Gaming a Gold Stock Bottom

By: Michael Swanson | Tue, Aug 5, 2008
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Last Wednesday morning I wrote an article titled "Gold Stocks are Near a Key Bottom." When I put the article together I was looking for a bottom in gold stocks to put my own money to use in. Except for a small position, I have been out of them for awhile now and have been looking for a bottom in July/August to mark an end of their summer long consolidation phase.

When I wrote the article I wasn't sure exactly when or where the bottom would come. I thought it could happen that day or within a week, but by the end of that day gold stocks put on a classic "key reversal" by falling hard on the open and then closing in the green. I had started to average in a few days before, but built a full position that day, but then ended up selling out on Friday as the stocks fell back down to my Wednesday entry point. My thinking was simple - I bought thinking that Wednesday was a bottom, but when the gold stocks fell back down they negated that possibility and therefore the reason for my Wednesday trade had proved to be invalid. The only thing I could do is to sell the position I entered on Wednesday and reevaluate things.

This is the type of thing you have to do when you try to game bottoms. Last week we saw gold stocks fall to a key support level at which they should have bottomed. They didn't. When you make a trade or take a position you have to have a rational and reason. If that reason turns out to be wrong then you must sell your position and look to get back in later or reevaluate your thinking. Few people do this and that is why most people lose tons of money in bear markets. How many mutual funds are still holding on to Fannie Mae and Freddie Mac? From watching CNBC most mutual fund advisors are in denial of the reality of the bear market.

Now I still believe that this current drop in gold stocks is going to lead to a huge buying opportunity. At the moment I write this though I'm not sure exactly where they will bottom at. I don't look for bottoms simply because something is down. The market or stock I'm looking at needs to hold at a key support level - which is what gold stocks appeared they were doing last week - or else make some technical sign that they are bottoming. Buying just because something is down and with no game plan can send you to the poorhouse.

So let's take a look at the charts for gold stocks and see what we can gleam from them.

Gold stocks have been in a bull market since 2002. During this time the 200-day Bollinger Bands for the XAU and HUI have tended to act as support and resistance. The lower 200-day Bollinger Band for the HUI is now sitting at 377 so you should consider the 375-380 zone as key support for the HUI. For the past six years the lower 200-day Bollinger Band has only failed to hold as support for the HUI twice. Once was in 2005 and the second time was last August when the market went into a mini-meltdown.

During both of these times the HUI fell 11% below its 200-day Bollinger Band and then bottomed. After that they bottomed and rallied hard, went sideways for about a week, and then blasted higher to rally well beyond their 52-week highs.

What is more both situations led to extreme oversold levels in the XAU/gold and HUI/gold relative strength ratios. In fact these ratios are extremely oversold right now, but that doesn't mean they can't go lower.

In a Monday morning WSW Power Investor Elite members only note I wrote the following:

"This means one of two things."

"Either gold is going to fall hard and fast to catch up with the oversold readings in these ratios, but gold stocks won't fall as much as the metal. For instance we could see gold fall down to 850 while gold stocks actually hold up. That would give us a powerful signal to go long gold stocks. In 2005 for instance - forget about it falling below the lower band for a second - gold stocks lagged the metal badly for week after week. Then all of a sudden the stocks stopped dropping and the metal continued lower. Something like that could happen now. Last week I was looking for the stocks to hold support for a buy point, but if they fail to do that this week then I'll have to look for another signal to buy."

"If they don't hold support here then gold stocks will likely go through their lower 200-day Bollinger Band and have a hard and fast sell-off like they did in August of 2007 and May of 2005. That would lead to an extreme oversold condition in the stocks only seen twice in the last six years. Both of those times led to incredible buying opportunities and if it happened again it would be another one."

Right now as I write this I can't say exactly what is going to happen or at what point I will buy. I can't predict the future. That isn't the point of this article. What I'm trying to show you are the thinking processes involved in trying to play bottoms in a market. You need to have evidence that points to a bottom and then be willing to get out if the evidence turns out to be wrong. That is what happened to me last week when it comes to gold stocks.

Secondly I want you to know what is it I'm now looking for to try to show me that gold stocks have probably bottomed. The bottom line is that I need to see some sort of evidence that gold stocks have bottomed before I buy back in to try to play a bottom again. Gold stocks tend to bottom in one of two ways. They either start to hold up for several days - or even a week - and then turn up or else they start to hold up while gold continues to drop to start to show strong relative strength against the metal. Neither of these has happened yet. It looked like gold stocks were about to turn up last week, but that was a fake out. So I'll be watching the gold market carefully going forward for signs of a bottom.

Once it comes I still believe it will be an incredible buy point. The bottoms in 2005 and 2007 led to immediate huge rallies in gold stocks. There is no reason now not to think the same thing isn't going to happen again.

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Michael Swanson

Author: Michael Swanson

Michael Swanson,
www.wallstreetwindow.com

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