The 2008 Plunge All Over Again or Merely a Quick Correction?

During the past few weeks, we saw a slight bounce followed by decline, short uptrend, and now we have seen a sharp decline. Still, we are at a strong support level created by the 50-week moving average – the blue slope on the above chart. Many times in the past this has proven to stop both rallies and declines (blue ellipses on the chart). We have also seen a spike in the volume on a weekly basis, which indicates that the bottom for this decline might have been reached – or at least that a temporary upswing is likely. Please note that this is precisely what we’ve seen at the previous bottoms in the past several years.

The thing that changed the most in the past weeks is the RSI indicator, which has moved much lower. Here, the RSI is based on closing weekly prices and after being above the 70 level (which is signals an overbought market), we have seen it decline dramatically. It is now below 50 as this dramatic downturn has occurred in a very short period of time.

Looking at the historical charts, we see there were two times in past 10 years where a similarly overbought condition (RSI above 70) was followed by a sharp decline that took the RSI to or slightly below the 50 level. This occurred early in ’07 and also later in the same year. Please note that in both cases, a sharp rally followed.

While we can’t rule out the possibility that the general stock market plunges severely in the future, it is unlikely to take place right away. Please note that even the gargantuan 2008 plunge didn’t start right after the top was formed in 2007 – instead we’ve seen a sharp corrective upswing before the end of the year.

Looking at the long-term chart this week we see a second spike in the daily volume and this normally corresponds to lows in the index. Moreover, the RSI has fallen below 30 and this level has frequently coincided with market bottoms in the past. The question everyone has today is are we seeing 2008 all over again?

We need to have a confirmation before we can agree to this premise. So far there is no evidence that what we’ve seen recently is more than just short-term correction. Once bearish signals are confirmed, this could actually be the beginning of a significant downturn trend – but until we see that confirmation, the trend remains up. Strong resistance levels at this time have not broken. This suggests that the odds still favor a rally ahead even though the decline appears very scary.

Since stocks have recently plunged severely on huge volume, at least a small rally is likely. The key point to monitor is the volume during the following upswing. There were two cases in 2008 when the volume was low before the next downturn began. It was extremely low in the period prior to June and September 2008 and the downtrends materialized respectively in the middle of 2008 and in October. This is one of the things that we will watch and monitor the days and weeks ahead.

Additionally, in 2008 we’ve seen a severe under-performance of PM stocks relative to the general stock market. This occurred very visibly before the final part of the market’s decline, and also – less visibly – in the middle of 2008. We have not seen this in the PM sector recently. Even though the decline in the PM stocks has been huge and rapid, gold stocks didn’t drop more than the main stock indices. The major stock indices are much below their March low, while the HUI Index is clearly above it. This is certainly not what we would call underperforming.

Speaking of the precious metals stocks, let’s take a look at the long-term HUI chart.

With respect to the precious metals stocks, the risk/reward ratio for speculative investments has not been favorable since May 12th (we’ve sent a Market Alert to our Subscribers). The significant decline in PM stocks that followed week was much greater than the decline in gold itself. This is clearly visible on the above HUI chart above, which shows that the downswing has been stopped by the 50-day and 200-day moving averages. Still, this, and the RSI close to the 30 level suggests that PMs are not likely to fall any further.

The short-term chart confirms this. Here, we see additional two support levels. The lower border of the rising trend channel and the 50% retracement level of the February-May upswing provide this additional support. The RSI also indicates a possible buy signal.

Summing up, whether or not we will see much higher prices in the following weeks will depend on the PM sector’s performance relative to the way they are influenced by other markets. Early in 2010, during the final part of a rally, actually a correction within a bigger decline, we saw low volume during up-trends and rising volume during downtrends – as marked with a black ellipse on the above chart. This was in fact, confirmation of a fake rally and the future move was likely to be lower. Should we see a similarity to this pattern develop, we will suggest exiting the market. As of now, we have yet to see evidence that the trend has broken. Although things might appear very bad today, this was also the case in October ’09, which was followed by a big rally. So far there is no evidence suggesting that this pattern has been invalidated. Conversely, so far we’ve seen the GDX ETF rally on average-to-strong volume (not visible on the chart above), which supports the bullish case.

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Thank you for reading. Have a great and profitable week!