Why gold is set up for a good rally

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Now that the US has avoided the fiscal cliff, markets will be in thrall to rumours surrounding the horse trading that surrounded the debt ceiling negotiations, not to mention the postponed spending cuts' that will loom large in January.

Nevertheless, markets will always do what they do best express the shifting hopes and fears of investors as aggregate sentiment waxes and wanes.

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Before the holidays, markets were fearful.But now, they are hopeful.Such is the manic-depressive nature of investors as we head into 2013.

For my firstpost of the new year, I want to follow up on gold, that most emotional of markets.

In my 19 December post, I noted the curious behaviour of the gold and stock markets. Briefly, stocks were rallying strongly, while gold was falling strongly.

Because markets are being driven by changes in liquidity, this should not happen! So something had to give.Either gold would reverse and start rallying, or stocks would reverse and start falling.

Since then, we are actually seeing both occur!

Gold hits amajor tramline

Take a look at the gold chart below. The chart patterns in December were suggesting a possible third wave move down:

(Click on the chart for a larger version)

But what I had not mentioned was the possibility of a large A-B-C pattern off the $1,796 top more later.

I had my short-term tramlines in place:

(Click on the chart for a larger version)

And following my post, the market broke down to the fourth tramline in the $1,635 area.

This had all the hallmarks of verifying my third wave thesis, where much lower targets could be set.

But note the positive momentum divergence at the low (red bars). That was a note of caution.

But now, let's look at the daily chart for perspective.When focusing too hard on the short-term charts, it is easy to lose sight of what the bigger picture can tell us:

(Click on the chart for a larger version)

Aha!I can draw a superb tramline pair with my lower tramline catching the first touch point (green arrow) and the major November low.

The market had then fallen down to the lower tramline and with a positive momentum divergence.

The odds were now stacking up for a major upside reversal off the lower tramline.

So let's fast forward to this morning:

(Click on the chart for a larger version)

I have the large A-B-C pattern (corrective) off the $1,796 top, and within the C wave, there is also a clear A-B-C form (which is also corrective).

The implication is clear:the direction is up.

If my tramlines are still valid, a major target is the upper tramline in the $1,700 region.

Recently, the futures professionals have turned their previously bullish sentiment around 180 degrees.Latest figures from trade-futures.com show only 10% or so bullish on gold (and silver).This is an amazing turn-around and augers well for a good rally!

And here is the latestCommitments of Traders(COT) data:

The large specs also have fallen out of love with gold as they have reduced their longs and increased their shorts, as have the small specs. They remain overwhelmingly long, though.

And these changes occurred in a week when gold fell.

This is shaping into a very interesting set-up.

If you're a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:

The essentials of tramline trading

Advanced tramline trading

An introduction to Elliott wave theory

Advanced trading with Elliott waves

Trading with Fibonacci levels

Trading with 'momentum'

Putting it all together

Don't miss my next trading insight. To receive all my spread betting blog posts by email, as soon as I've written them, just sign up here . If you have any queries regarding MoneyWeek Trader, please contact us here.