Oversold Gold Does The ‘Trick’, Bulls Get The ‘Treat’

What started as a depressing month for gold investors has turned positive with metals and mining stocks posting their best performances since August.

Investors may have dreaded October for various reasons – not the least of which was the U.S. government shutdown and debt ceiling showdown. But the “scariest month” is turning out to be nothing more than a phantasm heading down the final stretch. In this commentary we’ll examine where gold is likely headed thanks to a historic technical condition mentioned in previous commentaries.

Last Wek's Breakout
The latest precious metals sector rally was telegraphed last week when the gold stock advance-decline (A-D) line broke out from a multi-week downtrend. By breaking the downtrend, the A-D line sent a “heads up” signal not only for the gold mining stocks but also for the metal itself. We continue to view the A-D line as the most important leading indicator for the mining shares since it has proven its merit time and again this year.

The price of gold was given an additional boost on Tuesday from a disappointing jobs report, which suggested to traders that the Federal Reserve would leave intact its $85 billion/month bond purchasing program in the foreseeable future. Gold hit a three-week high for the day. Also helping gold was a notable decline in the U.S. dollar index, which is at its lowest level since February 4.

Confirmed Bottom
The gold price has finally emerged back above its 15-day moving average and managed a two-day higher close above the dominant immediate-term trend line as of Tuesday, Oct. 22. This is the first confirmed immediate-term bottom signal gold has given since August, which is amazing in and of itself.

Now that gold and the mining shares are once again showing signs of life, the first of what will probably a growing list of investment banks are beginning to upgrade the outlook for the PM sector. According to Ben Levisohn, writing in Barron’s, HSBC upgraded several gold stocks on Oct. 21 as the bank expects gold prices to rebound. HSBC analyst Patrick Chidley wrote:

Despite the rush to the door by speculators in the. SPDR Gold Trust ETF (GLD), we continue to believe the fundamentals are supportive of higher prices. China continues to report gold imports at very high levels (over 130 tons in the month of August from Hong Kong alone). Based on our belief that the pressure on gold price is temporary, due to continued strength in Chinese demand, continued strong Indian demand (despite recently ramped up government tariffs on gold imports), growing demand in other emerging markets countries, continued central bank purchases, a strong physical supply response coupled with a lack of new projects coming into production in the next few years, we believe the gold price will rebound in the next few months.

Hence, given the rebasing of gold equity prices to reflect the current gold price below USD1,300/oz, and HSBC’s view that gold can climb back above USD1,400/oz within a few months, we are upgrading a group of stocks and hold a generally bullish view on the gold sector, looking forward, while recognizing the current situation is tough unless gold rebounds.

The Players
Chidley and his HSBC team upgraded Agnico-Eagle Mines (AEM) and Yamana Gold (AUY) from underweight to neutral. Barrick Gold (ABX), Goldcorp (GG) and Iamgold (IAG) were upgraded from neutral to overweight.

HSBC also believes that inflation in Asia will drive gold demand. Demand for jewelry, bars and coins in India, Greater China, Indonesia and Vietnam increased to about 60 per cent of the global total compared to 35 per cent in 2004, economists including Frederic Neumann wrote in a note to investors on Oct. 18. Citing data from the World Gold Council, Neumann wrote that bullion is mostly used in the region as a store of value.

“With inflation still elevated in many markets and interest rates not offering adequate compensation, expect Asia's voracious appetite for gold to persist," Neumann wrote. "Asia is going for gold. Over recent years, demand has soared.” He foresees continued strong demand in the coming years as inflationary pressures increase in China, India and other regions of Asia.

Oversold Levels
Also helping buoy the metals and mining stocks is the fact that gold is coming off its most oversold technical extreme in years. As we talked about in a previous commentary, the 10-month oscillator for gold fell to its lowest level in over 10 years recently. Historically the price of gold tends to rally vigorously when coming off such oversold levels.

Gold has earned for itself a much needed respite and should be able to enjoy one thanks to this historic oversold condition. Sentiment on the metals and mining stocks has been bearish to the extreme in recent weeks as one investment bank on top of another has piled onto the “sell everything” bandwagon. Capitulation has been evident, which from a contrarian standpoint supports a short-term recovery for the sector.

Clif Droke is the editor of Gold & Silver Stock Report, published each Tuesday and Thursday. He is also the author of numerous books, including most recently, “The Stock Market Cycles.” For more information visit www.clifdroke.com