Negative Divergences Enjoin The Gold Rally

06/22/05 08:01:53 AM

by David Penn

While more upside is still likely, the easy money might already have been made in gold stocks.

Security: $HUI
Position: N/A

While I am less confident about using moving average convergence/divergence (MACD) histograms to mark divergences (preferring instead to use the peaks and troughs of the 7,10 stochastic), one use of the MACD histogram that I do enjoy comes as markets attempt to rally from bottoms or slip from tops.

I've written about this concept before in Working Money ("Post-Breakdown MACDH Extremes," May 19, 2004). When the histogram of the moving average convergence/divergence provides an extreme reading to the upside or downside, it often signals that further price movement in the direction of that extreme is likely. Sometimes this movement presages a true cyclical move--other times, merely a significant bounce.

But the point of the matter is that an extreme MACDH reading is a warning sign (or an "alert," to keep things value-neutral) that traders can use to position themselves for market moves that are potentially worth participating in.

Figure 1: $HUI. The MACDH peak in June suggests further upside, while negative stochastic divergences allude to a pullback--and perhaps a test of the lower boundary of the trend channel--that may have to happen first.

Graphic provided by: Prophet Financial, Inc.

The index of unhedged gold stocks might provide an example of this in real-time. First, note how during the decline in the $HUI from mid-March to mid-May, the MACD histogram (or MACDH for short) made an extremely deep trough near the end of March. This was a signal that the bears were exceptionally powerful and that further lows were all but assured.

That MACDH extreme in late March arrived as the $HUI was at about 195. Thirty days later, the $HUI was at 175. And two weeks after that, the $HUI had fallen to almost 165. During this time, each subsequent trough in the MACDH was higher than the previous one. This suggested that downside momentum--the passion of the bears, as it were--was waning, and that the potential for a bounce, or even a significant move to the upside, was increasing.

Something similar may be happening at the $HUI moves higher in June. The MACDH peaks in earliest June are as high or higher than any in months. While it is true that the term "extreme" is a subjective one in many respects, a straightforward comparison of histogram peaks or troughs from previous months usually suffices to distinguish merely sizable MACDH peaks or troughs from truly extreme ones.

In any event, the June MACDH peak is comparably large enough to be considered "extreme" in this context, which meant that it was little surprise that the early June price highs were exceeded by mid-month.

The question at this point is, how much more upside does the $HUI have? This is especially pertinent, as the $HUI has begun to develop multiple, or running, negative stochastic divergences over the past 30 days. These divergences--in and of themselves--do not necessarily mean reversal, but they do suggest a waning of upside momentum. In the context of the MADCH peak of early June that allowed for further upside in $HUI, what are the negative divergences really suggesting?

I suspect both the stochastic and the MACDH peak are "right." By that, I envision a scenario involving a pullback into support--either in the form of the lower boundary of the trend channel or at the 50-day exponential moving average (EMA)--and then a move to establish a higher high vis-a-vis the highs in mid- and early June.

But don't be surprised if such a higher high arrives with still yet another negative stochastic divergence.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Negative Divergences Enjoin The Gold Rally

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