A Case of Correlations Behaving Badly

01/31/2013 6:00 am EST

Focus: COMMODITIES

The USD Index is interesting because of the unusual way three charts align to flash three different, yet consistent bearish signals, writes Przemyslaw Radomski of SunshineProfits.com.

The recent situation in the currency markets is all that precious metals investors like to see—“ for some time now we have been witnessing the strength in euro and weakness in the US dollar. Unfortunately, what we did not see was the usual rally in gold, silver, and other precious metals that normally accompanies such a set-up. That is mainly due to the unnatural state of correlations that we already discussed before.

But there were exceptions, such as the rally at the beginning of January, sparked by a plunge in dollar. These exceptions are a good sign—a sign that correlations are returning to what we are used to, i.e. negative correlation between precious metals and the dollar and positive one between stocks and precious metals. Maybe a strong signal from the market is what is needed to push correlations back to normalcy. For now, let’s take a look where the pressure from the currency markets will be and in which way gold, silver, and mining stocks will likely move eventually.

The situation on the USD Index is interesting because of the unusual way three charts align to flash three different, yet consistent bearish signals. And we believe that the subsequent moves downward are likely to eventually translate into higher precious metals prices. Let us see why—we will start with the short-term cart (charts courtesy of stockcharts.com).

chart
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The index is now at its declining resistance line and cyclical turning point. With the previous short-term move to the upside, there is a bearish combination in place and index values are likely to reverse right now since the resistance line has been reached. This means that declines are likely to be seen in the days ahead or at least very soon. The index has already declined quite a bit on Friday, after two days of slightly higher prices.

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To see what may follow from here, let us use an analogy to the beginning of January that was already mentioned above. At the beginning of the year, the USD Index moved to the declining resistance line—breaking it temporarily. The breakdown was then invalidated, which caused gold and silver to soar. The USD Index is once again at this resistance line and metals and miners once again declined. The difference is, however, that the dollar index is now lower and metals are higher. Miners are more or less at the same level.

Let’s now have a look at the medium-term chart, as an important bearish pattern has almost been completed there.

chart
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On the above chart, we can see that the bearish short-term picture could easily turn into a bearish medium-term outlook if the head-and-shoulders pattern is completed here. A breakdown below the 79 level would accomplish this and likely drive prices down to around $74, as indicated in the above chart.

Finally, let us move on to the long-term chart, as yet another bearish factor is in play here, further strengthening the bearish outlook for the US currency.

chart
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In this chart, we see that the USD Index is also at its very long-term resistance line. This chart shows that we could very well see a bigger decline if the index level does move below 79 and a move as low as 74 would not be all that surprising, as mentioned before when analyzing the medium-term chart. This move would be in tune with the completion of the aforementioned head-and-shoulders pattern. And such a move would be very much in tune with this very long-term chart as well.

Summing up, the short-, medium-, and long-term outlooks are bearish for the USD Index. It is at the long-term and short-term declining resistance line and also at a cyclical turning point after a short rally. Lower values are implied for the weeks and months ahead, and the medium-term implications are bullish across the whole precious metals sector. The short-term, however, can be volatile even though the USD points to higher prices in the medium term.

By Przemyslaw Radomski, CFA, Founder & Editor-in-Chief, SunshineProfits.com

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