Gold at a Crossroads?

On moderate volume, the S&P500 inched up another 0.88% last week. Volatility was virtually unchanged…..still pinned down to ultra-low levels. Apparently, the momentum generated from the non-taper news from the Fed and the end to the partial government shutdown has carried the equity markets even higher.

But make no mistake, US equity markets are at extreme levels. Valuations are almost off the charts. At 25, the Shiller P/E for the S&P is now the highest its been in about 80 years, except for the dotcom period. Bullishness is also back to extremely high levels; the difference between bulls and bears among investment managers is back up to the highs reached earlier this year. And the S&P500 is certainly overbought, now that it’s hugging or exceeding its upper Bollinger band on the daily, weekly and monthly resolutions. And it’s from extreme levels just like these that equity markets always suffer their greatest losses, falling by 40% or more in subsequent months.

Does this mean that this type of fall is imminent? Of course not, but it’s important to understand that it’s more possible now than during most other periods when such extreme conditions are not present.

On the economic front, the US government is catching up with its delayed reports. Last week, Existing home sales were released and the results just missed expectations. The House Price Index, however, missed badly. Initial jobless claims came in much higher than expected….again. The PMI Manufacturing Index missed. Durable goods orders beat on the headline figure, but this was skewed by airplane orders received by Boeing. When transportation orders are stripped away, durable goods fell.  They were supposed to rise. And finally, consumer sentiment fell to the lowest level of 2013.

All in all, there is no evidence that US economic growth is picking up. Instead, it’s stuck at stall speed and possibly even slowing down. Not good.

And all of this means that the Fed’s taper may be delayed, which perversely means that the stock markets may cheer.

But what about gold? For the last five years, gold’s appreciation had been closely correlated with the expansion of the Fed’s balance sheet, until recently, when it entered into a bear market correction. But over the last several months, gold has stopped declining, and has rebounded about 15% from its summer lows.

More importantly, gold is forming an important formation that is often quite bullish for future prices. Gold has followed an almost classic inverse head & shoulders pattern, and head and shoulders patterns signal a change in the major trend. Since gold has been falling for almost two years, the successful completion of this trend suggests that there could be significant upside to the price of gold over the next six months.

The test for this patter will come at the $1,450 price level. If gold can reach, maintain, and then go beyond this price, then it could be off to the races. Because beyond $1,450 not only will the inverse head and shoulders be complete, but the down trend line that began in late 2012 will be broken.

If this happens, technical traders around the world could pile into the yellow metal and drive its price much higher, first to the $1,525 level that used to be strong support, and then to the $1,800 level which is still an area of strong technical resistance.

The next several weeks will be very interesting for gold.

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