Gold Ends the Year in a Bullish Fashion – What’s Next?

This essay is based on the Premium Update posted on December 30th, 2010

It’s instructive to look at the end of the year financial magazines and see their analysis of the past year and their projections for the future. For example, the special issue of Fortune Magazine Investor’s Guide 2011 had a glimmering stack of gold coins on the cover with a headline “Gold Gone Wild.”

The article noted that people are rummaging through their dressers for gold jewelry to sell and that gold vending machines are selling out in Abu Dhabi and Germany. Exchange traded funds have made it easier for average people to invest in gold. More people have come to realize this year that gold is not just a commodity, but also a currency. The sole issuer of gold is Mother Nature and she follows a tightfisted policy. The article noted that all the gold ever mined would fill up fewer than four Olympic-size swimming pools.

As we all know, especially approaching the round of New Year’s Eve parties, after an epic size binge comes an epic size hangover. The world is still reeling from an enormous headache caused by the real estate and subprime binge.

Things seemed stuck in 2010—the economy, Chilean miners, the accelerators of 2.3 million recalled Toyotas and 1.2 million European airline passengers stuck in airports by the eruption of the Icelandic volcano.

The Green shoots that Fed Chairman Ben Bernanke had promised never seemed to break through the hard ground. By May hopes for a quick recovery were dashed when the stock market tumbled 10 percent and unemployment did not improve, getting stuck at around 10 percent. The European Union bailed out Greece where workers retire at age 55, and in 2010, Irish eyes were not smiling. China’s economy, by stark contrast, grew by an impressive 9.6 percent in the third quarter.

For ordinary Americans the rise of China is increasingly associated with job losses and a challenge to American wealth and power. During the more prosperous times there was a win-win world where the U.S. and the euro zone enjoyed prosperity and China, India and other emerging countries felt themselves getting richer. It is likely that 2011 will bring protectionism, anti-immigration sentiment and tensions in the European Union. There could be worsening relations between the U.S. and China over China’s keeping the yuan undervalued against the dollar by as much as 40%.

In 2011, according to the Economist, investors will get a much clearer idea of the eventual outcome of the inflation/deflation dilemma. Either the economy will start returning to normal, in which case short-term interest rates will rise and the bond markets will suffer, or, it will become clear that the recovery is stalled and there will be talk of a Japan-like deflation. Governments will have to walk a tight-rope in 2011 trying to show enough budgetary austerity to reassure the markets without overdoing it and damaging their recovery.

The one thing we can safely predict is that 2011 will be unpredictable. Let’s hope for the best and at the same time be prepared for the worst by holding our physical gold and silver holdings intact.

Meanwhile, let’s take a look at the way the USD Index is ending the 2010.

In this week’s long-term USD Index chart (charts courtesy of stockcharts.com), we once again see that the index failed to move above the declining support line. And because of that any rally in the USD Index is still likely to be capped by this particular level.

The implications for precious metals seem to be rather nonexistent at this point. They have recently moved higher during both: USD Index rallies as well as consolidation periods. A move lower from here in the USD Index would seem to be only slightly more bullish for gold, silver and mining stocks as opposed to a move up.

The situation for the dollar is rather unclear at this time. The USD Index is approaching a cyclical turning point, which appears slightly more likely to be a local bottom. Until a breakdown is seen in the Euro Index, it is unlikely that any breakout for significant gain will be seen in the USD Index.

Since the USD Index is close to a resistance level, the uncertainty of its next move should be removed soon. Either a decline or a breakout will likely be seen fairly soon and the likely implications upon precious metals will likely also become more easily read.

With weak influence coming from the analysis of the U.S. Dollar, let’s take a look at the situation on the general stock market for more meaningful clues.

In this week’s very long-term S&P 500 chart, a breakout above the key retracement level from a previous 2010 high can finally be clearly seen.

With the RSI close to 70, that is, near the overbought area, it is likely that a consolidation will be seen rather sooner than later. Verification of the previous breakout is therefore quite likely. This would be a decline to the level of the previous high followed by an additional rally.

The situation in the general stock market has turned slightly bullish. If and when the breakout above previous 2010 highs is verified and the 61.8% Fibonacci retracement level holds, great buying opportunities will be at hand for both stocks and precious metals.

Even though the economy is still rather weak, the stimulus money finds its way to the stock market, which helps pushing prices higher. This goes double for precious metals as investors find them particularly valuable during such inflationary periods.

Therefore, the recent move higher in stocks appears to be bullish for metals, but let’s check it that is indeed the case. Please take a look at the correlation matrix below for details.

The coefficients between precious metals and stocks continue to weaken but are still significant. This means that for precious metals analysis, we must continue to take stocks into account. In addition, bullish sentiment for the general stock market likely implies the same for gold, silver and mining stocks. Consequently, it means that the fact that stocks are now visibly above their key support/resistance level is bullish also for precious metals.

The correlations with the dollar are mixed once again. The 10-day column indicates that the relationship between precious metals and the dollar is weakening further. Overall the influence from the currency sector upon precious metals is rather weak. It appears best at this time to independently analyze gold, silver and mining stocks and then check the correlation matrix. At this point, the implications from other markets are generally bullish for the precious metals sector.

Summing up, the situation for gold has moved from a slightly bearish sentiment to a bullish outlook for the near and medium term. Silver appears likely to take out previous highs and further increases are likely based on current signals. At this time, it seems best for investors to stay with current holdings and – again – perhaps open small speculative long positions.

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