Gold forming a bullish chart pattern

Gold seems to be forming a bullish pattern after a brutal sell-off last year, increasing the possibility of a bullish reversal, or at least a short-term correction.

The bullish pattern — inverse head and shoulders — will take some more time to confirm and, hence, patience is in order. At the very least, now is not the time to sell or short gold, unless you are playing in the very short term. An inverse head and shoulder is a very powerful bullish pattern, often leading to long-term rallies. In fact, the 2009 rally in the US equity index, the S&P 500, began with an inverse head and shoulders.

In a classic inverse head-and-shoulders pattern, price falls to a low (known as the left shoulder) and then rallies up. It then makes a new low (known as the head) and rallies to the level prices went to previously. The two high points of the rally are connected by a line (known as the neckline), which could be sloping up or down, or just be straight. In the next step, prices fall again, but don’t make a new low (known as the right shoulder) and rallies above the neckline. Once the prices go above the neckline, if one goes by the textbook, that’s the signal to buy.

A look at the gold chart will show that prices have probably formed the left shoulder, head and neckline. Only if the right shoulder is formed and the neckline broken will the bullish inverse head-and-shoulders pattern be complete. The bullish pattern has the power to drive gold prices to at least $1,750. And, the prices were ruling at $1,617 at the time of writing this article. Sometimes, the bullish pattern is so powerful that it can result in a long-term rally, which could take gold to new highs.

However, now is not the time to buy gold. We would wait for prices to fall and form the right shoulder to buy or wait for a break of the neckline. If buying on a fall, one could take a position between $1,565 and $1,685.

In fact, the best price to buy gold was between $1,480 and $1,525 a few days back. The level is marked by two horizontal lines. That is where most professional investors buy, as it is the level from where prices had a very strong rally. The strong rally was due to the fact that the demand exceeded the supply at that level. Note that when prices came back to that level recently, it shot up again, showing there was plenty of demand left in the area. The fact that prices are making a bullish inverse head-and-shoulders pattern near that level should be good news for gold bugs.

On a fundamental level, too, there are factors to support a gold rally. First is the uncertainty in Europe that has lead to a rally in the US dollar. Both the dollar and gold are considered safe havens, and gold could follow the rallying dollar. Second, there is some growth coming to the US. But, remember that there is also a lot of liquidity overhang in the system due to the easy money policies of the US Federal Reserve. Growth with liquidity overhangs stokes inflationary expectations, which is a positive for gold.

Additionally, gold had rallied too far too fast in the early part of 2011 and a correction was inevitable. Given the price action now, it is possible that the corrective phase is over. However, one must keep in mind that nothing is guaranteed in the market and chart patterns can fail.

The author is based in Chicago and is the editor of www.capturetrends.com