The Order of Things in Gold-Land

In the gold sector one frequently encounters what we refer to as either bullish or bearish 'hooks'. Before explaining this concept further, we should note here that we actually fell for one of those after it had seemingly become slightly less reliable for a while. As it turned out, it made a strong comeback at a rather inopportune moment.

The remember the first time we discussed the concept on the old Kitco message board in 2001-2002 (before it was 'modernized' and virtually all the posters active at the time left). What was debated at the time was the fact that gold stocks routinely outperformed the metal from late 2000 to early 2002. Several people contended that this could not continue, and that unless the metal were to 'catch up' with the gold stocks, their rally was surely doomed (note that in spite of two huge bear markets that have since then occurred in the sector, the prices prevailing at the time have not been seen again).

At that time we began to refer to this phenomenon as a 'bearish hook' – it was the bull market's way of keeping people bearish and doubtful. What they didn't realize at the time was that the sector's performance was actually a leading indicator of the far bigger advances in the gold price that were to occur later. Interestingly, when these far bigger advances finally did occur a few years later, the sector promptly began to underperform the gold price. This was the prelude to creating the 'bullish hook' that was a hallmark of the recent severe bear market (and which we admit to having ignored or downplayed at what in hindsight was a rather crucial moment in 2012). The 'bullish hook' has the precise opposite effect of the bearish one: it keeps people bullish, because the metal itself appears to be staying quite firm even while the gold mining stocks sag and begin to underperform rather noticeably.

However, for the past nine months or so, we have repeatedly pointed out that since the gold stocks have so clearly led the decline in the gold price from its 2011 high, the one thing that would be a sine qua non precondition for a change in trend would be frequent occurrences of the opposite phenomenon -  a return of the 'bearish hook' in other words. Gold stocks need to outperform the gold price when it rises, they need to frequently ignore short term corrections in the gold price and clearly rise relative to the metal over time. In addition, we should quite often see instances of weakness in the sector at the open of trading, followed by strength near the close.

The Current Situation

Since the beginning of the year, all of these indications could indeed be observed. One of the most glaring examples was delivered in Tuesday's trading. In the wake of a more than $17 decline in the gold price before the market open, gold stocks opened down, but not down as much as one might have expected.  In spite of the gold price exhibiting rather lackluster performance throughout the rest of the trading day, they then managed to close in positive territory near the highs of the day.

So clearly, things are on track so far – the probability that the retest of the June low in gold in late December was 'successful' has now strongly increased. If indeed no additional leg down below this support level (at around $1,180) occurs, then the surfeit of extreme bearish sentiment in evidence last year and at the beginning of this year should eventually provide the fuel for a sizable rally.

There is only one caveat we have at this stage, and that is the fact that we are partly witnessing a reversal of last year's tax loss selling in the sector. Many of those who took losses in December in order to minimize capital gains taxes for the year are presumably repurchasing their positions, so the sector's strength is probably at least in part attributable to this activity.

However, should this show of relative strength continue for a while longer, it will be a strong sign that the turn from bear market to bull market has occurred. Note though that the gold sector will have to contend with a great many resistance areas that have been created in the course of the consolidation since late June 2013. The ease or difficulty with which these are tackled will also be informative. One probably shouldn't expect it to be a smooth ride though.

The resistance zone the HUI has just overcome (blue dotted lines) should serve as support in near term pullbacks. However, a lot of lateral resistance (red lines) has been created over the past several months just above current levels. There will likely be a lot of to and fro before they are overcome, but we will have to wait and see about that – click to enlarge.

For short term traders, things have become quite simple: the support zone (blue dotted lines) can be used for a protective stop. They therefore have a very low risk entry point here. Only if this zone actually holds on pullbacks can we be fairly confident that a change in trend has indeed occurred.

Looking at the HUI-gold ratio, we can state the following: similar to the HUI itself, it has been in a consolidation zone for several months. A breakout from this consolidation zone to the upside would represent unequivocal confirmation that a bull market has begun. Conversely of course, a breakdown below the lower boundary would indicate a continuation of the bear market. One thing that strikes us as very positive about this indicator is that there has been what looks now like a 'false breakdown' in December (this is also analogous to the HUI itself). Such false breakdowns (or conversely, breakouts if they happen to the upside) are usually very powerful signals. Essentially, the market had every opportunity to decline further from a technical perspective, but it didn't take it – instead it has reversed back up into the consolidation zone. Such failures to follow through after breaks of major support/resistance are often encountered at major trend change points.

The HUI-gold ratio – turning up after a 'false breakdown' – click to enlarge.

Let us however stress again here that one should not expect 'smooth sailing'. In fact, it is likely (although it obviously doesn't have to happen that way) that the initial rally attempt will run into trouble and lead to a prolonged period of volatile sideways movement. However, if the trend has changed, there should at least be a slight upside bias evident over time.

One reason why we don't expect smooth sailing is of course the gold price itself, which has so far not shown any indication that it has turned up for good. In order to give us initial confirmation of a trend change, it would at least have to rise above the $1,260 – $1,280 resistance zone. As an aside to this, even if it does manage to rise above this resistance area, one shouldn't necessarily expect a very big rally this year. It seems more likely that if a low has been indeed been put in last year, a year of consolidation will be in store, at least until the seasonally strong period begins in the fall.

February gold contract, daily, with the initial resistance zone indicated – click to enlarge.

Conclusion:

The recent action in the gold sector, especially the fact that it is outperforming the metal itself, is a very positive development and has strongly increased the probability that a change in trend has occurred. However, as long as no breakout from the post June low consolidation zone has happened, such conclusions must still be regarded as tentative.

In addition, traders and investors must be mentally prepared that a lengthy and  highly volatile bottoming period could be in store, even if a trend change has happened and a new uptrend is underway. There is of course no iron law that states that things must play out in this manner. We only want to point out that it would probably be advisable not to get overly enthusiastic just yet.

Consider for example a similarly volatile stock market sector that has also gone through an extended bear market and recently bottomed out, the shipping stocks. Below we show a two year chart of NAT, a crude oil shipping company that is actually one of the financially more solid shipping companies (it has paid dividends on a regular basis, even during the recent deep recession in the sector). As you can see, it took the stock more than a year of consolidating near its lows, and there were both 'false breakouts' and 'false breakdowns' in evidence during that time. If the gold sector regains its footing faster than that, all the better, but one must be aware that bottoming periods after extended bear markets can sometimes be quite drawn out affairs that are putting the patience of investors to the test.

Crude oil shipping stock NAT – it took more than a year of sideways movement in a large and volatile range before the change in trend was finally confirmed by a significant breakout (and there is still a small chance that this breakout could also turn out to be a false dawn, although to our mind,  it looks like a fairly solid bottoming phase in the stock followed by a legitimate breakout) – click to enlarge.

Charts by StockCharts, BarCharts