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Breakdown in Gold Triggers 'Sell' Signal Traders Only See Once a Year

Stock market investors sometimes believe it is best to "buy the dip" so they can benefit from short-term declines.

This often works because stocks have what is known as a "long-term upward bias."

Over the long term, a time frame measured in years or decades, stocks should go up. This is true because earnings will grow for successful companies to match the rate of economic growth. In the United States, this relationship is shown in the chart below.

Both the S&P 500 and the Gross Domestic Product (GDP) have been rescaled to equal 100 in January 1957. Over time, the lines tend to converge. This chart also provides long-term hope for stock market bulls since the stock market index is currently below the long-term rate of economic growth. The relationship shows stock prices should move higher over the next few years. This relationship between economic growth and stock market prices has also been seen in other countries.

Commodities are different. There is no reason to expect an upward bias in their prices. Technology could lead to changes in supply, as it has for some agricultural products, and increased supply leads to lower real prices (which are adjusted for the rate of inflation).

There are complex models that can be used to determine the supply and demand of commodities. For example, it is very likely that Starbucks (NASDAQ: SBUX) has a model of consumer demand for coffee and information that allows them to forecast the production levels of the commodity. Based on this, they can develop an estimate of what coffee should cost and develop an appropriate hedging strategy.

The chart below shows that the price of coffee is about the same as it was in 1978, even though demand has more than doubled over that time.

Gold is a commodity, so there is no reason to expect a strong upward bias in gold prices. Yet gold is widely believed to be pushed higher by inflation. Even if that is true, gold has actually gotten ahead of inflation.

Because there is no reason for the real price of any commodity to rise over time, buying on their dips can be a money-losing strategy. Despite that reality, many investors are wondering whether they should buy gold simply because it has suffered a sharp pullback.

The answer is to wait for a turnaround. Starting with the fundamentals, gold has now fallen to a price that is close to the cost of production for many of the miners. The cost to produce an ounce of gold ranges from about $950 to $1,300 an ounce for major gold miners and could be much more for smaller companies.

As prices fall, these companies may use rallies to sell forward their future production if the market gives them a chance to lock-in a profit. This would place a ceiling on short-term increases in gold.

This behavior is seen in many commodities markets: Producers sell at a level that is profitable for them, and large consumers -- like Starbucks in the coffee market -- buy when prices seem low. Because of this, commodities tend to spend extended periods of time in trading ranges, like coffee has since 1978 and gold did from 1996 to 2006.

Many of the most successful commodity traders use this pattern to create trading strategies. Some traders will go short when prices fall to new 20-day lows or when prices fall below the lower Bollinger Band. We have both of these trade setups in gold.

Gold actually fell 3 standard deviations below its 20-day moving average, a trade setup that occurs less than once a year on average.

Looking at gold futures for a longer trading history, we find that selling short after a large decline in gold would have been profitable almost 60% of the time and delivered an average gain of 10%. In the 1980s, when gold was falling from all-time highs, the average gain on this trade was 12%. These gains came from selling short after gold broke below its lower Bollinger Band and covering the position when gold traded back above its 10-day moving average.

Many successful traders follow the trend in commodity markets. This strategy calls for shorting gold now and avoiding the temptation to buy the dip. PowerShares DB Gold Short ETN (NYSE: DGZ), an inverse fund that goes up when gold prices fall, is my favorite way to do this.

Recommended Trade Setup:

-- Buy DGZ up to $13.80
-- Set stop-loss at $12.85
-- Set price target at $15.30 for a potential 11% gain