Channel Testing

10/25/05 08:45:10 AM

by David Penn

As gold reenters a trend channel from which it recently emerged, gold stocks slip closer to support at the lower boundary of their trend channel.

Security: $XAU, $HUI, GC
Position: N/A

Anyone who still refuses to believe we are not living, trading, and investing in liquidity-driven markets should take a good look at these charts of gold stocks and the yellow metal itself and ask themselves just when it was that the stock market bottomed and when it was that the stock market appeared to have topped.

It is this kind of addiction to liquidity that has gold bugs and credit-expansion equities bulls both in a lather. It is also another reason why there is such a universal aversion to the Federal Reserve board's efforts to rein in "inflation"; credit-based inflation is the fuel that is powering every asset -- from stocks to gold to residential real estate.

FIGURE 1: GOLD & SILVER INDEX. Breaking out above the multimonth trend channel in September, the Philadelphia Gold and Silver Index finds itself slipping to the lower boundary of the trend channel by mid-October.

Graphic provided by: Prophet Financial, Inc.

So while in some ways the liquidity fever has made looking at stocks and gold analytically redundant, I want to take a closer look at gold and gold stocks for a couple of reasons (Figure 1). The most important reason is that as the business cycle progresses deeper into expansion, the last asset group to be embraced by investors--after capital goods, after basic materials, after energy--are, typically, gold stocks. So even if stocks in general have moved with gold, any weakness in gold at this point could possibly signal the last gasp of expansion for the current economic cycle and the beginning of a more apparent contraction. As Jon Gregory Taylor alludes in his book, Investment Timing And The Business Cycle:

Industrial materials such as iron and steel and metal mining companies are acutely sensitive to GDP growth. These sectors register their worst performance when the economy is experiencing a sharp deterioration in growth. Gold producers have experienced the strongest performance when the economy has been emerging from a slow growth period ... Iron and steel producers ... tend to modestly outperform when the economy is operating above trend and rising.

By "above trend and rising," I believe Taylor is referring to what mainstream economists often call an "overheating" economy -- such as would be encountered at the twilight of the expansion phase of the economic cycle.

FIGURE 2: $HUI. The $HUI, or index of unhedged gold stocks, mirrors the Philadelphia Gold and Silver Index in penetrating the lower boundary of a trend channel that began with the lows of the spring.

Graphic provided by: Prophet Financial, Inc.

In my last look at gold earlier in the month, I pointed to the possibility of a pullback or correction in gold ("Time Out For Gold," October 4, 2005). I thought the vehicle of that pullback would be the 2B test of top in the second half of September. That 2B test didn't result in an instant reversal -- in fact, prices rallied above that level in the beginning of October. But it is clear now that some sort of correction was clearly in the cards, as the movement in gold stocks as shown in Figures 1 and 2 -- and increasingly in the gold futures themselves.

FIGURE 3: GOLD TREND. Gold, as measured by continuous futures, also broke out above its trend channel, but has yet to correct back to the lower end of that channel.

Graphic provided by: Prophet Financial, Inc.

John Murphy reminds us in his classic book, Intermarket Technical Analysis, that typically, commodity stocks lead the underlying commodity. There have been exceptions, to be sure. But if there is a tendency in the relationship between the stocks that represent companies who mine a given commodity and the futures contracts taken out on that commodity itself, that relationship is one in which speculators in the stocks tend to be more sensitive to the potential for upside or downside than speculators in the commodity.

As such, the fact that gold stocks have slipped beneath the level of their August highs, while the metal itself has not yet done so, does represent a warning for those speculating in gold stocks at present. With regard to the trend channels, any further slippage in the $XAU and/or $HUI will not only lead to a violation of the lower boundary of the trend channel, but will also force the gold stock indexes to have to rally against a new, lower, resistance level--namely, that same lower boundary that will have been transformed from potential support to potential resistance (Figure 3).

David Penn

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

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