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November 9, 2010

Key Reversals

My last few blog posts primarily discussed the prospects for a return of the bear market for equities. However, the Docfolio is mostly focused on trading precious metals. One may then wonder why I don't write much about gold and silver these days, and the simple explanation is that it is difficult to provide a fair analysis without getting into a discussion of cycles, the analysis of which constitutes my primary tool for making trade decisions. However, cycle analysis is the purview of the Member Area... and I really don't want to upset my paying readers by giving away their content for free! However, I think I can dabble a little without stepping on any toes.

November 9 has the potential to be a key day in the course of a gold rally which I believe will reach an important peak in the second quarter of next year. The key feature of today's action is, of course, the hard reversals suffered by precious metals, and especially by silver.

Silver daily price chart

As supporting evidence I submit that today's contract volume blew away any recent notion of normality. Both the mini and full contracts saw activity at roughly six times the average pace. Even the world's favorite silver stock, Silver Wheaton, suffered a huge reversal on enormous volume:

Silver Wheaton stock chart

I frequently imbue readers with the notion that a single candle should not be taken too seriously, but combined with the stretched nature of the rally and bullish sentiment, today's activity should be given due consideration. Also consider what transpired on the dollar chart:

US Dollar Index chart

Intermediate rallies often initiate from pivots which occur off important support levels. Furthermore, the trend break from last week occurred on the heels of the initiation of a new counterfeiting operation by the Fed, a decision which got everyone talking about the demise of the dollar. The environment and the action have all the characteristics of a bear trap.

The caveat is that a weekly swing low is not complete until the week itself completes. If the buck sharply reverses course by the end of the week, we could see the head fake backfire. One of the reasons why I believe the odds favor the former scenario is the action in the equity market:

S&P 500 chart

I outlined in the last couple of posts... and detailed in the Member letter... how the cycle setup favored a return to bear mode. The break to a new cyclical bull high negates those signals. To be fair, I did note that a catalyst would be required to help stocks break their inverse relationship with the dollar, and such a catalyst has yet to appear. In any case, stocks are also due for a weekly cycle decline, and it would make sense for such a pull-back to occur in conjunction with a dollar rally.

Coming full circle, we can anticipate seeing at least a consolidation of the gold and silver rallies in coming weeks as the dollar bounces. The nature of the PM action over this time frame will be quite revealing with regard to what to expect next. If we see a price progression that plays out as a coil, we should then interpret the action as the midpoint consolidation of a larger move:

Gold Weekly price chart

The action could also play out as a bull flag or a rounded basing pattern. The key for us gold bulls will be to identify the pattern so we can buy either the impending intermediate cycle low or the pattern breakout. Since the pattern should also constitute a mid-point consolidation of the move out of July, we can then anticipate an extension to roughly the $1700 area. However, given the expectation for the dollar to induce a mini-crisis as it finds a major low next year, we should not underestimate how far precious metals could rally.

I mentioned that a 2Q peak in gold may constitute an important high. One should note that after 10 consecutive winning years, gold is finally gaining some respect among the masses. Usually when the acceptance of a bull market becomes ubiquitous, the market will find a way to burn all the latecomers. I suspect that after surging into a springtime peak, gold will retreat severely enough to make everyone believe the bull is over. Gold may even post its first losing year in a decade. Of course, we may be getting ahead of ourselves here. Let's keep our eye on the ball and first put forth our best effort to trade the coming rally. We will worry about the aftermath when the time comes.


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