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Exactly one year ago precious metals and their stocks were more suited to shorter term time horizon trading. This was the position of gold about a year ago as described in a previous Wrap Up. “Here’s the story on gold. It’s either an excellent entry point, or its getting ready to breakdown. As a fundamental gold bull, I took this opportunity to speculate with a stop loss, that the trend line will hold. We’ll see how that trade works out.”
February 3rd of 2005 presented investors using technical analysis with an excellent opportunity of joining the bull trend in gold while assuming very little risk. Gold was oversold and on top of its upward sloping trendline. A decisive break below the trendline would have triggered a small loss stop-out, but the trendline held:
Now with gold surging, can one assume that in a similar manner as they were oversold a year ago, gold and precious metals stocks are now overbought and should be sold? This was the situation in the Gold Bugs Index ($HUI) as described a month ago. “Finally, since we are on the topic of the black magic that is Elliott Wave, below is presented the long-term chart of the Gold Bugs Index ($HUI). After having broken out of a trading range (labeled as an a, b, c, correction), I believe that we are in the third wave (wave III) of a bull market in gold stocks. And as with the correction of a couple of weeks ago, as with any wave III, pullbacks are likely to be of relatively short duration and minor magnitude.”
The gold bugs index was overbought a month ago and it is still overbought now as illustrated below.
If the HUI was overbought and due for a correction a month ago, it must be super overbought and really due for a correction now! So would it be wise to now sell? After all, isn’t it “the crowd” that is now piling into precious metals supposed to be wrong most of the time? Not so fast! If one puts any credence in Elliott Wave theory, it is clear that in the long term (years) precious metals are in the 3rd wave (2nd UP wave) of a 5-wave bull market. With that in mind, what are the characteristics of the 3rd wave we are in now? Here’s how Frost and Prechter describe 3rd waves in their book Elliott Wave Principle: Key to Market Behavior (page 78): “Third waves are wonders to behold. They are strong and broad, and the trend at this point is unmistakable. Increasingly favorable fundamentals enter the picture as confidence returns. Third waves usually generate the greatest volume and price movement and are most often the extended wave in a series. It follows, of course, that the third wave of a third wave, and so on, will be the most volatile point of strength in any wave sequence. Such points invariably produce breakouts, “continuation” gaps, volume expansions, exceptional breadth, major Dow Theory trend confirmations and runaway price movement, creating large hourly, daily, weekly, monthly, or yearly gains in the market, depending on the degree of the wave. Virtually all stocks participate in third waves. Besides the personality of B waves, that of third waves produces the most valuable clues to the wave count as it unfolds.” Similarly Steven Poser describes 3rd waves in his book, Applying Elliott Wave Theory Profitably (Page 15, Emphasis added by Martin): “The third wave is the wave that Elliotticians dream about. Prices rise rapidly and anybody waiting for a pullback to enter will be sorry, because pullbacks will be short-lived and shallow. Volume is usually extremely high. Wave 3 is where much of the public will realize that the bear is over. It is at this juncture that the Elliott Wave analyst must be careful and remember that it is okay to be on the same side as the crowd some of the time. Wave 3 is usually at least 1.618 times as large as wave 1 in price terms, although since it is very powerful, it will probably take less than 1.618 times as long to complete. As is always the case, wave 3 should develop in five clear impulsive waves, three up and two down. Momentum almost always confirms the price highs.” The preponderance of evidence suggesting that precious metals stocks are in a long-term third wave leads me to the conclusion that it would not be worthwhile to sell and take profit due to an overbought condition. I wouldn’t want to be out of my position waiting for a re-entry point because, “Anybody waiting for a pullback to enter will be sorry, because pullbacks will be short-lived and shallow.” Other Overbought Markets Consumer Related It is reasonable enough to believe that precious metals stocks are due for a significant correction. Yet I believe that because we are in a 3rd wave, most investors should maintain a “playing with the house money” attitude while exhibiting patience and holding through these inevitable corrections. What is the best way to do that? Perhaps this can be accomplished by focusing on other overbought markets that don’t share precious metals' favorable fundamentals and may be suitable to short term trading, and even (pardon the expression), shorting. Consider the long-term weekly chart of the retail holder’s exchange traded fund (RTH).
If searching for a hedge against resumption of a bear stock market, the retailer holders’ may be a good bet. It is a notable laggard in recent weeks. On a relative price basis, compared to the S&P 500, the retail holders’ index has broken support at 0.075. If the stock market rallies, the RTH is likely to lag; if it swoons, the RTH is likely to swoon more than the general market. A decisive break above the green down trendline may clue traders into whether the bearish trade is not working, and should be terminated. On a point-and-figure basis, the RTH is in a bearish pattern having broken down in a particularly bearish manner. While the price objective is only about 6% downward, a print at 93 or below will represent a particularly bearish sell pattern – the dreaded descending triple bottom breakdown. A print of 98, would trigger a “buy” signal, and be a good point at which to consider closing out a bearish position and moving onto greener pastures.
More evidence that a resumption of the bear market is likely to be led by consumer-related stocks can be observed in Investor Business Daily’s (IBD) “Industry Group Rankings.” Following are the rankings of selected consumer-related stocks in terms of 6-month stock performance (IBD, January 27, 2006). Rankings range from best 6-month stock performance to worst at 1 to 197, respectively.
While the fundamental case for gold is strong, what’s the case for this company being worth more than all but a few Dow Industrial stocks? And now for an absurd valuation of over 80 (after items and one-time events), you also get a stock that is technically wounded. Sell gold? I’d rather sell Google.
Google’s tall point-and-figure chart suggests a bearish price objective of 316.
A theoretical long Ebay/short Google position as described last week, is up over 7% as of Wednesday evening. Momentum is looking strong, as Google put out its first big cockroach in their quarterly earnings. Over 40 analysts follow this company and none of them said anything about Google’s higher tax rate before their quarterly report, thereby proving that except for errant emails, Henry Blodget was a man ahead of his time. It also shows that if the dog is man’s best friend, the lap-dog analyst is Wall Street’s best friend.
If you are looking for trading opportunities in overbought stocks, there are many better opportunities than precious metals stocks and gold. Today’s Market Chalk up a distribution day as the major indices were all down on relatively high volume by what seems to be the “maximum allowable” amount. Today’s weak market did not seem to hit any sectors particularly hard except that financials and technology were each down about 1-1/2 percent. More importantly perhaps, the Dow Jones US Homebuilding Index was down by 2.6%. Within the homebuilding index, one of the most important stocks appears to have broken down technically – that is the stock of luxury homebuilder Toll Brothers, Inc. (TOL). The stock has formed a massive 1-year head-and-shoulders reversal pattern and the plunging neckline looks ready to give way. The reversal pattern is “textbook” in its volume characteristics (high on the right shoulder and low on the left), and relative symmetry. The RSI momentum trend (shown above) has been broken as has the relative price support line. The October 2005 low has been taken out today on confirming high volume. Below is the 3-year weekly chart that illustrates TOL's long term technical position.
A word of caution is warranted, though. The market has had a bullish bias since October of 2002, and as a result selling into technical breakdowns has usually been heartbreaking. So if the reversal continues downward for Toll Brothers, it will probably have serious implications for other homebuilders as well as the market in general. A change of market character would be signaled. And how poetic is it that the most important homebuilder stock technically breaks down the day after Mr. Greenspan leaves office? As with Mr. Bernanke, the homebuilding stocks are “set up for failure.” The XAU and the HUI were marginally down today as they grope for their long overdue correction. They finished strong – but no matter for most investors. Gold finished up and the divergence between the stocks and the metal will trigger some more contrary opinion that the correction is coming. After hours, Amazon reported results that disappointed the street, and they may need some organized support tomorrow. All things being equal, it appears that light crude oil is similarly overbought as gold.
There are two overbought commodities. Oil sits below its high and therefore has “overhead” to overcome. This all changes if oil breaks its old high. Gold has no overhead. Which commodity is more suited to trade? Finally, there is every reason to believe that the bond market will remain in its intermediate term trading range for a considerable period of time. Yet an examination of the 10-year treasury note yield dating back to the late 90’s suggests that interest rate trends appear to be “lighter” and it is fairly easy to see that what was once a downtrend is now probably an uptrend.
Have a great evening. Martin Goldberg
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