This essay is based on the Premium Update posted on February 19th, 2010.

In the previous essay, we commented on the recent developments in the price of gold. The technical part of this week's essay is dedicated to the situation in the precious metals stocks and the general stock market. The prices of these stocks are highly correlated with the underlying metals, which means that the following analysis is useful also to Investors and Speculators following the spot prices of gold and silver.

We summarized that the precious metals market has moved higher, and it appears that it will need to take a small breather relatively soon, and this is what we've seen so far this week. Still, the long-term picture didn't change much. Let's take a look on the chart below for details (charts courtesy of http://stockcharts.com.)

The analysis of the long-term HUI chart suggests that gold stocks may need to move a little higher before forming a temporary top. In the past, local tops have been formed after HUI Index moved above the 50-day moving average, which hasn't been the case yet.

Given the strength of the current rally and the previous performance of PM stocks after the bottom, it seems that the coming correction is likely to be relatively small. Naturally, that is the case if the general stock market doesn't begin a massive plunge soon.

Speaking of the general stock market and its influence on the prices of precious metals, please take a look at the current version of the correlation matrix.

The above numbers don't look too encouraging for precious metals bulls given the situation on the general stock market. In the previous Premium Update we wrote the following:

An interesting fact is that the very-short-term (based on just 10 trading days) influence of the HUI Index is stronger for the general stock market than it is even for gold. In other words, during the last 10 trading days, gold stocks were more closely following main stock indices than there were following gold.

Not only is this tendency still present, but it is also much more visible in other parts of the precious metals market. The correlation coefficients for S&P and gold, silver, and juniors are currently very strong. This means that if we don't see signs of a disconnection between these markets in the coming weeks, it will become much more likely that the next medium-term (months) move will be down, not up.

For now, we are waiting for a disconnection between the main stock indices and the USD Index, to estimate which of these markets PMs are likely to follow next. We wrote about this phenomenon two weeks ago, but since it is relevant also today, we will quote a part of the previous update below:

(...) we have to wait for additional signals of confirmation for either of the two scenarios (general stock market plunges along with PMs or without them). So far both markets have been declining together.

The first thing to monitor is the way PMs react to changes in the value of the main stock indices - especially gold, because silver and PM stocks are historically more correlated with the general stock market (silver's industrial uses etc.), so high correlation here is not much of a divergence. If PMs trade very much in tune with the general stock market during both upswings and downswings and we don't have identical moves in the USD Index (as we will see in the main stock indices - but in the opposite direction), then PMs may be in trouble.

If, on the other hand, PMs stop declining or even rise modestly along with falling main stock indices, it will mean that even more declines should not cause serious damage to the PM market.

Additionally, if we see the USD Index move higher and PMs refuse to move lower, it will give us a "probably the bottom is in" signal. The abovementioned phenomena should be visible for at least several days before we can make decisive calls.

Unfortunately, if the USD Index and the main stock indices trade in tune (but in the opposite directions) - meaning that they will be highly correlated, then the abovementioned technique won't work. Should this be the case, and suddenly this correlation (between USD and the general stock market) disappears, then the market which PMs will follow in the next several days following this "disconnection" is likely to be the market leading the metals in the coming weeks.

The phenomenon mentioned in the last paragraph is what we've seen very recently. USD Index and the general stock market move in tune, so it is impossible to tell which of them actually drives PMs. We will have more information once we see some kind of divergence, for instance if the U.S. Dollar tops and the general stock market continues to slide. Speaking of the former, let's take a look at the chart of the USD Index.

The situation is becoming more and more difficult each day, because the general stock market doesn't appear to have bottomed, which means that each day we are getting closer to the next downleg. On the other hand we didn't get the abovementioned confirmation so far, which means that it is not certain what actions should the long-term Precious Metals Investors take if/when the general stock market declines. If PMs are to follow the main stock indices, then it seems it would be a good idea to limit one's exposure to metals for a few months or so. On the other hand, if PMs prove to hold well despite weakness on the general stock market it will indicate that gold and silver are a strong buy at the moment.

Therefore, monitoring this correlation is one of the most important things that PM Investors need to focus on. Naturally, our Subscribers will be informed as soon as we spot any critical divergences that might indicate that one outcome is more probable than the other.

Moving on to the analysis of the general stock market, let's begin with the long-term chart.

There are no big changes on the long-term chart of the SPY ETF since we wrote about it last week. The values of the main stock indices are rising, but the volume doesn't confirm that direction - it declines, which suggests that this is just a consolidation within a bigger move lower. Either way, it seems that the general stock market will be stopped relatively soon, as it is relatively close to the strong resistance level (black declining line on the chart based on three key tops).

Summing up, gold, silver, and PM stocks are currently following the general stock market more closely than they follow the USD Index. This is a positive factor in the very-short-term, as it provides additional positive signals for short-term Speculators.

On the other hand, this factor is negative in the long run because the situation on the general stock market is still bearish from the long-term point of view. Therefore, if you already own physical gold/silver, and you want to add to your positions, you may want to wait for additional information. If you don't have any at this point, we would still suggest buying some (25% or so of what you would like to own.)

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Thank you for reading. Have a great and profitable week!