Gold: From the "It Ain't A Pattern 'Til It's a Pattern, But" File

The dollar rally is extending a bit further than anticipated in the last report, though we're on target in the original forecast area for an 81-ish handle on the USDX, though there's a case to see it extend to 82-ish. We doubt that this rally has much longer, but time will tell.

The USDX chart below shows the probable targets.  It appears that we're in an A-B-C correction (a bull flag) from a larger downtrend with a target in the 150-dma-to-200-dma range at the 81.74 - 82.00 range.  This corresponds also to a 50% retracement from the June highs of 88.71 and the target of the A-B-C retracement.  RSI is approaching overbought and the stochastics are overbought.  Cyclically, the dollar should be in a down daily cycle, but more EU fears continue to make it trend higher.  We do not anticipate a break through the 200 dma to be sustained more than intraday.  If we're wrong, that means the dollar is going to enter an intermediate term uptrend.

 

The implications for gold are interesting.  Since last year, gold has been moving up whether or not the dollar has moved up.  This is because gold is now a safe haven regardless of currency it is being measured against.   Since the bull market began in 2001, gold has had only 1 major correction--the 2008 deleveraging episode.  Since then, central banks have kept liquidity high (forget austerity--that's for the peasants, not for the banks) which has allowed only modest gold corrections.  It is unclear what fundamental event could force the price of gold down in any significant way at this stage.  Perhaps another liquidity crunch that forces deleveraging (unlikely as long as any monetary regime has fiat currency and a central bank), or perhaps a sustained period where the illusion that "the major problems are solved" reigns supreme.  Regardless of the fundamental event that justifies such a dramatic sell-off, the gold picture may be presenting such a scenario.  Below, we use the GLD as a proxy so the volume information can be easily analyzed as a useful indicator:

As the title of this article states, "it ain't a pattern 'til it's a pattern, but" we're setting up for the first opportunity in some time for a meaningful reversal in gold price.  Note that we have developed a left shoulder, a head, and what appears to be a right shoulder in development.  The shoulder heights are symmetrical, but if they are to remain so, today will likely be the short term peak in price. The neck is modestly upslanted, meaning that the degree of sell-off may not be as strong as the pattern should count downward.  The volume pattern supports a developing head-and-shoulders pattern.  The initial left should peak climaxes on peak volume, sells off on lower volume, and has a minor rally at the low point.  The head is formed at higher highs on higher volume.  The right shoulder rises on lower volume.  This is a classic sign of a trend running out of steam.

In support of this position are the MACD, ADX, and MFI, which have all been in a downtrend (bearish divergence) since the top of the left shoulder formed in late October:

 

 

Short term momentum disagrees and is still rising, but this is a shorter term indicator and will turn over only after the first day sell-off begins.  RSI and stochastics are not overbought, however. 

It seems gold is at a crossroads.  If it continues to move upward with momentum, the h&s pattern will likely not form.  If, however, short term momentum weakens, then any reasonable retracement will likely activate the h&s and lead to an intermediate term sell-off.  The answer may lie in timing:

The above chart can be complex to explain.  It attempts to mathematically measure the cyclical behavior of the underlying security and provide indications on when the security will "obey" the cycles or ignore them and trend in some direction.  With gold in a bull market, clearly the bias is to trend up.  The above chart shows gold trending up against any cyclical "magnets" that should cause it to sell off.  It is currently in a short term up cycle, but that that cycle is halfway through (approximately 5 more days of "up" time) and behaving very cyclically (as opposed to trending).  Unlike most indicators, the Hilbert indicator above is predictive and not based on moving averages or other time-delayed data.  In short, we believe that there is a good chance of a turn in the next 5 days that may activate the head and shoulders and produce a significant sell-off in gold (and corresponding buying opportunity when the weak hands are shaken out).

Head-and-shoulders patterns are reversal patterns--meaning that if it becomes active (as in, the price breaks below the neckline)--we should see a downtrend occur that has some moxie.  The pattern target would take it below the short-term Fibonacci retracements toward the 1225 level as a minimum downside target.  If we see a true intermediate term sell-off ala 2008, the target price will be closer to $1000.  We know, we know--no one believes that can happen (even us).  However, that's exactly why it might.  Note that you don't hear anyone out there talking about this pattern, which usually is a sign that it may just happen.

In summary, the preponderance of the evidence suggests a correction is coming.  It may be significant.

Here's what you need to watch:

• Gold price cannot move much higher than today's high without putting the h&s pattern at risk.  If we see a higher price movement, especially higher than the previous high, the trending will continue higher and a major sell-off will have to wait
• It is possible that a sell-off will only go to the neckline and not activate the pattern (somewhere near the 1320 level). We need to see a break through this level on volume to get a bigger sell-off.  This is the first stop now for a bounce.
• If the price breaks through that level on strength, the next level to watch is between the 150 and 200 dma in the 1250 range.  A sell off that doesn't stop there will see 1225.  It is in this region that we believe is most likely to hold.
• A sell-off that breaks through 1225 may well see something around 1000 - 1050.  This is an outlier, but a possibility.  At some point during this bull market, we expect to see a sell-off that will shake the confidence of the most die-hard bulls before moving to truly unbelievable highs.

We'll know a lot more about the possible outlook within a week.