Next Six Weeks to be Moment of Truth for Gold Stocks

By: Michael Swanson | Mon, Mar 19, 2007
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Gold and gold stocks have certainly shaken up the gold bulls over the past few weeks. And with good reason. Gold fell from almost $700 an ounce to its $630 support level while the XAU fell below 130 after reaching 150 in February. The correction caused many to sell and throw in the towel, while others now worry that gold will go down in a broad market correction.

But in reality, due to various technical and fundamental factors, gold and gold stocks are actually in a better position to move up now than they were six weeks ago.

After peaking out last May, gold and gold stocks have been trading in a range for almost a year. They have had volatile ups and downs, but even these moves have been well defined and remained within a year long trading range. We have seen gold stocks do this before.

Since 2002, gold has been in a bull market characterized by sharp rallies of eight to ten weeks followed by year long periods of consolidation. The action over the past year has fit this pattern of consolidation following an intermediate-term peak which precedes the start of a new bull run.

You can see this pattern clearly in the chart above by taking note of the green 200-day bollinger bands. These long-term bollinger bands measure the weekl volatility of the XAU. When they come together it means that volatility in gold stocks is shrinking and when they move apart it means that volatility is expanding. These two bands have also acted as powerful support and resistance zones for gold stocks.

Not only have the two bands defined the support and resistance of XAU consolidations preceding strong bull runs, they have also given warnings when each of the large bull runs in gold stocks were about to begin. The past three bull runs in gold stocks began when the two bollinger bands came together. The past three major intermediate-term rallies in gold stocks began within six weeks of this important technical signal.

The 200-day bollinger bands are in this position once again. They are alerting us that the one year phase of consolidation in gold stocks is about come to an end. By themselves they can't tell you that a move is going to be up or down. But they do indicate that a major new intermediate-term trend is right around the corner, which is just as important. Six weeks from now gold and gold stocks are either going to break out above their intermediate-term resistance level (the 150-152 area) and begin a new bull run or they are going to break below 123 and begin a bear market.

The next six weeks are going to be the moment of truth for gold stocks. In my estimation the result will be a move to the upside due to fundamental factors, which I'll cover in a moment, but first I want to take note of another technical factor in the gold market.

Gold stocks tend to lead the action in the metal. That means when gold stocks outperform the price of gold it is bullish for both but when gold (the metal) outperforms gold stocks it is often a warning that the rally is not going to last. We just saw this happen in February. Gold stocks didn't go up faster than the metal during this rally and, not surprisingly, a dip was the result. I thought we were going to pause a bit, but not drop as much as we did, But I can see the reasons why.

During the previous three major periods of consolidation in the gold market gold stocks lagged the metal. You can see this in the downward plot of the XAU/gld ratio in the above chart. However, once this condition came to an end and the XAU/gld ratio broke out of its downtrend resistance lines, new bull runs in the gold market began that led to riches for gold and gold stocks investors.

I'm expecting a rally over the next few weeks. One that will take the XAU up to its upper 200-day bollinger band. If that rally is accompanied with the XAU/gld ratio trending up to its downward resistance trendline then I will take this as confirmation that a new bull run is right around the corner. Once the XAU gets up to the 150 area I'd expect it to pause for a few weeks. This should be the final calm before the big move and it is during this time that I'd expect the XAU/gld ratio to breakout and give a major intermediate-term buy signal.

There are fundamental reasons to expect gold to rally this year. The US current account deficit hit a record 6.5% of the total US economy in 2006. Historically, when nations reach a current account deficit level above 5%, foreign creditors begin to worry about the sustainability of the country's deficits and the prospects of inflation and so they sell that country's currency and demand higher rates of interest for its bonds thereby causing a financial crisis.

We are nowhere near a crisis, but we could very well be on the verge of one. Last year the U.S. ran a deficit on investment income for the first time ever since record-keeping started in 1929. Investment flows turned negative by $7.3 billion from a surplus of $11.3 billion in 2005.

The current account deficit has been growing since the 1970's, but its growth has recklessly accelerated under the Bush administration. With the administration committed to expanding the unwinnable Iraq war (which will cost an incredible $1,000 per person in the U.S. in 2007) and beating war drums in regards to Iran, one should expect this trend to continue. Vice President Dick Cheney has claimed that budget deficits "don't matter."

So far he has been right, but at some point it will matter to foreigners. The debts will become so massive that creditors will not believe they will be able to be paid off. Or they will fear that the US will have to allow its currency to drop and create inflation in order to pay the debt. There has been talk of creating a controlled drop in the dollar on the part of powerful banking interests in the United States for the past several years as a way to fix the current account deficit.

The current account deficit and potential run on the dollar on the part of foreign investors is a hidden monster in the room. Clear for everyone though is the reality that the US real estate market is slowing down. This will eventually put a damper on consumer spending and US economic growth. The previous red hot real estate markets in the US are nowhere in the shape they were a year ago.

The financial markets are now expecting the Federal Reserve to cut interest rates later this year, with the Fed funds futures markets pricing in over a 90% chance of a rate cut in August and then another in November. With the present inverted yield curve in the bond it seems very likely.

Ultimately, higher gold prices and a falling dollar will be driven by lower interest rates. It is the last cycle of rate hikes that has indeed kept the dollar index above its 80 dollar support level and gold prices below $700 an ounce for the past year. Lower rates will be extremely bearish for the dollar and bullish for gold. This is the key fundamental factor that I believe will drive gold higher.

Right now two things define gold and gold stocks this year. One is that they have been consolidating for over a year and are poised to begin a new powerful intermediate-term trend. And secondly, that the Federal Reserve is going to begin to lower interest rates six months from now which will pressure the dollar and provide fuel for the gold bull market.

What to do now? Take a risk-free trial to WSW Power Investor and read my daily thoughts and bulletins on the gold market and the rest of the stock market. Get access to my Top Ten list of stocks that I think you should look at buying right now. Learn how to adjust for risk in this highly rewarding market and be a more profitable investor in general. If there ever was a time to sign up it is right now. These are going to be the most critical six weeks of the year and you don't need to be left in the dark.

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Michael Swanson

Author: Michael Swanson

Michael Swanson,

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