Standard Resources (SSRI) had peaked at a high around $16.50 at the end of September that year and then fell to a low of $13 by the beginning of November, violating its 90-day moving average in the process. This early warning gave a "heads up" on the coming top in the gold stock sector as measured by XAU and HUI.

The leading silver shares usually peak and bottom at important turning points before the gold shares do. The white metal itself is quite sensitive to shifts in the interim trends among the precious metals and can be consulted when looking for potential trend reversals in gold.

Returning to our example of Silver Standard Resources, SSRI fell from its high of $16.50 in late September 2004 to a low of about $10 in April 2005. After reaching this area in April '05, SSRI started a bottoming process around the $10 level that continued until about mid-May, at which points SSRI reversed higher and signaled that its corrective decline from late '04 had ended and a recovery rally was born. During this same period (April-May 2005) the XAU index was still declining and didn't reach its correction low until about mid-May '05. The preliminary bottom in SSRI was made almost a full month earlier than the XAU's bottom, and there were many positive divergence signals in the internal indicators for SSRI (i.e., higher highs and higher lows) relative to the price line which also signaled a "heads up" that a bottom was being made.

At tops, SSRI usually precedes the XAU in turning down, sometimes leading the XAU by as much as 4-6 weeks. SSRI can also precede the XAU by being the first to bottom and, sometimes, by being the first to turn up after the bottom in commencement of a new upward trend. One of the best all-around leading indicator for confirming that both tops and bottoms have been made in the XAU, however, is FCX. By watching the action of FCX a trader can gain valuable clues as to the most likely direction the gold stock sector will move in.

Now let's fast-forward to October 2005. This you may recall was a period when many gold stock traders were becoming bearish on the short-term outlook for the sector and many expected a decline to lower lows to take place in the XAU and HUI indices. From a chart standpoint both the XAU and HUI had temporary peaked in late September and gradually edged lower through the latter part of October, briefly touching the 90-day moving average but staying above it.

If you were watching only the action of XAU and HUI alone you might have been misled into thinking this was bearish price activity. But had you been watching the action of Freeport Copper & Gold (FCX) at the same time you would not have been so misled, for FCX actually stayed above its 90-day moving average in October '05 and actually made a high above the late September peak by the end of October to send a positive confirmation signal when compared to the XAU and HUI indices. This is yet another of many instances when FCX has been a reliable leading indicator for the gold stock sector at important trading junctures.

To give another example of how the FCX often precedes the XAU at both tops and bottoms we'll journey back to December 2003. At that time Freeport had been in a long and uninterrupted momentum uptrend since May of that year. It rose from approximately $18/share in early May up to a high of about $46 in early December '03. By later that month, however, FCX had slightly penetrated beneath its 60-day moving average to warn of a possible top formation. After a minor rally to a lower high in early January, FCX once again broke below the 60-day MA and then broke below its 90-day moving average by mid-January 2004. This was the confirmed top signal.

The lower high FCX made in early January 2004 coupled with the break below the 60-day and 90-day moving averages was the leading indication that the XAU index was likewise headed for a fall. Once again, if a trader had merely fixed his attention on the action of the XAU alone without consulting FCX or another leading indicator he would have possibly been fooled into thinking that the trend was still up, for the XAU index actually made a slightly higher high in early January '04 even as FCX made a lower high. Moreover, the XAU did not break below its 60-day moving average in December '03 as FCX had done.

By mid-January 2004, three of the four leading gold/silver stock indicators (XAU, HUI and FCX) had all broken below their 90-day moving averages to confirm that a top had been made and warning that a potential decline would follow. The decline that materialized took the XAU from its early December 2003 high of 112 to a low of 77 in early May of 2004.

This is yet another example of why it's important to use the leading indicator/confirmation approach when trading the gold/silver stock sector. The XAU index by itself can sometimes provide trend indications but for consistently reliable signals over time it's best to use the combined action provided by the XAU and HUI indices along with FCX and PAAS.

Clif Droke
ClifDroke.com

Clif Droke is the editor of the daily Gold & Silver Stock Report. Published daily since 2002, the report provides forecasts and analysis of the leading gold, silver, uranium and energy stocks from a short-term technical standpoint. He is also the author of numerous books, including'How to Read Chart Patterns for Greater Profits.' For more information visit www.clifdroke.com.

Copyright © 2003-2008 Clif Droke

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