Has gold finally bottomed?

Let me start by saying I think it’s hard for anyone to call a bottom.  Many experts do, and often they do so with the guidance of charts, fundamental analysis and other informed speculation.  I am no expert, but I do think we’re finally seeing a turn in the precious metals markets based on two critical factors.

The US dollar and gold have rallied together as of late.  This doesn’t often happen, especially at multi-year highs in the dollar.  But it has for the past couple of days.  And during very large US dollar rallies.  As you can see in the chart below, for the past six months when the US dollar rallied, gold and silver were sold.

US dollar chart

This is a convincing indication that the precious metals markets are looking beyond the myopic view of the US dollar index (which really only measures the Euro and Yen weakness/strength vs. the US dollar) and seeing that rising risks demand a safe haven.  It may also indicate that the US dollar rally is beginning to lose its luster.

We also saw that the tax loss selling last year did not push gold and silver to new lows, or break down the miners further.  This is a very powerful indication that sentiment bottomed out in the October/November bloodbath that was likely a capitulative event.

I am not ready to say that we are turning right now, but I do think that there is a good chance of it.  In essence, if the precious metals markets can look beyond the dollar, or better yet, the dollar can begin to give back its rally from late 2014, we will be in for a year of renewed strength in precious metals, and their miners.

US dollar short vs long

The US dollar trade is as crowded as a trade can get and so many are short Euros and Yen that any unexpected surprises will roil the forex markets.  But gold and silver are telling us that doesn’t matter.  That they can look beyond forex and see that the risks are strong enough to warrant a significant bid (and most likely short covering — we’ll see the COT tomorrow).

Gold chart (daily)

From a technical standpoint I’d like to see gold trade above $1,260.00 on a sustained rally (closing the week on Friday above that level would be critical).  Ideally this price action would occur by the close of the second week of January, 2015.  After that I believe we’ll see some short covering and less aggressive posturing from the sellers counting on another waterfall capitulation in prices.

If gold can make its way back to $1,400 by the end of the first quarter of 2015, then I do believe we’ll see the momentum chasers come back to the table and start driving prices higher through leveraged speculation.  This may also renew the appetite from Asian buyers for physical bullion as the low prices have turned from a positive to a perceived negative as of late.

Head and shoulders setup on major indices?

Could the Dow Jones and other major indices be setting up for a head and shoulders style technical-driven sell-off?  It will depend on what the Fed has to say next week, but also on the rate of deterioration in Europe and other news-driven event risk.

For the pattern to play out, some more upside may occur, but not further than about 11,600.  The downside target, should the Dow slip below 10,600, would be approximately 10,000, but if the sell-off accelerates we could see a dip to the 9,600 to 9,800 level.

Which way the market goes is uncertain, but on the weekly charts the recent technical damage has created the potential for further downside risk.  I began aggressively taking equity positions off the table in July, with the exception of some silver and gold miners.  I encourage all readers to exercise extreme caution in the coming weeks and months as the global equity markets are extremely volatile, illiquid and therefore less volume can create much larger percentage moves.

Is the rally real?

Much of the rally has been predicated on increased optimism because the recession may be slowing. Many recessions have double dip bottoms and most bull markets are not led by the same groups that led the last bull market.

In addition, the US still has a lot of problems with the deleveraging consumer, potentially insolvent banks and a financial system whose accounting has reverted back to off balance sheet trickery and mark to make believe models.

How can we believe the rally is real if it is within the context of one of the sharpest downturns the world has ever seen, where the fundamental macroeconomic picture has not improved and nor has there emerged a true cyclical leader for the next bull market?

It’s time to sell the rally

For the past seven weeks there has been an impressive, rip roaring 30% bear market rally from the March lows.  There has been no fundamental reason or glimmer of hope that truly spells the end of this recession.  Instead what we have are bank earnings that no one in their right mind can trust with the amount of accounting trickery taking place.  Consumer credit card interest rates skyrocketing.  Record foreclosures in both residential and commercial real estate.  And a parade of uninspiring earnings and guidance from the S&P 500.

Room for gloom and doom

The market has been ignoring bearish news which  could be viewed as bullish, except it is also ignoring the fundamental macroeconomic picture.  Emerging markets in Eastern Europe and Asia are hard hit by the global economic crisis.  Some are on the brink of default with their sovereign debt, forcing them to seek loans from the IMF.  Others are rapidly devaluing their currencies.  Either  path demonstrates signs of extreme financial stress.

There is no end in sight to the problems with real estate, which led us in to this mess.  We have yet to see a meaningful bottom in housing and now commercial real estate is suffering.  GM is on the verge of bankruptcy with few alternatives and to top it off global GDP will likely shrink the first time in decades.

Froth at the top

On a technical basis the S&P 500 seems to be overextended.  It has been overbought too quickly for most of the momentum to be sustainable.  In the last week we’ve seen a lot of that momentum fall to the wayside.  While consolidation is normal, we can’t with any confidence declare this as more than a bear market rally to which an abrupt and painful end may be in sight.  The bank stress tests are expected to start being released to banks this Friday and to the public in early May.  The old adage “Sell in May” could be a very meaningful pronouncement for this Summer.

Keep your powder dry

I recommend using this rally as an opportunity to raise cash, sit on the sidelines and wait for a good buying opportunity for the long term.  Short term the best position is a short bias.  I don’t feel that being constructive after such a massive build up, especially when some of the larger gains have been on light volume, is warranted.  Possible support exists at 850, 830, 800 and 775.  At this point it is conceivable that we also retest the lows in the 660s over the Summer depending on how severe some of the interim problems become.

Anatomy of a bear market rally

Why have we witnessed four up days of trading that rocketed from the lows of 741 to nearly 890 on the S&P 500? Is it the start of a new bull market? This would be a very pleasant scenario, but bear market rallies can last days or sometimes even weeks and months. The most violent rallies, like those as of late, are generally short lived. The last time the market was up four days in a row was April, 2008.

How are bear market rallies possible?

Lately we’ve seen anything from government appointments to bail outs of multinational banks significantly lend to positive momentum. This is quite a contrast from the traditional inspiration of good earnings or economic data.

Bear market rallies are not created by investors buying to commit capital in to a stock for the long term, but instead by short covering and trading. The short term horizon of the participants and the lack of fundamental positive catalysts usually lends to these rallies collapsing to worse levels than they had climbed from, rather than a constructive bottom forming process.

When will we see the bottom?

A) The worst must be over: House prices are still dropping, unemployment is rising, consumer sentiment pushing all time lows and credit availability is tight. There is likely another leg down coming in both commercial mortgage backed securities and consumer credit card defaults.

B) There must be a positive catalyst within sight: Green energy has been promised to be the next bull market. Is there demand for these measures when oil is at $50 a barrel? The other question is, after committing half of last year’s GDP to financial bail out programs, how will the Federal Reserve and US Government continue to finance their spending? More importantly, will foreigners continue to lend to a less credit worthy nation?

C) The Federal Reserve must complete lowering rates and change to a neutral or tightening bias: The next Fed move will likely be another rate cut. To Bernanke’s Fed, deflation is still a bigger threat and he has the helo running full time dropping cash. Until this reactionary behavior is over, there is no sign that we are out of the woods.

D) Businesses must begin buying back shares: Many buyback programs have been halted, not accelerated. We have not seen corporations step back in and buy back their own shares. We also haven’t seen many insiders provide substantial equity commitments in their companies as of late. This is an important component of building a sustainable bottom.

E) Risk indicators must begin to show signs of significantly decreased aversion: The Japanese Yen, crude oil, one and three month T-bills (and lately even the long bonds) have all shown us that the flight to quality and away from risk (or growth) remains. The VIX is still above 50 and has major support at 45. Even gold prices are back above $800. Fear still seems to be a greater motivation than greed.

What are the charts saying?

Structural bear market in S&P 500

The above S&P 500 chart is not confidence inspiring. The trend lines illustrate the wedge patterns and the horizontal lines show major resistance areas.  Currently the stock market is bumping in to major resistance. My indicators confirm this rally is overbought and due for a correction soon. 

Where are we heading next?

Based off the above analysis, I don’t feel this rally will get much above 900. Instead, we need to retest the intraday low of 741 on the S&P in the next few weeks.  There will probably be support areas on the way down at 875, 850, 830, 800 and 776. If the 741 low doesn’t hold, 600 is the next level of major chart support.

If you’ve made some money on the rally, don’t fall in love with the upside.  Remember that we still have a lot of problems to work through.  Folks with investments should use this as an opportunity to raise cash. If you’re looking to trade this rally, you may want to begin adding to short positions.  FinViz.com has some great tools for screening stocks if you use technical analysis to find your trades.  Good luck and stay safe!