Part 2, An Epic Battle in the Stock Market

S&P's Mark Arbeter thinks the skirmish between bulls and bears could end up being a draw for many months to come.

Note: This comment was originally published by Standard & Poor's Equity Research Services on Jan. 30, 2009

There is another battle going on between the U.S. dollar and gold prices, and this could really be fascinating how this plays out. Many times, a weak U.S. currency leads to higher gold prices as well as other commodities. The flip side of course is that when the U.S. dollar is strong, gold and commodity prices tend to be weak. What's interesting here is that the dollar has been in an uptrend since July 2008, and gold has been rising since the latter part of October. Some have said that both the dollar and gold are getting bid up together as they both represent safe havens from all the turmoil going on around the world. Can the two coexist in harmony, and, if so, how long can they advance together?

We really are not sure, so let's look at both markets separately and then try to mold a prediction. First off, gold is in a long-term bull market that started in back in 1999, but really got into gear in 2001 down at about $250/oz. At the recent peak in March 2008, the price of the yellow metal had quadrupled. This explosive move pushed the 14-week RSI to an extreme overbought condition in May 2006 and to a slightly lower high in March 2008. These extreme overbought weekly readings in conjunction with a bearish weekly divergence could be a warning sign that the great bull run in gold maybe nearing an end. In addition, the latest correction in gold sent the 14-week RSI below levels of prior bull market corrections over the last 5 years.

However, there are some bullish arguments to be made before we throw in the towel. The latest correction held right at the top of the rally that ended in 2006, so the pattern of higher lows is intact. Prices have also traced out a complex inverse-head-and-shoulder pattern and broke out of this pattern today. Prices have also retraced more than 61.8% of the recent correction, suggesting a full retracement back to the all-time highs just above the $1000/oz. level. So it appears that gold has a clear shot of running back to its all-time, but that's when things really get interesting. A strong break above $1000 would open the door for a move to the $1200 to $1500 zone, in our view. However, a failure from current prices up to $1000 could set up a massive double top, and potentially set the stage for a huge decline back to the $400 to $600 range.

The dollar, on the other hand, is in a long-term bear market that started in 2001, and has sent the U.S. dollar index to a 2008 bear market low near 70 from a peak of 120. However, we actually have some constructive things to say about the greenback, which we sense is quite the contrarian view. The dollar index has bullishly broken above the bear market trendline that has contained prices since 2002. While it has not yet completed a long-term bullish reversal pattern, it may be working on a massive inverse head-and-shoulder formation. The 17-week exponential average has crossed above the 43-week exponential average for the first time since 2005, a bullish sign in our view.

After moving to an extreme oversold condition, the dollar traced out bullish divergences on the 14-week RSI chart in the first half of 2008. In addition, the 14-week RSI has cycled into an extreme overbought condition late last year, suggesting to us that a new cyclical bull market had begun. Many times, markets do not get extremely overbought on a weekly basis while they are in a bear market. In addition, the monthly MACD traced out a bullish divergence in the summer of 2008 and this indicator is on the cusp of breaking into positive territory for the first time since late 1996. While the near- to intermediate-term technical outlook for the dollar is in question, suggesting that we could see a pullback, the long-term outlook is bullish for the first time in about a decade.

Putting this all together, any near-term corrective action in the dollar could send gold zooming, setting the stage for all-time highs in the metal. However, with the longer-term outlook for the greenback improving, and potentially higher treasury yields in the cards, which raises the cost to carry bullion, we think a long-term top in gold may not be too far away.

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It's going to be a wild ride all year long. Fasten your seatbelt!