Why Gold Is Poised for a Breakout

Stacks of gold bars

So this Brexit thing is freaking markets out, is it?


Or is it just a convenient excuse to take profits after a very strong rally from the lows in January?

I’m not suggesting the risk of Britain’s exit from the European Union is a non-event. It will certainly have some implications. But it’s not as if it’s a major economic upheaval. I’m sure we’ll all survive it.

All I’m saying is that global markets were due for a correction anyway. They just needed an excuse. That’s not a hindsight call, either. I said as much to readers of my Crisis & Opportunity advisory last week before the selloff, when discussing the outlook for the S&P 500:

…the world’s most important stock index is again at a point where it faces strong resistance. At this point you need to be wary of another correction.

Don’t get me wrong. I don’t believe you’re looking at another 2008-type moment. I think the odds of a major stock market crash like that are very low right now. The conditions just aren’t right.

But can we have another mini-panic like you saw in August 2015, and again earlier this year? Absolutely. The global economy is sluggish and stock valuations are stretched. This creates an environment ripe for a selloff.

I wasn’t even thinking about Brexit when I wrote that. In fact, I was more concerned about a correction in the oil market driving a broader stock market selloff.

Even though the price of Brent crude hit new highs this week, the momentum indicators are stretched and…starting to show signs of fatigue.

This is a warning sign that the rally is running out of puff. It’s not a definitive signal, of course, but it bears watching.

Given the correlation between oil and the market, if the oil rally IS running out of steam, then this could be the catalyst to bring on a broader stock market correction.

Brent crude fell another 1.7% overnight. It’s corrected around 6.6% in a week, which is hefty, but not surprising given the recent strong run.

But oil’s performance overnight suggests it’s not really acting as a ‘commodity’ these days. Rather, it’s more correlated to the stock market.

Let me explain…

Overnight, the US Federal Reserve decided to leave interest rates unchanged. This was expected. But the accompanying statement was ‘dovish’, meaning the Fed has effectively backed right away from its tough talk on rates from just a month ago.

Who would’ve thought?

As a result, the US dollar weakened as the pricing in of the interest rate tightening cycle in the US unwinds completely.

When the US dollar weakens, commodities normally rise. They are an ‘anti-US dollar’ trade. But oil, the king of commodities, fell, along with the dollar and the stock market. That tells me something isn’t quite right with oil.

Gold, on the other hand, jumped about US$10/ounce straight after the Fed released its statement.

With Japan and Europe’s monetary policy in a shambles, and the Fed looking like its tightening cycle is over before it even began, it makes sense that gold continues to attract attention.

But, before getting carried away, understand that gold has one major hurdle to overcome. That is, it needs to break above last year’s high, around US$1,300 an ounce.

Have a look at the chart below to see what I mean. It’s a weekly chart of gold going back to early 2013. The first green arrow shows gold trying to break out of its bear market in early 2014.

Source: Market Analyst
[Click to enlarge]

But the rally was unsuccessful. It halted at just over US$1,300 an ounce, before selling off and resuming its downward trend. After finally bottoming out in November/December 2015, gold had another early-year rally.

It peaked in March around US$1,300 an ounce (second green arrow), just below the January 2015 high.

It was tough talking from a barrage of Fed officials that saw gold sell off sharply again. But as you can see, it found strong support right on US$1,200, and over the past few weeks has bounced right back into this area of resistance around US$1,300.

Whether gold will break through and head higher no one can say for sure. In my opinion it will, but my opinion doesn’t count for much. The only opinion that matters is the markets’.

So why is this level so important?

Well, if gold can trade above US$1,300 an ounce, it will represent the highest close in nearly two years. That’s a bullish sign and will be further proof that the bottom really is in for gold. That will draw more money into the asset class, and the bull market momentum will gather.

If it can’t break above that level, then gold is simply stuck in a trading range —US$1,200 an ounce at the bottom, and US$1,300 an ounce at the top. That’s pretty much what gold has been doing all year so far.

Given the fragility of the global economy, and the dearth of ideas to remedy what ails it, in my view the risk for gold prices is to the upside. At the first hint of more weakness in the US economy the Fed will pull right back from any interest rate rise this year.

Once the market prices this in, gold will head higher.

My guess is we might get another pullback first…a breather before another rally. But soon enough, you’re going to see this new bull market take another leg higher.


Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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