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Making Sense of This Gold Drop

Yesterday the XAU dropped 2.06 points while the HUI fell 5.75. Both fell much harder than gold on a percentage basis. We've seen a huge rally in gold stocks in the past few weeks - one that on a long-term chart appears to be a key turning point as the gold market appears to have ended its lengthy seventeen month long period of consolidation and is beginning a new bull run. However, at the moment it is setup for a period of consolidation for the next 2-3 weeks before it moves higher. I'm going to be looking to add on to my gold position during this time frame. If past history holds than the 153-156 area will be key support for the XAU.

The XAU and HUI both rallied above their 200-day bollinger bands, which tends to act as long-term support and resistance during periods of consolidation in the gold market like we have seen in the past year. Once a market breaks above its upper 200-day bollinger band and enters a bull run it usually pauses or has a quick pullback before going higher. Each of the past three times the gold market has done this in the past six years it has pulled back before going higher. I have circled these areas in the above chart and examine them below.

During 2002 the XAU broke above its 200-day bollinger band and then traded back below it. It then broke out a second time and pulled back before moving higher. The first pullback was a 14% correction and the second was a 9.3% correction. The first breakout was a fake out and the second the real deal. The same pattern seems to be true now. We saw the XAU and HUI move above its upper 200-day bollinger band in July and then collapse. This second breakout in September appears to be the real move.

The breakout in 2003 was a bit different than the other two moves and current one as the time spent between the upper and lower 200-day bollinger bands before the breakout was of much shorter direction. Consequently the bull run was the shortest, lasting only nine months from the bottom to the top. As a general rule the longer the period of consolidation the greater the price gains of the subsequent bull run and the longer it lasts.

The move in 2005 is similar to the current one as gold stocks collapsed right before the rally began. They then rallied 50% off of their May 2005 lows and peaked above the 200-day bollinger band. The XAU then corrected 12.4% and moved higher. Something similar is likely to happen now as the XAU rallied roughly 40% from its August low to its September peak.

There are some key lessons to learn from the past:

1)Each time the XAU and HUI for that matter started new bull runs they did so by breaking above their 200-day bollinger bands after at least 8 months of consolidation in which the 200-day bollinger bands narrowed. The length of each bull run was related to the length of time spent consolidating beforehand. The longer the period of consolidation the narrower the 200-day bollinger bands became before the next bull run began and the longer the next bull lasted. This is the narrowest the 200-day bollinger bands have ever been and therefore this next bull run in gold stocks should be longer than any of the previous three.

2)Everytime the XAU began its bull run after its breakout above its 200-day bollinger band it quickly corrected. Past corrections were between 11% and 14%.

3)These corrections all ended near the XAU's 10-day bollinger band, 50-day moving average, or upper 200-day bollinger band.

4)Once the short-term correction ended the XAU spent up to another week consolidating in a very narrow range, which caused the 10-day bollinger bands to almost pinch the candlestick price plot of the XA and led to another blastoff in gold stocks. My plan is to buy if we dip and I think the correction is over and then add on once the XAU's 10-day bollinger bands narrow. I will also be tracking the HUI and GDX for buy signals.

If the XAU corrects from here support is at the following levels:

1 - 160 - the point of the XAU's upper 200-day bollinger band.

2 - 153 - the 1/3 retracement level of the XAU's August low and September peak. This would be a 11.5% correction off of its highs and equivalent to 357.77 on the HUI.

I consider the 153-158 area as solid support for the XAU and a buy zone. During short-term corrections in gold stocks the stocks tend to underperform gold for a very short period of time as they are doing at the moment. Once they start to hold up against the metal declining the correction is usually soon over. If this were to start to occur below the 160 level on the XAU I would use this a sign that we are near a bottom, and it is time to start to average in and build or add on to a position.

Past history suggests we will see a correction in the XAU over the next 5-10 trading sessions that brings a fantastic buying opportunity. I will use it to buy more gold stocks. It is possible that this time is different and we don't get as big of a correction as we did in the past. If this is the case than I'd expect the XAU to continue to consolidate for the next 5-8 days, with support at around 160, before it breaks out. Either way I expect to be buying more within the next two weeks.

I expect the next leg up in the XAU and HUI to be at least a 30% move higher from its current levels. It would then likely have a correction before moving higher again. If you aren't in gold stocks or want to add on next week is going to give you an incredible opportunity that you can't pass up. I've just recounted how the XAU has corrected in the past when it has rallied like it has and started a new bull run. What comes after this rally is returns in excess over 50% in just a few months.

For daily comments from Mike and a list of stocks that he believes will lead the next big rally in gold stocks take a subscription to his WSW Power Investor service. Just click here.


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