Gold Stocks Break Out — What’s Next?
Despite the outstanding performance of numerous gold stocks, investors should be on the lookout for these key indicators of a possible change in fortune.

On Friday morning, gold-stock investors finally saw the breakout they’ve been awaiting all year. Gold stocks have been mired in a trading range throughout 2011 even as the price of the metal has surged, causing a wide performance gap between the stocks and the underlying metal. This disconnect has led many prognosticators to call for mean reversion to occur via a rally in gold stocks, and the events of the past month indicate this might finally be coming to fruition. Does this mean now is the time to buy?

First, a look at the charts. On Friday, the Market Vectors Gold Miners ETF (NYSE:GDX) finally moved above the key $64 level after testing it since December 2010. This move was mirrored in the NYSE Arca Gold BUGS Index (HUI):

While these indices have moved out to new highs, we have yet to see a confirmation in the more widely followed PHLX Gold/Silver Index (XAU), which has been held back by its weighting in silver-related shares. Meanwhile, the Market Vectors Junior Gold Miners ETF (NYSE:GDXJ) remains far from a breakout and is struggling to stay ahead of its 200-day moving average:

Take a moment to look through the charts of the largest gold stocks, and you will find a mixed picture despite the GDX breakout. So far, only two — Yamana Gold (NYSE:AUY) and Randgold Resources (NASDAQ:GOLD) — have experienced runaway moves to the upside. Among the sector’s mid-sized names, New Gold (AMEX:NGD) and RoyalGold (NASDAQ:RGLD) both are showing excellent technical strength, and El Dorado Gold (NYSE:EGO) moved to a 52-week high Thursday.

On the other hand, the sector’s big boys — Barrick Gold (NYSE:ABX) and Newmont Mining (NYSE:NEM) — still are below their breakout levels of $55.74 and $65.50, respectively. Goldcorp (NYSE:GG) also closed Friday short of a new high, but just barely — with another 2.7% of upside, the stock will surpass its 52-week high of $56.20.

On Aug. 18, I urged caution with respect to gold stocks. This call has proven incorrect so far, with the GDX up more than 8% since that article was published. Clearly, gold stocks are one of the few areas of the market in which investors feel comfortable right now. At a time in which the majority of stocks are being pressured by falling earnings estimates and concerns about economic growth, the earnings profile of gold miners (steady input costs, rising gold prices) makes the sector appear to be a relative safe haven.

Further, the charts are now in a strong position. A look at the two-year chart of GDX shows a breakout above a similar base in September 2010. The 50 level had offered resistance for more than nine months at that point, and the move above it brought a rally of about 20% in the three months that followed. The current breakout also represents a move out of a nine-month base, indicating that history is on the bulls’ side:

Still, the almost uniform positive sentiment toward gold and gold stocks is a red flag. Anyone who owns gold stocks is now firmly on the side of the crowd, which means caution is in order no matter how positive the underlying story. While these stocks remain among the most dangerous to short, buyers should also recognize that no commodity — even gold — should ever be considered a “safe haven,” and that this warning also extends to gold stocks. If nothing else, be wary of the reversal that typically follows shortly after the initial breakout. This is visible in November 2010 in the chart above.

The takeaway is that while gold stocks seem to be a can’t lose proposition here, a high level of caution remains in order — especially with the GDX up over 20% in just the past 20 trading sessions. With that in mind, keep an eye on these three indicators to determine whether the GDX/HUI breakout is real:

  1. The technical status of the metal itself. GLD currently is just short of its high of $184.82. A move above this will set the stage for further extreme bullishness in the market, while a failure will raise talk of a potential “double top” forming. With so much hot money in gold right now, technicals will be a key factor in performance, and any sign of a double top will likely be met with vigorous profit-taking.
  2. Newmont and Barrick. Unless these two stocks can establish sustainable moves into new high ground, investors should keep a wary eye on the gains in the broader gold-stock indices.
  3. GDXJ. It’s much smaller than GDX and has about a quarter of the average daily trading volume, but investors should closely monitor the performance of this ETF with respect to its 200-day moving average.

The bottom line: Enjoy the gains while they last, but stay on high alert for any sign that this breakout is just a sucker’s rally.

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