The general market and gold stocks have been behaving very well in anticipation of the next week's Fed cut. We expect that after the coming cut, there will be a sell-on-the-news reaction on the market, including the gold stocks.
The technical picture supports this point of view as gold stocks are short term overbought. Another worrisome factor is the almost solidly bullish consensus on gold and bearish consensus on the US dollar among the gold bugs and even on the Main Street. In addition, much of the gold's rise has been attributed to the weaker dollar - and this has rarely produced a sustainable breakout. In fact the gold price in most other major currencies has been rather weak.
As a result, the risk/reward ratio to the upside looks poor and although further gains are possible, downside risks are more significant. Therefore, we are waiting for a pullback before making a decision to add to positions.
In a best case scenario, if gold manages to hold above $690, XAU will stabilize around 150 or upper 140s. But a deeper correction could possibly bring XAU back to the 134-141 range. We currently favor the second scenario even though we cannot rule out an additional upside in the next couple of days in the event of the Fed delivering a 50 bps cut coupled with dovish remarks.
From the chart above it is clear that XAU is now at a pivotal point. The vertical orange lines indicate a beginning of a major bull run. Each time, the XAU/Gold ratio led the way by breaking above its descending trend line. This time around, the XAU/Gold ratio remains weak and with overbought conditions in stocks, it is doubtful that a substantial breakout can occur right now.
We will be looking for a bullish divergence in the coming pullback. In particular, while finding a support level, gold stocks should demonstrate strength against gold and the general stock market indicating that we are entering a major up-leg of the gold bull market. Without this divergence, consolidation may easily continue for a few more months.
This is an excerpt from the RSG Newsletter posted on September 15, 2007.
