Daily Global Market Outlook
Technical Analysis:
The Coiling Gold Wedge
17 July 2003

a currency & gold market analysis
by Ed Bugos

It's always better to be safe than sorry, especially when dealing with leverage.

When I'm trading futures, for instance, I always have a predetermined point of exit if it goes bad - a maximum amount I'm willing to lose - and I'd execute it automatically regardless of my outlook. The same applies to trading stock on margin.

The operative words are trading, and margin. That's not to say an unleveraged investment in a specific blue chip stock can't turn to dust. I don't need to remind anyone I'm sure. There are enough examples in recent history.

However, if your unleveraged "investment" is a diversified portfolio, or if you own a mutual fund, your situation is quite different. In such cases, often, the main challenge is to avoid haste, and to put near term volatility into perspective.

For, chances are you aren't trading (or trying to capture) the short term moves.

First, Investors Should Determine Which Trends They Want, and Stick to It
Short term moves are trends like the three month rally in gold shares post March you just saw. Floor, Desk, and Day traders would call them long term.

The moves we like to capture are the primary and intermediate legs, and to do that, leverage is inadvisable. The reason is that an investment strategy geared to exploit the longer term outlook requires all but ignoring short term volatility. Leverage makes it harder to do this.

Intermediate trends tend to last from six to nine months in my experience, but can last longer. Primary trends can last from two to four years. I don't tend to develop my investment strategy around an outlook much longer than that.

The rally in gold shares from December 2001 to June 2002 (see chart below) is one example of an intermediate leg where we made money. It doesn't always work that way, particularly if you're focus is on trying to capture the primary moves. But for those traders looking to capture the intermediate legs, their goal is to put their money where such moves are just about to launch.

They don't like hanging around for a full year while the stocks they'd bought or sold do nothing, or worse, go in the opposite direction.

It's a matter of opportunity cost; whether their capital could have been better deployed to capture other intermediate moves, such as the rally in some of the stock or bond prices that has unfolded in the first half of 2003.

If you see yourself as an allocator then, you have to first determine which trends it is you want to capture.

The longer out you go, as a rule, the less leverage should be used. People can get confused simply by not being clear on such objectives.

If, for instance, an investor determines he or she is long gold shares to capture a primary bull cycle, it's better not to react to developments affecting only the short or intermediate term outlooks.

The underlined part is important, because some developments that happen in the short term indeed have implications for the intermediate or long term outlook. But I mean to distinguish that from the previous proposition.

At any rate, this is where discipline comes in. It also holds true the other way around.

If someone was determined to capture the short term moves, imagine them suddenly rationalizing the embrace of a longer term outlook as the leveraged position moves against them. It makes no sense right?

It happens all the time. A lot of long term investors start out as short term traders. Need I say more? Haven't you heard the one about the client that made a small fortune investing in penny stocks? He started out with a large fortune. What you haven't heard is that he started out as a trader, but ended up wearing his paper.

Pullback in HUI is Surprise, Not a Failure
So the question the investor with an intermediate or primary market outlook should be asking is whether or how the developments this week affect that outlook. In other words, will this short term stuff turn into something more significantly bearish?

I don't think so. Sure, the down turn in gold stocks and gold prices was unexpectedly brutal this week. But the technicals aren't clear in their implication as of yet.

The intermediate trend in gold shares has been neutral since last June. Please note that in US dollar markets, this trend has retained a bullish bias as you can see by the ascending triangle formation in the HUI, but that in foreign markets (Canada, South Africa, Australia) the bias has been bearish almost all year long.

When I chose the title "do or die" Tuesday, I meant it.

The type of pattern we observe developing in the chart over the past year (ascending triangle) suggests one of accumulation, and imminent break out. The failure of such a break out tends to have dire implications technically and psychologically.

So it is important to understand first what constitutes a failure. The most common sign of a failure in this sense occurs when a break out reverses and prices fall back to within the formation.

First, failed bullish break out attempts have much more significance to the medium and long term outlooks in a bear market than in a bull market. Second, a pattern isn't a pattern until it is confirmed, so a failure of that specific pattern can't be a failure unless the break out is legit.

For example, from the period between June and November last year, the AMEX Gold bugs index traded in what looked like a symmetrical coiling continuation formation from where it appeared to break out in December 2002 (see black lines in chart within the green lines). Sinclair called it a teacup formation.

The break out was legitimate, and if that was indeed the correct pattern, which was never confirmed by new highs, it too could have constituted a failure. Fortunately in this case, gold prices themselves went to a higher high.

Meanwhile the pattern has mutated. In the HUI it has turned into an ascending triangle. In the XAU it has continued to coil. And in the foreign gold bourses it's turned into a large trading range.

The thing is, the break out in the HUI last month wasn't legitimate enough to confirm the pattern in the first place. The break out point for the triangle in the HUI is 155 (the June/02 and Jan/03 highs). It got to 158 last month. But three points does not constitute a break out. Edwards & Magee used to say a validation requires the price to move 10% past support/resistance.

We did think it was (and is) 'breaking' out, but we also said we needed to see a higher short term high to confirm it, which never came. Moreover, none of the other gold sector indexes broke out. For a break out to fail it has to be a break out in the first place.

The other thing is, the primary sequence (approximated by the 200-day moving averages in the chart above) remains bullish, which means to me that the likely party to be deceived by short term moves like this is the bearish one. The patterns in gold stocks have looked bearish all the way up. Have a look yourself. Note in the above chart how the bears faked us out in the fourth quarter '02 just before bulls took them out and went to the moon. What's different now is the patterns themselves are looking increasingly bullish. No, that's not enough for a contrarian case.

Similarly, every dip in the major stock averages has looked like a bottom. It was for a while. And in fact, every new bear market low in the averages was preceded by a fake break out to the upside. The operative word is bear market low. If you're concluding the selling this week implies a failure of a bullish chart pattern in the gold sector, which is going to turn into a rout, the other thing you need to consider is that it implies gold stocks are topping. Before you make that conclusion, however, look around. It seems to me more people are bullish on tech stocks than gold stocks at the moment. It doesn't look like a top.

I think it's an overreaction to infer anything significant from this week's activity yet. I agree it's a flag, but it doesn't constitute a failure of anything. It constitutes some short term capitulation, which could turn into something more serious, or it could just mutate into another chart pattern, or it could just be a bear trap.

The do can still trump the die scenario if this pullback is just a backfill and the final deceptive wind up just before the break out appears as suddenly as the bear raid this week did.

Bear Raid Fails to Push Lower As Gold Prices Coil
Now let me share two bullish developments I think I see in the tape. Well, bullish may be a strong word. But maybe not. We'll see.

First, we can see that the bears haven't been able to produce a decent lower low (below $343) in COMEX gold prices, as we pointed out in the last issue of the DGMO, since late June. They're edging prices to lower ground but even now are trading at $344, a point higher than the June low. Bulls defended this level three times successfully last week, and twice this week.

At the moment I interpret this as evidence of support just above the 200-day moving average, and also an oversold indication. By that alone it might make for a good trade if one were a short term trader on the odds for a break through $354.

After all, you could apply the failed breakdown theory here, and would probably be more right, since the main trends are bullish.

Second, the volatility in gold prices, Tuesday's plunge notwithstanding (highlighted in yellow on the chart), clearly appears to be narrowing. You can see that in the chart by how tight the ranges have become over the past two weeks. I drew the lines to make it easier to see.

Gold, USD, Look Ready to Affirm Primary Sequence
So what we appear to have is a situation where gold stocks were trying to break out, but probably needed some kind of confirmation from gold, which remained confined to a short term (seven week) declining wedge, or downtrend.

Effectively, that alone was enough to check the enthusiasm for gold shares (and we all know how powerful a sentiment generator for gold the shares can be).

Whether it was manipulation or not, it doesn't matter. The point is that falling gold prices checked the break out in gold shares. And by the way, we aren't saying it was all manipulation. No doubt there is that, but if it weren't for a bounce in the oversold US dollar starting mid June, the manipulation would have failed like usual. It's the dollar stupid!

How come they couldn't cap gold when the dollar fell in April and May? Or when it fell in December and January? Or almost any time the dollar falls, before, during, or after?

In conclusion, absent a fundamentally cogent case for a bullish reversal in the US dollar, why shouldn't we believe the countertrend bounce in the dollar, and the countertrend correction (or declining wedge) in gold prices, is complete?

We expected the US dollar index could bounce as high as it has so far, but now it's brushed up against short term resistance (March's low near 98).

Thus, rather than concluding that the down turn in gold shares is telegraphing more downside in gold prices and more upside in the dollar, we prefer the following take: gold share owners are capitulating to the fact that gold prices haven't confirmed their enthusiasm - though just as gold and the dollar are ready to reassert their main trends - i.e. in the final hour.

So if we're right, that gold breaks out of its wedge, and the dollar takes a turn for the worst, it will also be a surprise, and it can work in our favor because the traders expecting the HUI to break out last week are now out of the market.

We can be wrong in two ways I can think of: a) deflation, or b) stocks and the dollar keep going higher.

However, with respect to the latter, keep in mind, I'm not talking about a few hundred points higher. I'm talking about 1000 plus points in the Dow's case. And even then, I'm not sure gold stocks wouldn't follow it all the way up.

There's room for the AMEX Gold bugs index to fall back to its 200-day moving average (132) on the backfill in our hypothesis, which essentially leaves room for a little more upside to the dollar in the short term. Not that it will happen that way. You'd be surprised how fast markets can turn around. Anything can happen now, and probably will.

But it usually begins with gold.

Edmond J. Bugos

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