February 27, 2009: Gold is hot and TV ads say the yellow metal is the next big investment. Is it hype or is there any substance to the bullish claims?

Its typical of novices to be optimistic when markets have run up substantially. At the point where professional traders and investors sell, novice traders enter the market in droves, buying. Novices give professional traders an opportunity to exit their positions in profit before the value of the stock falls. 

Gold has run up over the past few months. Given the fear in the economy is there a further upside in gold or has the precious metal peaked. Will a further drop in the equity markets lead to another rally in gold? We looked at GLD, the gold ETF and S&P 500 index to capture some interesting trends.

Price history

Let us analyze the chart of GLD to get a clearer picture.  We will also compare the movement of GLD to the S&P 500 to check out their correlation. A look at the weekly charts below show that GLD broke out of a range and began to rally in September 2007, a month before the S&P 500 peaked and began falling. As the S&P 500 was falling, GLD was rising all the way till March 21, 2008. Till this point in time there was a clear inverse correlation between the S&P 500 and GLD. 

However, after March you'll notice that the inverse co-relation does not work at all times. Between March 21, 2008 and July 18, 2008 the S&P rose and fell and GLD moved inversely, but with a difference. During the week of July 18, 2008, S&P made a lower low, but GLD did not make a higher high. Then from July 18, 2008 to November 21, 2008 the S&P fell and so did GLD, clearly breaking the inverse relationship. We did have a spike in GLD one week, but that rally was erased. 

After November GLD has rallied strongly, while the S&P has remained flat coming back to its November lows today. Note that S&P has made new lows ever since October 2007, but GLD has not made new highs after March 2008. Hence, the inverse relationship between gold and the equity markets has not always held true. 

But before we conclude that the inverse relationship is broken, note that between October 2007 and now, GLD and S&P have inversely moved about the same distance--50%. This shows us something crucial that during this recession, GLD and S&P move inversely over the long term, but can travel in the same direction in the short term. Keeping this in mind, let us look at where prices are right now.

Looking ahead

GLD is right now near its previous resistance level of $100.55 and S&P 500 is at its November 2008 support level. Hence, we would not buy GLD. Ideally, we would wait for one of the two things to happen.  We would wait for GLD prices to retreat to the $81 level before taking a position. Or we would wait for prices to go strongly above the $102 level and then buy when GLD pulls back. The ideal situation would be if the S&P 500 is also on a decline.

For longer term support, resistance and targets, we would look at the weekly charts. The red lines are the Fibonacci extensions that mark levels to which prices can go if it breaks the $100.55 resistance level. The lines below the current price show support levels or targets to book profits on the short side.

The daily charts on the other had show support levels for a shorter time horizon. When trading the short term remember that the inverse relationship between the S&P 500 and GLD does not always hold true.

The momentum of GLD since September 2007, favors the bulls in the long run. Take a look at the white lines on the weekly charts. From the September 2007 lows to the March 2008 highs GLD took 29 weeks to move up by $34. Then it took more time--33 weeks-- for it to fall by $31.71. In the final run up it took just 12 weeks for GLD to rise by $30. The ETF has been rising much faster than it has been falling, which clearly favors the bulls. But we would wait for GLD to reach our levels mentioned above before taking a position.

Caveats

Its possible for GLD to hit its all time high of $100.55 and then tank. This can happen in a deflationary scenario, when both the equity markets and gold fall.

Chart analysis 

GLD Weekly Chart

S&P Weekly Chart

GLD Daily Chart