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GOLD & METALS


Golden Nonconfirmations

08/05/05 11:37:42 AM
by David Penn

When gold stocks fail to confirm a new high in gold futures, contrarians and gold bugs alike should take notice.

Security:   GC, $HUI
Position:   N/A

After spending so much time beating up on the idea of nonconfirmations in Dow theory ("Dow Theory Dreams," August 2, 2005; Traders.com Advantage), I should probably feel chagrined about discussing nonconfirmations between gold futures and gold mining stocks. But as I've always said, it isn't that nonconfirmations don't have truths to tell. It is simply worth noting which truth a given nonconfirmation is telling. In fact, tradable nonconfirmations appear quite frequently in markets in the form of divergences between oscillators and price action as well as divergences between stocks and the sectors in which they operate.

Another form of nonconfirmation is possible. That kind of nonconfirmation is a divergence between commodity stocks and the commodities whose fortunes those stocks represent (in a manner of speaking). In other words, there can be divergences between oil and oil stocks, copper and copper stocks, and--as is the case here--gold and gold stocks.

Figure 1: Rallying consistently and powerfully from its bottom in early 2001, gold futures appear to be slipping into a symmetrical triangle from which a strong move can be expected.
Graphic provided by: Prophet Financial, Inc.
 
John Murphy, in his excellent book Intermarket Technical Analysis, points out that generally speaking, gold and gold mining shares tend to move in tandem. He writes:


One of the key premises of intermarket analysis is the need to look to related markets for clues. Nowhere is that more evident than in the relationship between the price of gold itself and gold mining shares. As a rule, they both trend in the same direction. When they begin to diverge from one another, an early warning is being given that the trend may be changing. Usually one will lead the other at important turning points.


And if that isn't tantalizing enough, consider what Murphy notes next:


Knowing what is happening in the leader provides valuable information for the laggard. Many people assume that commodity prices, being the more sensitive and the more volatile of the two, lead the related stock group. It may be surprising to learn, then, that gold mining shares usually lead the price of gold.


Murphy is quick to point out that this is not always the case, drawing attention to an instance in 1980 when "gold peaked eight months before gold shares," and another instance when gold led in 1986.

However, it is more the issue of nonconfirmations or divergences that is the focus here. Note the bull market in gold in the chart of continuous gold futures in Figure 1. Although volatile, the advance of gold from a bottom early in 2001 has been clear and unmistakable. To date, the peak in the gold move occurred in the fourth quarter of 2004, just shy of $460 an ounce.


Figure 2: Gold mining stocks, as represented by the $HUI, need a new high above 260 in order to keep this 18-month correction from turning into a significant bear market. The trendlines show a developing 1-2-3 trend reversal.
Graphic provided by: Prophet Financial, Inc.
 
The gold mining stocks--as represented by the index of unhedged gold stocks known as $HUI--have had a similar experience during the first few years of the 21st century. However, unlike gold, gold mining stocks didn't make their high in the fourth quarter of 2004; they made their high in the fourth quarter of 2003. That was fully a year before gold futures made their high.

Another way of looking at this is to recognize that as gold was making a higher high late in 2004, gold mining stocks--again, as represented by the $HUI (Figure 2)--were making a lower high. This is a classic case of a divergence or nonconfirmation, a sign that things are not quite right. And given Murphy's observation that, on balance, gold stocks tend to lead the price of gold, those feeling the bullishness in gold in early August may want to make sure that their stops--mental or not--are in their upright, locked position, so to speak.


All that said, there is ample room for bullishness in gold in the near term. As Figure 1 shows, there is a triangle in gold futures that stretches from the fourth quarter of 2004 to the third quarter of 2005 where prices appear to have broken out to the upside. At the same time, the $HUI looks to be emerging from a consolidation/sideways correction that began shortly after making its high for the move in the fourth quarter of 2003. The $HUI could rise another 40 points--an additional 19% from current levels--and still not set a new high vis-a-vis the Q3 2003 peak. And if the two--the $HUI and gold futures--are indeed diverging, then it would not be surprising to see gold break out to the upside from its triangle and set a new high--even if the $HUI failed to do so.

So for now, it seems as if the smart move is to follow short and intermediate timing signals as they provide opportunities to take advantage of any upside that might develop. But keep an eye peeled for this nonconfirmation between gold and the gold stocks--it might provide an opportunity of a different sort before too long.




David Penn

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

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