October 8 Market Update: Dollars and Gold

US Dollar
We've written about the dollar's double top, and of course, the poor fundamentals, for some time now.  Inevitably, though, things run counter to the prevailing trend for a while.  While the dollar has had minor "bounces" from its downtrend which started in March, it will, at some point, have to have a larger and more sustained countertrend rally.  As we posted earlier today, we are of the belief that this more substantial rally will occur when the dollar reaches the 72 area, though it could (obviously) occur earlier.  We will be watching to see if the circumstances change.  However, the 72 region has been strong support in the past, and any time you have a double top pattern, you must expect that the entire rally leading up to the pattern will retraced.  Thus, the likelihood of a substantial rally at 72, we believe, is in the cards.  One could also view this chart, also as we've discussed before, as a descending triangle.  That pattern would take the dollar down to the 67 range.  Either way, the 70-72 range is likely to offer substantial support.

You can see that we are approaching oversold longer term and downward momentum is slowing.

We must look to the short term chart to determine what to expect over the next few days to few weeks.  We can see that in the short term, the dollar has more downside room to run.  The 50 day moving average, currently at 77.63, has been resistance since the decline in March.  If the dollar were to definitely break above the 50 day moving average at any point between now and the end of the head and shoulders target of 72, that would be taken as a warning that a reversal may be underway.  Other indications would be a rise in the RSI above 50, and of course, a return of credit stress.

As we reported on Monday, the dollar broke down from its pennant formation and retested 76 today.  Much like the response it had at the 78 level, there has been a dip below support and now a rebounding.  As of this writing, the dollar is at 76.08, having recovered from a 75.80 intraday low.  As we discussed when the dollar was at the 78 level, we need to see a definitive breakdown below the 76 level to consider that level broken.  Definitive, in this sense is as much an art as anything, but we would be looking for a 3% move below support that holds for a day or two and continues to move down.  At the same time, we can see that the short term dollar is approaching oversold on the 14 day stochastic.  We still expect a little more rally in the dollar at this level--possibly up to the 50 day moving average before it comes back to test 76 again.  We would expect to see a failure at that stage and a fast move down toward 72.

To illustrate a possible scenario, we can look at the short term dollar chart that shows an interesting chart pattern, a falling (descending) wedge.

First, we can see that the RSI has called intermediate dollar reversals very well.  Since we're not at the 30 level yet, the dollar probably has more downside--to 72, we believe, when the dollar will show up as strongly oversold, and asset prices will have gone parabolic for a bit.  This scenario would be a classic "melt up" top.

The dollar is in a descending wedge as can be seen by the blue lines on the chart above.  Many deflationists may start arguing that the dollar is set to bottom and rise.  First, wedges, as a general rule, do not imply changes in trend--only consolidation patterns.  Second, rising and falling wedges are notoriously poor performers with high failure rates, while double top and descending wedge patterns have some of the highest success rates.  In any case, you can see that a rise in the dollar above its 50 day moving average would signal that this pattern was in play.  Until the dollar breaks that level to the upside, there should be little concern.

Gold
In contrast, gold just activated its long term inverse head and shoulders pattern that we've been writing about for months.  Gold's strength has surprised us.  We anticipated that gold would consolidate more before it broke 1000 (where we recommended buying any dips below 1000), then more between 1000 and 1020-1024, and then more after it broke 1033, before it ran through 1050.  Clearly, gold has moved beyond our expectations and surprised to the upside (this is why we rarely trade gold, instead focusing on good entry points).

Unlike the long term dollar chart, which has 67-72 as a target range, gold is poised to hit AT LEAST 1300 on its long term chart.  Of course, this depends on the dollar's actions, and we believe it is dangerous to analyze one without considering the other.

On the long chart below, we can see the neckline, broken to the upside.  We are overbought on the stochastic and approaching it on the RSI, but momentum is on gold's side and the seasonal cycle favors it.

 The short term chart is very interesting as well.  We are overbought on the RSI for gold, which signals a very likely short term consolidation, and is also oversold on the stochastic.  We would not be buyers of any gold right now, unless the dollar broke down hard through 76 to the downside.

There is minor support at 1020, but significant strength at the 990-1000 level.  We do not believe we will move below 990-1000.  Now that the inverse head and shoulders pattern on the long term chart is active, the only way of invalidating the target is if gold closes below the head at 700.  We're not holding our breath waiting for that one to happen.  It goes to show the strength of this pattern.

A Way to Play It
This brings up the issue of how to play this dynamic.

We expect that the dollar will hover around the 76 level for a bit longer, while gold consolidates its overbought condition and the dollar works off its oversold condition.  This could last as long as a couple of weeks, but may only last for a few days.  That would represent a good "gold-oriented" buying opportunity as it neared the key support lines.

Once the downtrend on the dollar resumes, which we would confirm with a convincing breakdown through the 76 level, we would expect the move to be fairly quick toward 72.  Since we know that 72 is strong support, and the "gap" between 76 and 72 is considerable, we could expect a major upward movement in gold--perhaps to that 1300 level on the long term chart.  At this stage, gold would be very, very overbought and the dollar would be very, very oversold.  There would have to be a substantial countertrend move to work off the longer term overbought and oversold conditions, perhaps bringing the dollar back up to the 80 level.  This, in turn, would force a major sell-off in gold and spark the deflationists to come out of the woodwork.

Going long gold stocks or paper gold would enable a nimble and careful trader to capitalize and a rapid, and probably manic, gold buying/dollar sell-off phase, then take the profits and buy physical gold when the trend reversed.

Another way to do this may be to leverage the gold/silver ratio.

Gold rises in times of crisis and silver outperforms during inflationary fears.  We can see that since the first dollar top in October/November of 2008, the gold:silver ratio has been declining in a predictable channel.  At the bottom of the channel, and assuming a continued dollar downtrend without a credit stress component, a trader could move to silver and ride the wave to the top of the channel, move to gold, rinse and repeat until the dollar bottomed.  You do not want to be in silver if there is a panic/deleveraging crisis.  As long as it's manic buying (and not manic selling), then silver should outperform.