Why Gold Could Stage A Big Rally In 2014

Once again, U.S. stocks ended the week with only a small change after high daily volatility. But after two days of large gains to end the week, bear market fears seem to have subsided.

Two-Day Rebound Eases Concerns of Market Drop
SPDR S&P 500 (NYSE: SPY) gained 0.84% last week. The small gain masks the size of the moves seen during the week. SPY traded as low as $173.71 on Wednesday and as high as $179.87 on Friday, a jump of 3.55% from low to high in only two days. That two-day gain retraced about half of the market’s January decline.#-ad_banner-#‚Äč

Friday’s gains came after the unemployment report delivered data consistent with slow but steady economic growth. The unemployment rate fell to 6.6%, just above the Federal Reserve’s target of 6.5%. The recently popular workforce participation rate increased slightly, and the number of long-term unemployed and discouraged workers fell slightly.

While employment gains are slow, the most recent report was consistent with economic expansion. In the past, recessions have started when the unemployment rate drops below the level the Fed considers to be the natural level of unemployment. Right now, the Fed believes full employment would be achieved when the unemployment level falls to 5.5%. This is known as the natural rate of unemployment. When unemployment falls below the natural rate, it is a sign that the economy is overheated and is growing at an unsustainable pace.

The chart below shows the difference between the actual unemployment rate and the Fed’s predicted level of the natural rate of unemployment. Recessions since 1950 have started when the difference is below zero and then begins to turn up.

The timing between the signal and the recession is variable, and this is just a warning of a recession (and a bear market) rather than an indication to sell everything.

Unemployment is a long-term stock market indicator. Another useful indicator for the long term is earnings. In the long run, fundamentals matter and earnings are a significant driver of stock prices.

For now, earnings reports for the fourth quarter are consistently beating expectations, and that is bullish for stocks. With about two-thirds of companies in the S&P 500 index reporting so far, 76% have beaten earnings estimates, well above the usual rate of about 65%. Bloomberg reports that 66% of companies have exceeded revenue estimates, another bullish signal.

In the short term, major stock market indicators are near overbought levels based on momentum indicators like the 2-day Relative Strength Index (RSI), but that is not a sell signal. Prices always become overbought at the beginning of a strong up move. After the recent sell-off, the fact that markets rebounded so quickly is bullish and SPY is a buy.

Presidential Cycle Says Gold is a ‘Buy’
SPDR Gold Shares (NYSE: GLD) gained 1.73% last week and is now more than 6.5% above the June lows. After forming a six-month base, more and more indicators are providing support to gold market bulls.

Many traders follow the Presidential Cycle in stocks. Logically, decisions based on political considerations could have an impact on the economy and this would be reflected in stock prices. Markets never trade in isolation and the economy also affects the price of gold, making it reasonable to expect a Presidential Cycle in the gold market.

The chart below shows that cycle overlaid on gold futures prices. Gold futures are used because they have a longer history. GLD began trading in 2004 so there is not enough data to observe long cycles. Price moves in gold futures and GLD are almost perfectly correlated, and analyzing one market to trade the other is an acceptable practice.

GLD should be near a bottom based on this cycle. There could be a small pullback or the consolidation could continue for several more months, but odds favor a relatively large up move in GLD before the end of the year that should last until the end of 2015.

This article originally appeared on ProfitableTrading.com:
Market Outlook: Indicator Says Gold Could Stage a Big Rally in 2014

P.S. In a recent issue of his Scarcity & Real Wealth newsletter, my colleague Dave Forest told subscribers about a gold miner that he thinks has fallen too far compared with the price of gold — especially when you consider that it’s one of the top low-cost producers in the sector. Out of fairness to subscribers, I can’t reveal the name of the company here. But to get all the details, click here.