The significance of the 200-DMA

During September we said that gold stocks were likely to experience a sharp correction and nominated the 200-day moving-average for the Amex Gold Bugs Index (HUI) as a reasonable objective for the correction [the HUI was trading at around 130 at the time]. On Thursday 10th October the HUI spiked below its 200-DMA, but closed above it. The same thing happened on Thursday 17th October. Then, on both Friday 18th October and Monday 21st October the HUI closed below its 200-DMA before rebounding strongly and closing well above this moving-average on Tuesday 22nd October. On 23rd October the HUI pulled back and closed right at its 200-DMA.

So, what is the significance of the HUI's recent short-lived breach of its 200-DMA? Also, will a future breach of the 200-DMA have dire consequences for gold stocks?

In an attempt to answer these questions, let's take a look at the below long-term chart showing the S&P500 Index and its 200-DMA. Each green arrow on the chart identifies a move from above to below the 200-DMA during the great bull market of 1982-2000, while the red arrow identifies the solitary break from below to above the 200-DMA during the bear market of 2000-2002. It is clear that breaks below the 200-DMA did not signal major problems while the bull market lasted. In fact, there were 14 definitive breaches of the 200-DMA between 1984 and 2000, but only the last one (the one that occurred in September of 2000) turned out to be a harbinger of bad things to come. The first 13 breaks below the 200-DMA turned out to be good buying opportunities! Furthermore, the break above the 200-DMA that occurred earlier this year was certainly not a harbinger of good things to come. In fact, it marked an important peak and turned out to be a wonderful selling opportunity.

Now let's take a look at the below chart showing the HUI and its 200-DMA since the beginning of 1997. Each of the green arrows on the chart identifies a move from above to below the 200-DMA during the HUI's bull market whereas the red arrows identify moves from below to above the 200-DMA during the preceding bear market. The chart shows 9 red arrows, that is, 9 breaks from below to above the 200-DMA. The first 8 of these 'upside breakouts' turned out to be good selling opportunities. Furthermore, the first break below the 200-DMA during the HUI's bull market, which occurred in November of 2001, turned out to be a great buying opportunity.

See the pattern? During a bull market, breaks below the 200-DMA tend to represent good buying opportunities. During a bear market, breaks above the 200-DMA tend to represent good selling opportunities. The challenge, of course, is to be able to weigh all the evidence and arrive at a high-confidence conclusion as to whether the previous major trend is still in force because every break of the 200-DMA will be a false signal...until the last one.

Further to the above and as we've mentioned a few times over the past 2 weeks, we think the recent break below the 200-DMA by the HUI provided a good buying opportunity. Also, if the S&P500 Index manages to claw its way back to its own 200-DMA at some stage over the next several weeks then we think a great selling (or short-selling) opportunity would be knocking at our door. This is because all of our work leads us to conclude that the major trend for gold remains up and the major trend for the stock market remains down.

Hong Kong

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