Why you should keep an eye on gold

published 9 July 2008

Precious metals have taken the back seat in the recent rally in commodities. While corn, soybeans, oil and other commodities were making either fresh contracts or all-time highs on a daily basis, precious metals simply consolidated. This was to be expected after the fantastic rally in gold from the low $600s to above $1,000 per ounce.

Personally, I exited the last of my precious metals equity positions at $975 per ounce and have been on the sidelines ever since (I do still own physical metals). But I believe that we are currently encroaching a good entry point in the precious metals. I'm normally not a big chart guy, but I would like to throw some charts at you and explain why I will be doing some discount shopping for my favorite mining stocks in the not too distant future.

The first chart I would like to discuss is the three-year daily chart:

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Please take note of the similar chart patterns in the circled areas. After spectacular rallies, both the May 06 rally and the rally at the beginning of this year, gold entered a consolidation period that took the form of a descending triangle. Gold proceeded to break out at $625 per ounce and rallied to a 60 percent-plus gain. The other point about this chart that I would like to point out is the extremely strong underlying support that the 200-day moving average has acted as. In rare instances, such as following the 06 peak, gold briefly broke below its 200-day moving average, but it didn't stay there for long.

The next chart I'm going to look at is the three-year weekly chart:

I like weekly and monthly charts simply because they drown out some of the intraday noise that might show up on a daily chart. You will notice that this chart has some strong similarities to the daily chart. It has the same descending triangle formations following intermediate peaks. Even more so than the 200-day moving average in the daily chart, the 50-week moving average has been pretty much unbreakable during this bull rally.

So where does that put us? Although I think we are getting close to an entry point in this market, I don't think we are quite there yet. In the daily chart, I would like to see, and fully expect, the 50-day moving average, the 200-day moving average and the spot price to really consolidate tightly. We have entered a trading period where the spot price is trading between the 50- and 200-day moving averages. They will continue to squeeze together until something breaks. This is a signal that a strong move is near.

In the weekly chart, I would like to see the 50-week moving average fully catch up to the spot price. Again, the 50-week moving average has acted as unbreakable support, and I would like to get my money in at or near those levels.

I've made my argument for the possible beginning of a new bullish phase in precious metals, so the next question to pose is how high will the next rally take us? This is a difficult question, especially with the ever-changing atmosphere in financial markets. Given that, I believe I can make an educated guess as to how high the next rally will take us. I am going to borrow a chart from my co-author John Polomny, as well as use the charts above, to come up with some specific numbers:

There is a strong correlation between the price of oil and the price of gold. John mentioned that the last time the gold/West Texas Intermediate crude ration dropped to current levels, it rallied sharply to 12. Let's go ahead and assume we move back to 12, and let's also use recent oil prices of $135 per barrel. That gives us a price for gold around $1,620 per ounce. Let's say gold rallies amid an oil rally to $150 per barrel. With the gold/WTIC ratio of 12 and $150 oil, we get an approximate price of $1,800 per ounce.

Keeping that in mind, I am going to refer back to the daily chart. The percent rise in the price of gold between the 06 breakout of $625 and the peak of $1,025 per ounce was approximately 60 percent. If the next rally moved another 60 percent, we would be looking at gold around $1,600. This is consistent with the figures I derived using the gold/WTIC ratio.

Using all of the above data, I believe that the next interim high will be in the neighborhood of $1,700-1900 per ounce.

There are a couple of things to keep in mind going forward. In a bull market, like the one we've had in gold since 2000, each consecutive bullish phase tends to move by a higher percent than the prior one. For example, although the rally to $1,000 gold was approximately a 60 percent rally from the last intermediate high, the next rally could result in a 70 percent move. This is a result of the Johnny-come-latelys entering the market. Each rally simply has more investors than the prior one.

There's another item worth noting. Although the 2007/2008 gold rally was spectacular, it didn't sprint out of the gates. You can see that at the end of 06 and in the first half of 07, gold just didn't move much. After a brief rally, it kind of puttered around. But looking more closely, you can see that the chart was actually making higher highs and higher lows, building a solid base. We may have a period like that in the following months.

All in all, I think we are close to a really great entry point in precious metals. I would recommend following a couple of your favorite mining stocks and getting comfortable with their price action in order to determine a proper entry level. There's no reason to hurry, so take your time and make your moves when you're ready.

This article was written by Nick Jones of The Real Deal for Whiskey and Gunpowder.