Gold Correction Underway?

At the risk of sounding like a broken record, we may finally be seeing the gold market have a healthy correction here.  In brief, assets have a tendency to return to their short term, intermediate term, and long term mean trend.  Although our intermediate term forecast for gold is at least 1300, running into spring of next year, that journey should be made up of smaller rises and consolidations.  A trip too quickly to 1300 implies either some euphoric buying without fundamental support that is unsustainable (sometimes called a blow-off top, a melt up, or a parabolic move) or, in this case, a dollar crash.  While the latter is absolutely possible, as we've discussed before, we don't believe we're quite there yet (just in case, that's the reason one should own some physical gold as insurance).  That leaves the former condition--simply put, we believe that gold has "gotten a bit ahead of itself."

Any correction in gold should be taken as good news for those bullish on the yellow, barbarous relic.  It's quite clear that the bull market has years--by our estimates, upwards of a decade--left to go.  Thus, consolidations represent good buying opportunities and can provide both traders and long term investors with good accumulation points that have a high reward/risk ratio.

Let's take a quick look at gold's action, some likely points of consolidation, and signals that could be used to make short and intermediate term decisions.  [Quick Aside: Our gold report, which is being written now, outlines the information presented here in greater detail.  We're working on getting it out the door now, but it's slowly but surely rivaling War and Peace in length...]

First, as always, the dollar....

As has been the case for a while, the slow stochastic has shown the dollar to be oversold.  Momentum is negative, but at a decision point where it could turn, and the RSI could go either way.  The dollar broke down through a triangle but has quickly rallied today, appearing to be thwarted at the 50 dma (the blue rectangle is our attempt to show what we believe today's dollar trading range will look like in advance).  We consider this a "false breakdown" which will likely be short lived before the downtrend is resumed.  Of course, a breach through the 50 dma that "sticks," meaning there's a clear penetration that holds at least overnight, will be a warning that something else could be in the works.  Note that the weekly and monthly charts do not show the dollar as oversold--yet.  That would be the catalyst for a larger rally.  We just don't believe that's quite in the cards until the spring.  The upcoming gold report, available by request only, has more detail on this condition.

So, why the dollar run up now?  What's the implication on the gold price?  Since the USDX is a basket of currencies, we have to look at the major components that move it, namely the euro and the yen.

Though it broke out last week, the euro has been tentative about moving further over the last 3 trading days.  Today, as noted by the large, red candlestick with the yellow highlighting (meaning that it is an intraday candlestick that is not yet final), the key support level around 150 (150.47, or 1.5047 in real currency terms, to be exact) gave way, implying a false breakout to the upside.  With the euro representing 57.6% of the USDX, obviously this has the most impact on a strengthening dollar.  The slow stochastic and MACD show it could move lower.  The key will be watching the RSI.  Note the red trendline since July just below 50.  There's not much downside room for the euro here.  We would expect a testing of the RSI trendline, which corresponds with a testing of the blue uptrend line which is tracking the 50 dma.  That will not take long to accomplish.  If the retest is successful (meaning it turns back up after it tests the blue trendline), then we will probably see a real, lasting breakout, especially if the slow stochastic is closer to 20 than 80 when the breakout occurs.  From a fundamental perspective, yesterday we saw dovishness from the European Central Bank (ECB) along with considerable jawboning down of the euro and support for the Fed.  It's a talking game, but it can work.  You can watch the replay of the press briefing at http://www.ecb.int/home/html/index.en.html.

Similarly, the intraday, 1 minute chart of the dollar against the yen shows a similar story.

The six month daily chart shows the yen's strongly overbought condition on the RSI and likely support region.  There's still some downside as the move that began around 5 days ago is probably only halfway done.

With both the yen, from an overbought condition, and the euro, from ECB jawboning, moving down against the dollar, this dollar move is not unexpected.  However, in both cases, the corrections will likely be over within the next week--at most.  Notably, the euro will probably not move much further down from here, implying that most of the dollar damage will be done in the next couple of days.

To contrast, gold is overbought on the daily, weekly, and monthly charts--implying that a substantial correction is ahead.  Given that this is a seasonally strong period for gold and the dollar is not oversold, we do not believe that gold will face a large correction until both the dollar is substantially oversold and the seasonally strong period for gold is over.  That will likely occur when the USDX is in the 70-72 range, at some point at the end of Q1/2010 or early Q2/2010.

So, what's the likely damage to gold during this correction, and how long will it last?

First, now that gold and the euro have "caught up" to one another and both are correcting, we believe this correction will be short term (next couple of weeks, at most) and will largely end when both the euro and yen are done.  For the dollar, it is likely that most of the rally will be done today with more possible "sideways movement" as the yen finishes its correction over the next week or so.  The implication is that most of gold's correction will likely happen today as well, with the potential to sell off more since the run thus far has been incredibly strong.

We overlayed the Fibonacci retracement lines from the point of this rally's breakout over the support lines we drew Wednesday to see where the likely support points are to watch.  If the dollar rally ends today, and it may, we may see the lows already at the 1195 area.  In that case, gold will remain dangerously overbought.  We would not add new positions until a more substantial correction occurs, though we would continue to hold our existing positions.

The more preferable target is around the 1130-1135 area.  Gold has found buying there several times already, including during the massive intraday sell-off last Friday (when it touched 1138).  1131 is a key Fibonacci retracement point.  All in all, that's a likely accumulation point given that it would not take too long (a week or less) to pull back to that region.  The timing works well with the anticipated pull back in the yen.

The 50% retracement level occurs near the 1100 level, which is where we originally anticipated the first sell off.  This would move gold, in the short term, to oversold and would a prime buying point at this juncture.

Finally, our old friend 1070 is also both a support point and a key retracement point.  That would gold if we could get such a pull back at this stage--pun intended.

 To each according to his own needs and risk tolerance, but here's how we'd play it.  We'd accumulate physical at 1070 and "paper gold" for trading purposes at higher levels.  Our longer term goal is to accumulate as much physical gold as possible with a low to zero cost basis.  The way we get there is to trade the intermediate term pull backs and accumulate when gold is strongly oversold.  That opportunity will likely come in the spring, but on the odd chance that we see a buying opportunity at less than 1100, we'd take it.

An important note.  If the dollar breaks its 50 dma, we'd hold off on buying anything until it appears that it is rolling over again.  The dollar rules it all, so there is not buying without a confirmation of a lower dollar move through a bearish pattern or a failed attempt at breaking resistance.  Again, we doubt that is in the cards until next year, but anything can happen.

We'll flash a buying signal here if the gold correction moves below the 1190 mark--enough to take a position in either paper or physical gold.

Enjoy the weekend!