Between August 1976 and February 1980, gold bullion rallied in price from about $100 an ounce to well over $800 an ounce. It was quite an amazing rise I am told, and made gold bugs dizzy with excitement. In fact, between October 1979 and February 1980 alone, the yellow metal more than doubled in price as it soared in parabolic fashion to its ultimate high. Yes it was all very exciting. Well, right up until the point that gold topped out and proceeded to plunge over 64% in the following two years. But it sure was great fun while it lasted.
And for some the fun apparently never ended. For throughout all of the 1980s (and much of the 1990s) the "gold bugs" apparently did not get or chose to ignore the memo explaining that gold had experienced the classic parabolic rise, followed by the classic blow-off top, followed by the classic inevitable plunge, followed by the agonizing years of base building typically required to put Humpty Dumpty back together again, so to speak. So as a market junkie, for most of the 1980s my mailbox was filled with advertisements touting "the next big spike up in gold", "buy now to protect yourself from the coming hyperinflation", and "we will import all of our stuff from China, housing prices will collapse, politicians will grab our money in ways we cannot possibly fathom and entire industries will be swallowed whole by the federal government" (OK, a few guys were simply ahead of their time). But in general the point was that anytime you got a flyer touting gold or gold stocks you pretty much just snickered and went back to the important work of calculating earnings estimates for rock solid companies like GM, Fannie Mae and Sears. Now it appears that the worm has possibly turned.
Since 2001, gold bullion has rallied from about $260 to $1,000 in 2008. From there it fell back into the mid $700s and is now once again flirting with the "magical" $1,000 an ounce level (I assume that it must be magical because so many people are saying that it is). Sidebar: what exactly does it say about human nature that financial assets tend to hit support and resistance at round numbers? But I digress. So clearly the question on everyone's lips is "Paula Abdul for Ellen DeGeneres, are you kidding me?" Er, no wait, the question is "should I buy gold now?" And as usual - sadly - I don't have the answer. The only thing that I can predict with any accuracy is that the accuracy of my predictions cannot be predicted with any accuracy. Now this sounds like kind of a bummer until you consider the combined level of "accuracy" of all predictions ever made in the financial markets. In a nutshell, it amounts to a tremendous amount of sound and fury accomplishing next to nothing.
Fortunately, once you realize that relying on some guru's predictions is not such a good idea, there is in fact a better way:
Step 1 - Assess all relevant factors.
Step 2 - If action seems warranted, enter a trade.
Step 3 - Manage the trade so as to maximize profitability if the asset goes in the direction you anticipate and to minimize the risk if things go the wrong way (and by the way, losing trades are a part of trading, so learn to cut your losses and deal with it).
Back in the day this process was typically referred to as "intelligent investing", an unfortunately foreign concept to many people in this day and age of cable shows and blogs all shouting "buy" and "sell" at the same time. So let's take a closer look at the factors presently impacting gold and gold stocks.
THE GOOD NEWS
There are several positive factors presently impacting gold and gold stocks.
The Trend - The oldest adage in all of trading (not including "I'll trade you this apple for that fig leaf") is "The Trend is Your Friend." And my friends, truer words were never spoken. As one can see in Figure 1 the price of gold (ticker GLD) and gold stocks (ticker GDX) is presently in an uptrend (i.e., price is presently above the 30-week moving average). So to actually contemplate selling short gold or gold stocks involves violating one of the oldest rules of trading (which doesn't mean it would ultimately be wrong, only that it would be fighting the trend and would entail assuming a larger than normal degree of risk).
Figure 1 - Gold ETF (GLD) and Gold Stocks ETF (GDX) with 30-week moving average
Of course, most individuals are not considering shorting gold and gold stocks so much as they are wondering whether or not now is the time to buy. So let's put the trend down as "up" and move on to the next factor.
Triangle Breakout on Increased Volume - Hard-core market technicians recently experienced a "thrill up their collective legs" as gold essentially formed a triangle within a triangle within a triangle and then broke out sharply to the upside on higher volume. If you have studied charts patterns for countless hours ("Hi, my name is Jay") then you know that a strong breakout on big volume from within a triangle pattern can be a very powerful sign that the market in question is about to embark on a major move in that direction. Expect of course, for when it isn't. Ah, there's the rub. For when the breakout from a triangle fails to follow through and proves in the end to be a "fake out", the reverse move can be swift and severe. So the jury is still out on this one.
Figure 2 - Gold ETF (Ticker GLD) - Upside Breakout on increased volume
The K-Ratio remains bullish - One day in the mid 1980s, I day divided the Barron's Financial Weekly's Gold Mining Index (GMI) by the price of gold bullion. To make a long story short, when the ratio is "low" (ostensibly anything under 1.20) then gold stocks are considered "undervalued" and likely to rally, and when the ratio is "high" (roughly 1.90 or higher), gold stocks are "overvalued."
Nelson Freeburg, the highly respected Editor of the "Formula Research" newsletter dubbed this the "K-Ratio" (the "K" for Kaeppel, which is nice - but would it have been so bad to call it the "J" ratio? But again I digress) and used the K-Ratio to develop a much better system with it than I ever did (I hope to forgive him for this one day).
Figure 3 - Gold Stocks (GMI) versus Gold Bullion; K-Ratio is GMI/Bullion; K-Ratio is still at low end of historical range suggesting more upside for gold stocks
In any event, the K-Ratio plunged to an all-time low of 0.60 on 11/20/08 when gold stocks (along with virtually every other kind of stock) were - for lack of more tactful term - "puked". Interestingly, since that time gold stocks have rallied over 150%. Interesting too isn't it that it took this long for most investors to start wondering whether or not they should be considering gold and/or gold stocks. Despite the advance in gold stock prices, at the moment the K-Ratio is still in "undervalued" territory at 1.15. This suggests that much greater upside still exists for gold stocks.
So on one hand gold and gold stocks appear to be trending higher and poised to break out to sharply higher levels. Still, there are a few developments which might give one pause.
THE BAD NEWS
Resistance at $1,000 - As I alluded to earlier, it is indeed a strange quirk of human nature that markets and stocks tend to get hung up at round numbers. But under the category of "It Is What It Is", it is, well, what it is. The way to look at this in regards to gold is quite simple. Unless and until gold can close over $1,000 an ounce and stay there, the possibility of another pullback in the price of gold is quite high. If all of the buying that has been done and that will be done cannot push gold through this key resistance level, then "the Law of the Charts" (kind of like "The Law of the Hills" only with teeth) virtually mandates that price will eventually fall under its own weight.
The best development in this regard for gold bulls would be a close well above $1,000 (say $1,020-$1,050) and then a pullback that tests $1,000 from the upside and establishes $1,000 as a support level rather than as a resistance level (i.e., a situation where $1,000 is a floor rather than a ceiling), followed by a breakout to higher new highs.
Figure 4 - Gold futures take another shot at key resistance level
As you can see in Figure 4, this is the fifth time since March 2008 that the spot gold futures contract as tested the $990 level. A failure to breakout to the upside will almost certainly be followed by another sharp break back down to at least $900.
The Month of October - In a recent article (Have a Happy September. Or Not. Part II), I illustrated the fact that gold stocks have shown a tendency to exhibit strength during the month of September. Not so the month of October. Figure 5 displays the growth of $1,000 invested in Fidelity Select Gold (FSAGX) only during the month of September versus $1,000 invested only during the month of October since 1988. You don't need to look all that closely at Figure 5 to notice the "slight" difference in performance. Whereas September is "gravy time" for gold stocks, October is essentially "where gold stocks go to die."
Figure 5 - Gold stock performance during September versus October (1988-2009); Growth of $1,000
For the record:
- $1,000 invested in gold stocks only during September since 1988 is now worth around $3,100, a gain of +210%.
- $1,000 invested in gold stocks only during October since 1988 is now worth around $391, a loss of -61%).
SUMMARY
So if you were to ask me "where is the price of gold headed and should I buy now", I would have no choice but to go with my standard answer - "it beats me." Still, this is not exactly the same as saying "I have no idea what to do." As you saw under "The Good News", the trend of gold and gold stocks is presently bullish and gold stocks remain at historically undervalued levels relative to gold bullion. So I continue to hold a long position in gold stocks. If gold wants to run to $2,000 an ounce and gold stocks triple, hey, there's nothing I can do to stop it. I might as well enjoy the ride.
What would cause me to get out? If gold fails to break through resistance at $990-$1,000 in a meaningful way as the (dreaded) month of October approaches, any break in gold stocks (a simple moving average crossover or a drop back below $990 could be used as a warning signal) should be taken seriously as a sign to cut back. If gold and gold stocks do experience a sharp decline in October, the K-Ratio would almost certainly decline to lower (i.e., more undervalued) levels, possibly setting up another good buying opportunity for gold stocks.
As always, time will tell.
Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site
Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.
NOTE: To learn more about Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, please click here.
Look for the interview with Jay Kaeppel in the upcoming November 2009 issue of Technical Analysis of Stocks and Commodities magazine.
