Three Signs of a Gold Bottom

By Mike Swanson                        May 25, 2005   wallstreetwindow.com

For several weeks now, I have been on the watch for a gold bottom to use as a buying opportunity. We are seeing three technical signs that we are near a definitive bottom for gold and gold stocks.

1)The divergence between the XAU gold stock index and Gold reached an extreme level

The action in gold stocks tends to lead the action in the metal. When gold stocks outperform gold it has historically been bullish for both the stocks and the metal. However, when the stocks trade weaker than gold a correction is usually near.

I keep track of the relationship between gold stocks and the metal by looking at the price of the XAU gold stock index divided by the price of gold. This is the XAU/gold ratio. When this ratio is rising, gold stocks are outperforming gold and when it is falling, gold stocks are trading weaker than the metal, which is bearish.

As you can see from the above chart, this ratio has been falling since the middle of March. Over the past two weeks however the ratio has turned back up. During this time, gold stocks have rallied harder than gold has on days when gold has been up. This is a positive sign that the gold stocks are starting to base and act stronger than gold.

Most people who follow the gold market know that gold stocks have been trading much weaker than gold over the past several months. What many of these people don't know is that this divergence between the stocks and the metal has reached an extreme level, which has marked important bottoms in gold and the gold stocks over the past 14 years. As you can see on the chart above, each time the XAU/gold ratio fell below .20 an important bottom has formed in gold stocks. There has been only one exception and that was during the final bear market bottom of 2001.

According to John Doody, who puts out the excellent Gold Stock Analyst report, the divergence between the mining shares and the metal reached such an extreme level by the end of April that gold stocks were trading as if gold was around $384 an ounce. This is a testimony to how oversold and cheap the stocks have become. Doody found that, on average, gold stocks are undervalued 19% based upon historical valuations of market divided by ounces produced.

Gold stocks are actually fundamentally cheap right now!

2) Commercial futures traders are covering short positions

Commercial futures traders have been apt at timing market tops and bottoms by being heavily short at tops and covering at bottoms. According to last week's commitment of traders report, commercial shorts closed out 26,697 short contracts last week and went long 1,991 contracts. As of May 17, they are net short 79,861 contracts. They have likely closed out more contracts since then. This is important because, during the past five years, important bottoms in the gold market have been made when the commercials have been net short 40-60k contracts. A move below gold's recent low of 416 towards 410 would get the commercials to that level. We'll get a more current update on their position and what they have done this week when the next commitment of traders report comes out on Friday's close.

3)Major support levels have held

Despite the current correction in gold and gold stocks, long-term bullish trends remain in place. Since 2001, the 65-week moving average for gold has acted as solid support. It has never traded below the 65-week moving average for more than two weeks. That moving average now sits at 416.51.

The important point is that the technical bull market for gold and gold stocks has remained intact despite the correction. At the same time, two important technical signs are telling us that the bottom in gold is either in or very near.

Although the gold stocks are beginning to outperform gold, I can see gold briefly breaking its 65-week moving average to cause the remaining commercial shorts to cover and flush out any remaining stops.

If this happens, I plan on using such a quick dip as a buying opportunity. After gold bottoms, I fully expect gold and the gold stocks to trade sideways for several months and consolidate. Gold stocks should then begin to exponentially outperform gold and signal the start of a large rally in both. We saw this happen last year - a consolidation in the summer and huge run from August to November. An even bigger run should happen this time.

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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