Market tops and bottoms are always a popular topic of conversation. There are a number of theories about how to forecast key turning points in advance, but, in reality, those theories rarely work.
While it does seem like an exercise in futility to forecast the day and price of tops and bottoms, there is valuable information to learn from studying the general nature of market turning points. This knowledge will help us understand what to look for and how to react to the market as it develops rather than provide a false sense of comfort about what we should see.
In the stock market, we tend to see tops build slowly and bottoms appear unexpectedly. This can be seen in the chart below, which shows the 2007 market top on the left and the March 2009 bottom on the right.
SPDR S&P 500 ETF (NYSE: SPY) built a top slowly, over a period of several months. The bottom, on the other hand, came unexpectedly and was greeted with disbelief.
This pattern has been seen at other significant stock market turning points. The bottom that occurred in 2002 was also unexpected and sudden, while the top in 2000 had been formed over several months. While the top was forming, stocks moved within a relatively narrow range as the transition from bull market to bear market was completed.
This behavior can be explained with investor sentiment. In a bull market, investors become conditioned to buying dips. They respond to price drops by buying, and this is why we see prices trade in a consolidation pattern at a top. Buying the dips shows up as support on a chart, and excessive valuation levels prove to be resistance levels.
Bottoms in stocks begin when sentiment is negative and selling has reached a peak. When the selling pressure is exhausted, prices rebound suddenly. Gold and other commodities tend to behave differently, as the next chart shows.
Gold futures are shown in this chart because they have a longer trading history than SPDR Gold Shares (NYSE: GLD). The behavior seen in these charts is the opposite of what we see in the stock market. With commodities like gold, investors seem more concerned about missing the upside than buying at a bottom.
This might be because gold cannot be valued like stocks. In March 2009, some investors considered stocks to be a bargain based on price-to-earnings (P/E) ratios and other valuation tools. Similar tools for gold do not exist, and the market moves based solely on what investors believe gold should be worth. When it is moving up, investors seem to be willing to push the price higher, and when the decline starts, they seem willing to forget about gold as an investment option.
The next chart shows that, for now, GLD appears to be in a consolidation pattern that could be the beginning of a bottoming pattern.
This pattern has been developing over the past seven months, and there is no indication that GLD is at the beginning of a new bull market yet. We could actually see gold trade near these levels for several years.
As gold finds a bottom, there will be a number of trading signals generated by any trading system.
After selling SLV, the model portfolio will consist of four positions:
This article was originally published at ProfitableTrading.com:
A Turning Point in Gold Could Be Developing