GOLD STILL HAS MORE RESISTANCE BARRIERS TO OVERCOME -- WHY GOLD CAN BE A DEFLATION HEDGE -- GOLD STRENGTH HINTS AT DOLLAR WEAKNESS

GOLD STILL HAS MORE BARRIERS TO OVERCOME... I've gotten a lot of questions about the recent upturn in gold. I'll try to answer some of them here. I wrote on Friday that gold had "broken out" to a three-month high and had exceeded its July/October down trendline (green line) as shown in Chart 1. [Although I used the Gold Trust (GLD) in that earlier piece, I'm using bullion itself here]. Some readers correctly pointed out that there are still overhead resistance barriers to be overcome. Two obvious ones are the October peak near $925 and the (orange) trendline drawn over the March/July highs. Given the size of its recent advance, I wouldn't be surprised to see gold pull back a bit (it closed down $12 today to $896). Although I remain positive on the outlook for gold, there's no question that it still has to overcome its autumn highs to confirm a major upturn.

Chart 1

GOLD AND DEFLATION ... Some readers questioned my reference to gold as a hedge against deflation. You might want to reread my December 16 Market Message which explains how various markets act in a deflationary environment. Quoting from that earlier piece: "One possible beneficiary of those (deflationary) trends is gold which usually thrives in an environment of lower interest rates, a lower dollar, and weak global equities...during the depressionary years from 1929 to 1932, the only two assets that rose were Treasury bonds and gold stocks (bullion was set at a fixed price). The green line in Chart 2 is the 10-Year T-Note yield which plunged during the fourth quarter of 2008. One of the reasons for the plunge in bond yields (and the surge in Treasury prices) was fear of deflation resulting from falling stocks and commodities. Notice that the upturn in gold started in mid-November just as bond yields started to tumble. In the months since then, the two biggest winners have been Treasuries and gold -- not unlike the situation from 1929 to 1932.

Chart 2

ARE GOLD AND THE DOLLAR DECOUPLING ... One thing missing in the bullish case for gold is a falling dollar. Normally both markets trend in opposite directions. Chart 3 shows them doing that throughout 2008. The July gold peak coincided with a dollar bottom, while the November gold bottom coincided with a dollar peak. Both markets have been rising together, however, since the start of 2009. I doubt that will continue much lower. I strongly suspect that the recent upturn in gold is hinting that the dollar rally is overdone and could start to weaken. Chart 4 shows the Power Shares US Dollar Dollar Fund (UUP) gapping down yesterday and forming a bearish "island reversal" pattern (see circle). [An island reversal occurs when an upside gap is followed a few days later by a downside gap]. Only time will tell which of the two markets will continue its recent uptrend. I doubt that both will do it together.

Chart 3

Chart 4