Are gold stocks overbought? Is a pullback in order?

Markets have hit some resistance as the weather has warmed and seasonality is a likely catalyst for the correction. The S&P/TSX Composite Index has found resistance just above 14,000. Technical analyst Brian Hoffman names two gold stocks that may be ready for a pullback and one that may still have some room to run.

There's some merit to the investment strategy "Sell in May and get out of the way". After a volatile start to the year, where stock prices stumbled out of the gate, the stock market has enjoyed a nice run-up over the past few months.

With the onset of the spring season though, a pullback of some sort is likely. Stock market seasonality splits the year in half, where stocks generally perform better from November to April versus the other six months of the year.

During the multi-year bull market over the past seven years, the summer and autumn stock market corrections were either minor or the damage inflicted was quickly replaced by the next leg-up.

This year, the pullback in stocks may be more severe. In any event, investors should regularly re-balance their portfolios. The beginning of May and the end of October are generally optimal times of the year to make such adjustments in light of stock market seasonal trends. Recently, both Canadian and U.S. stocks have run into some major resistance levels right on cue with the switchover to the stock market's weak half of the year. In fact, since the spring of 2015, the broader North American stock markets have failed to make new highs. That's bearish since it bodes ill for the stock market over the next few months.

Trading range has been set

A stock's price, or a stock market index, is in a trading range when the price peaks and valleys result in a sideways trend. For the past two years, U.S. stocks, as measured by the S&P 500 Index, have been range-bound between 2,125 on the high side and 1,810 on the low side. The S&P 500 Index has run into resistance around the 2,100 mark and a pullback could see some key support levels tested - first around the 1,950 level and then around 1,875. Should a breach occur of the lower support level of the S&P 500 Index's trading range - about 1,810 - then a more serious stock market correction could unfold.

Meanwhile, the S&P/TSX Composite Index recently ran into resistance just above the 14,000 mark.

Is the stock market overbought?

Canadian stocks have become overbought after a nice run-up in a few stock market sectors, particularly the precious metals miners.

Based on the recent price action it appears the bottom may be in for both gold and silver bullion as well as the miners of those precious metals. However, a major test of support levels is about to unfold.

The move in precious metals stocks, as measured by the iShares S&P and TSX Global Gold Index ETF (TSX?"EURXGD), an exchanged-traded fund that tracks the performance of gold mine stocks, has become extremely overbought.

As a result, a pullback is in order and we'll see whether it's a healthy correction or something more concerning. Should the XGD ETF hold support at $12.50 a unit, then it could be game-on for the gold miners - even more so for the silver miners.

However, a larger correction in the XGD ETF may be in order, perhaps to $11 or even $9 a unit. After that kind of a pullback, the share prices of gold stocks could become spring-loaded for a massive upward move.

Since my previous column, the share prices of the two gold stocks that I profiled in February have increased substantially. Sandstorm Gold Ltd. (TSX?"EURSSL), a gold streaming royalty company, moved up about 40 per cent.

Whereas Alamos Gold Inc. (TSX?"EURAGI), a Canadian gold producer that operates one mine in northern Ontario and two in Mexico, has moved up about 50 per cent.

Pullbacks are likely to affect Alamos and Sandstorm's share prices given the big run-up in the precious metals sector this year. Sandstorm's shares have support in the $4 to $4.50 range, whereas Alamos' shares should find support at $7 a share.

Another name I like in the gold sector is Alacer Gold Corp. (TSX?"EURASR). That's because it's mining high grades of bullion and also has its debt under control. Although Alacer's share price is up about 40 per cent this year, it's not up as much as many other precious metal miners.

As a result, it's a bit of a laggard and its share price could play catch-up. Watch whether Alacer's share price holds support at around the $2.70 level on the upcoming pullback.

Brian Hoffman, CPA, CA, is a member of the Canadian Society of Technical Analysts. Based in Toronto, he can be reached at bk.hoffman@rogers.com.

Investor's Digest of Canada, MPL Communications Inc.133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846