Technicals Point to More Upside in Precious Metals

Gold futures topped out at $1,432 on Dec. 7 and entered a major correction that's still in control more than six weeks later. Silver futures joined its more precious cousin, ending its historic rally three weeks ago at $31, and playing catch-up in a 5-point decline. Together, these overloved metals are causing a ton of sleepless nights and wave of second-guessing.

Of course, corrective phases after strong rallies are perfectly natural, shaking out excessively positive sentiment ahead of renewed buying interest and continued uptrends. However, healthy corrections and trend changes look nearly identical in their early phases, raising fears that precious metals may have topped out and are headed into longer-term declines.

As a trader and market analyst, it's my job to look at technical evidence without bias and come to logical conclusions about the future course of price direction. I'll attempt that task today with gold and silver, but I have to admit a major prejudice -- I own the iShares Silver Trust ETF ( SLV) in a long-term account, which places me squarely into the bulls' corner.

But one fundamental aspect of the precious-metals rally and recent decline makes me nervous. A big chunk of the historic 2010 buying frenzy spiraled off massive liquidity being pumped into the markets by our friends at the Federal Reserve. The inflationary aspects of their often-criticized program, aka "QE2," are obvious and indisputable.

It's common sense that Fed easing will last just as long as it takes for the U.S. economy to get back onto the fast track. I believe that long-awaited growth spurt will start this year, driven by higher-than-expected employment gains. This sudden growth is likely to put a damper on liquidity policies and force Bernanke and co. to starting thinking about the rate cycle once again.

Rate increases don't need to take place in 2011 to hurt precious metals. Rather, any speculation that puts a date on the first increase will force everyone still playing the notorious "risk-on, risk-off" trade to reconsider their positioning. In turn, gold and silver will return to traditional pricing, in which they're valued through natural supply and demand, monthly inflation reports and macro-fear gauges.

That transition might put a floor under gold and silver, but it won't have the salubrious impact of "QE2." In fact, I suspect this month's broad commodity selloff is closely aligned with institutions expecting higher 2011 growth rates and a return to normalized liquidity levels. In a word, they're quietly unwinding positions that depend on the final aftershocks of the 2008 credit collapse.

Let's get back to the technical outlook, which is easier to analyze because it relies on pure price action. In this regard, gold and silver are engaged in healthy weekly declines that are long overdue after their historic rallies. However, both downtrends might last longer than hopeful bulls expect and force many folks to question their love affairs with these volatile instruments.

Gold -- Weekly
Source: eSignal

It's easy to visualize the outline of an Elliott five-wave rally off the 2008 gold low at $680. The first wave brought price up into a test of the 2008 high, while the second lifted the yellow metal through round-number resistance at $1,000. A sideways pattern in the first half of last year gave way to a final rally wave that lifted price to an all-time high in a nearly parabolic angle of attack.

This pattern, which is common in the commodity markets, exposes the downside to a 100% retracement of the last rally wave. That would yield a selloff target near $1,050. The metal could avoid this fate, however, by holding firm at the 50-week moving average, currently near $1,260. You can see how that level roughly aligns with the September breakout (green line) above the June 2010 swing high.

Silver -- Weekly
Source: eSignal

As a silver bull, the seven-year chart is a real-eye opener and a little disturbing. The instrument shows a trend line that intersects four price peaks through this period, with four parabolic rallies yielding three steep and painful downswings. The fourth rally ended right at the trend line less than a month ago, suggesting a fractal decline that drops the metal to far lower price levels.

However, there is some good news here. Even though the August-into-January rally unfolded at a parabolic pace, its placement above the deep 2008 low points to a healthy third wave rather than an exhaustive fifth wave. If this observation is correct, the current decline might fool bears looking at silver's historic pattern and end at the 50% retracement of the parabolic rally wave.

As you can see, this predicts a downside target near $23. Not surprisingly, that level is aligning nicely with the 50-week moving average, which is also my target for the gold selloff. Indeed, there's a good chance that both metals will end their declines at or near that deep support and enter strong uptrends that lift the precious pair to new all-time highs.

At the time of publication, Farley was long SLV, although holdings can change at any time.

Alan Farley is a private trader and publisher of Hard Right Edge, a comprehensive resource for trader education, technical analysis, and short-term trading techniques. He is also the author of The Daily Swing Trade, a premium product from TheStreet.com that outlines his charts and analysis. Farley has also been featured in Barron's, SmartMoney, Tech Week, Active Trader, MoneyCentral, Technical Investor, Bridge Trader and Online Investor. He has written two books: The Master Swing Trader and The Master Swing Trader Toolkit: The Market Survival Guide, due out in April. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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