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August 13, 2008

The Dollar Breaks Out, So Buy Gold
by Guy Lerner

See figure 1 a monthly chart of the Dollar Index.

Figure 1. Dollar Index / Monthly

Last week when I was reviewing the monthly charts, I noted that the most recent monthly close was 12 cents greater than the high of the most recent positive divergence bar. This price bar is noted by the gray oval on the price chart in figure. The Dollar Index has a fair number of technical characteristics, including positive divergence bars, that are consistent with a market bottom that leads to a bull market, but as it turns out from a trading perspective, it is a monthly close greater the 10 month simple moving average that is the most important technical indicator. And prices are now above this key metric.

But this is where things get interesting. The last time the Dollar Index broke above its 10 month simple moving average was in May, 2005. I have noted this area on figure 1 with a rectangle. From that close, the Dollar only went about 5% higher before rolling over. I will also mention that many of the technical characteristics found at a market bottom were also present for the Dollar Index in May, 2005, but as we know, this was not the ultimate low.

As it turns out, the break out in the Dollar Index back in May, 2005 was the bottom for gold. Gold closed the month at $418 per ounce, and then went on to double over the next two years. See figure 2 a monthly chart of gold. The May 2005 low is noted with the black vertical line. So even though the Dollar Index is breaking out, I don't think we should give up on gold just yet.

Figure 2. Gold / Monthly

In particular with inflation near 5%, as measured by year over year CPI, and the 3 month Treasury yield at 1.7%, real interest rates remain negative, and this is one of the strongest fundamental dynamics for gold price appreciation. This dynamic was also present back in May, 2005 when gold started on its historic run to a $1000 per ounce.

In addition, economic weakness will also keep pressure on the Dollar. Some analysts are suggesting that the equity market's recent up turn means that there are better times ahead; however, I still think it is too early to make that call from both an economic indicator or a market perspective.

So let me clarify. A monthly close greater than its 10 month simple moving average is bullish for the Dollar Index. However, the last time this happened, it also marked the bottom for gold. The fundamental dynamics for gold price appreciation remain strong. The headlines say, "Buy the Dollar". I am not buying that story, and I don't think the bull market in gold will rollover so easily. Technically, gold has not broken down yet, and I don't see the Dollar's strength as a reason to liquidate my positions in gold.

Lastly, the risks to this analysis really lie with the technicals for gold. Returning to figure 2, I view the current price action as the biggest threat to the gold bull market since it started in 2001. This needs to be monitored closely as we should always defer to the price action regardless of the fundamental story.

To learn more about our quantitative and disciplined approach, please visit us on the world wide web at www.thetechnicaltake.com. We have lots of free stuff!!!

Guy M. Lerner
TheTechnicalTake.com

Disclaimer: Guy M. Lerner is the editor and founder of TheTechnicalTake.com. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Under no circumstances does the information in his columns represent a recommendation to buy or sell stocks. Lerner may on occasion hold positions in the securities mentioned in his columns and on the Web site; in all instances, all positions are fully disclosed at http://www.thetechnicaltake.com. However, their positions may change at anytime. For more information on any of the above, please review TheTechnicalTake's full Terms of Use and Privacy Policy (link below). While Lerner cannot provide investment advice or recommendations, he invites you to send your comments to: guy@thetechnicaltake.com.

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Copyright © 2004-2008 Guy Lerner

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