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Is Gold Ready For A Major Correction?

Last updated 1/5/2012 9:40 PM EST (GMT -5) 0 Comments - Add your comment

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Bradley W. Gareiss

Technical Analyst, GFT

Gold has been steadily rising for most of the 21st century.  After a slow start, however, the party really began in October 2008.  The low that month was $681 an ounce, which began an incredible bullish trend line.  From that low at $681, gold has steadily risen with that trend line (seen below).  Gold never strayed very far from the trend line, but never saw much of a correction either.  Gold simply marched on up, which led to a kind of gold mania.  When there is a gold covered kiosk in the mall offering to grandma's old gold earrings, it becomes clear that gold is a hot item.  There are a number of factors that have lead to this outcome.  A combination of fiat currency concerns, generally economic uncertainty, and popular new gold derivatives have driven prices higher and higher.

Then gold began to accelerate in early 2011.  It was pulling away from the comfort of its trend line.  The rally became steeper and steeper until gold hit its all time high at $1920.6 on September 5, 2011.  The initial decline was equally as steep, but gold began to rally again when it tested the 200 simple moving average on September 25, 2011.  This rally soon stalled, and actually created a bearish trend line with three points of perfect contact, which can be seen in the above chart.  Gold began to drift down again, and this time it pierced through the above bullish trend line at the end of 2011.  Gold quickly moved back above the trend line, but this was the most serious breach yet.  Sure, gold already has seen a sharp move down a few months ago, but it had stayed above the trend line.  The more recent move had not only broken below the trend line, but it also pushed gold below the 200 day simple moving average for the first time in nearly three years- nearly the entire time the above bullish trend line had existed.

Gold's recent price action is not totally unique.  In fact, in the past year we witnessed an extremely similar incident on the USD/CHF.  The USD/CHF had seen a very similar trend line, although this one was a bearish trend line.  The USD/CHF steadily moved along the trend line for months with a major correction.  Then it accelerated away from the trend line until it ultimately saw a quick move back up to the trend line seen in the chart below.

 Now take a look at the zoomed in version of the gold Daily Chart.

The price action of the two charts above is strikingly similar.  They spent roughly the same time beyond the trend line, and as of tonight they had both spent three days back on the original side of the trend line.  So why does this matter?  It looks like the USD/CHF was about to resume its downtrend and gold is about to resume its uptrend.  Below is what happened to the USD/CHF at the same point gold is at within the similar cycle.

The USD/CHF shot past the trend line for a major correction.  This doesn't mean that gold will follow the exact same path, but consider the following factors:

1) Gold just had its most severe breach of an extremely strong bullish trend line that has existed for over three years.

2) Gold is trading for the first time below the 200 day simple moving average for the first time in nearly three years.

3) It is likely that a good deal of buying that pushed gold this high was done with high leverage.  The current retracement is probably already putting stress on a number of gold bulls who used high leverage to buy as much gold as possible.  A relatively small move down could force these types of positions to liquidate, which could accelerate a correction down.

4) Most major corrections have a similar look to the two shown above.  Another good example was the decline of light sweet crude oil in second half of 2008.  The oil drop also shows how physical commodities are capable of experiencing significant drops.

 5) If gold follows the USD/CHF pattern exactly, the big move would happen tomorrow (January 5, 2012).  Coincidentally, non farm payroll comes out tomorrow.  If the announcement pushes gold lower, that could be the momentum needed to start a more serious decline.

In the long run, it is possible that gold could reach new highs well above $2000.  However, in the meantime, it is due for a correction.  It is possible that non farm payroll will push gold higher and tomorrow won't begin a sharp move down.  If gold doesn't break below its weekly low (around $1566) shortly after non farm payroll, it is possible that it could rally for weeks before the correction happens.  However, the correction will happen at some point, and it looks like tomorrow fits the criteria for a day in which that type of move could begin.

We can't give a specific trade idea for gold in this forum, but here are some basic principles to follow.  If the immediately move isn't down after non farm payroll, tomorrow likely isn't the day for a correction.  Gold would have to dip below its weekly low at $1566 before a much large move down would seem likely.  If gold quickly breaks down below $1560-1566, but subsequently rallies back up above the previous weekly high (~$1625), the analysis is probably wrong as well.  How far will the correction go?  That is tough to figure, but it wouldn't seem like a serious correction unless it touched the $1200 range.

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