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Locating the Next Gold Bottom

Last week gold fell over 20 points while the XAU dropped almost 9%. Energy stocks fell hard too as the price of oil fell to its 150-day moving average. There is a lot of action going on right now in the markets and the next few weeks are going to be critical. They are going to set the tone for the rest of the year and will provide prudent investors with excellent entry points.

The big drop in gold is shaking up gold investors. You might be asking yourself questions like...What happened? Is the gold run over? Should I buy now? Should I sell?

Well let me give you my two cents worth. Since my emotions aren't being affected by the gold market right now, I think it may give you a clearer perspective on it.

You see, I sold out several weeks ago in expectation that a big correction was coming. I didn't think that any correction would spell the end of the gold bull market - far from it - I just didn't want to hold through it. So I missed a few weeks of the gains. But now I have tons of cash on hand and am waiting to buy back into the gold market when I think the time is right.

First I want to tell you what is behind this gold smash up. Gold and gold stocks simply got overextended. In fact, since the early 1980's, they've NEVER been this overextended. Hedge funds, daytraders, and even Jim Cramer, who for years has poked fun at gold investors, started to pile into gold stocks in December.

Gold is doing now what all bull markets do when they get overbought - it is correcting. Yes, the correction is likely to continue. But this correction is likely to be different than the ones we've seen over the past few years in the gold market.

Why different? Well, Gold is now in stage two of its bull market. This is when the general public starts to recognize that a bull market is real. Stage two is the longest and most profitable stage of a bull market, however it has wicked and violent corrections. The corrections are sharp, but they are also a lot quicker than the corrections that come in stage one. They last weeks instead of months.

They also shake out the people who don't really know what they are doing. This prevents most people from making money despite the fact that the bull market is real. When this correction is over gold is going to go up again at an even faster rate than it has the past few weeks. Gold will be way above 600 by the end of the year and the right gold stocks will double.

When this correction runs its course I plan on buying gold stocks hand over fist. I'm looking at the charts to give me an idea of where gold and gold stocks are likely to put in there next major bottoms.

Gold has undergone several corrections throughout the past five years of its gold bull market. I define stage one as from 2002 until December of 2005 when gold broke through 450 and began a parabolic run up to 575. This run in gold pushed several technical indicators into giving the most overbought readings they had given for the metal since the early 1980's.

For instance, the bollinger band width indicator gave a higher overbought reading than any previous overbought reading it had given over the past several years.

Long-term support for gold is at its 65-week moving average of 450. This 450 level is also the one-third retracement level of its entire bull market move. Throughout stage one, gold fell all the way down to these support levels when it went through an intermediate-term correction.

If this was a year ago I'd expect the same thing to happen all over again. But since we are now in stage two we can expect this correction to be quicker and more shallow.

The bottom of stage two is last year's low at 414. The resistance peak is the January high of 575. A one-third retracement of this move would take us down to 513. A 50% retracement puts gold at 495. I think gold will ultimately bottom at one of these two levels over the next six to twelve weeks.

At this point the XAU has support at the 125.87 level and then 116.78, which is a 50% retracement of the move from last May to January and is just above its 150-day moving average. I think we'll likely see the XAU bottom somewhere between these two levels with gold bottoming in the 510-520 area..

However, I don't really buy or sell based on price projections. They give me an idea of where things are more inclined to go, but what I really look at to make my buy and sell decision is the price action between gold and the gold stocks themselves.

Gold stocks tend to lead the metal so it is bullish when the gold stocks outperform the metal and bearish when they underperform. The recent correction began just a day after gold made a new 52-week high and the stocks failed to confirm that action in gold.

I am going to be watching gold and gold stocks carefully from here on. If the XAU holds up while gold drops then I am going to take a position in a basket of gold stocks that I believe will lead the next rally. I will then watch the rally carefully and with hesitation. If gold outperforms the gold stocks on the rally then that would be a sign that the rally is just a bounce and the real bottom has not been put in yet. I'll then take some profits and sit on the sidelines again with the intention of buying on the next bottom.

This isn't as complicated as it sounds. Using charts makes it easy to determine when the XAU is beginning to outperform the metal. The chart above is a 60 minute chart of the XAU. The green line at the bottom of it is the XAU divided by gold ratio. When it trends down as it is doing now then the gold stocks are underperforming the metal. As you can see they have been falling at a faster rate than the metal for the past few weeks, causing this ratio to trend down.

At some point the stocks are going to firm up as the metal continues to drop. Once this happens the XAU/gold ratio will break its downtrend and turn up. That will give us the signal to buy gold stocks.

The longer it takes for this to happen the more reliable the buy signal will be. If it happens with the XAU around 125 and gold near 510 then we'll basically be able to buy with the expectations of holding for the rest of the year, because we'll be confident that a major bottom has just been put in place.

However, if something like that were to happen this week or next then we won't be able to be so sure. I'll buy then with the realization that I'm probably just buying for a short-term trade. If gold stocks bounce and then go right back to underperforming I'll have to sell and take profits and wait for a better entry point with lower gold prices. Instead of a major intermediate-term bottom we'd just be seeing a short-term bounce of one or two weeks on the way down to gold bottoming in the teens.

Whatever the case, I'll be looking very carefully at the action in the gold market going forward and I expect to be taking a position in gold stocks shortly for either a short-term trade or with the intention of buying and holding for the rest of the year. It depends on how the buy signal comes. I'll keep you appraised to what I see happening in the gold market and will examine individual stocks in more bulletins as we go forward from here.

To find out what gold stocks Mike Swanson holds and plans on buying subscribe to his free Weekly Gold Report at http://wallstreetwindow.com/weeklygold.htm.

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