Don’t Second Guess the Market

December 2, 2002

Many Technical Analysts have been excited by the fact that the gold chart below has no fewer than 5 "potentially" bullish formations/patterns:

  1. A Double Bottom which manifested in early 2001
  2. A Saucer (rounding bottom) Formation which completed in mid 2002 - followed by a "cup handle" which is a textbook occurrence that typically precedes a break-up through the saucer's rim (in this case at $325)
  3. A three line Fan Formation dating back to early 1996. (When the third downward pointing fan line is penetrated on the upside, a new Bull Trend typically manifests)
  4. The Gold price is currently sitting at the apex of two intersecting trendlines, and MUST break (one way or the other) within the next month or so
  5. The Gold price is also sitting at the Apex of an equilateral triangle, and this type of pattern is usually a "continuation" pattern - which implies that the breakout "should" be on the upside.

In short, with the exception of 3 above, everything is pointing to sunny days ahead.

Before we get carried away, there is a risk which needs to be addressed. Some Technical Analysts make the mistake of interpreting the chart patterns on price alone and forget that the volume patterns need to confirm price. With the gold charts - as there is usually no accompanying volume - it is possible for the untrained eye to make a serious mistake.

So, in an attempt to validate the saucer formation, I checked the monthly Futures chart for Gold below:

Note how the "saucer" formation seems to have been mirrored by the volume (which is a VALIDATION that the price pattern probably is a saucer formation).

Note also that as this chart represents a 100 oz contract, the open interest position is around 15.7 million ounces, worth around $5 billion - which could put an enormous upside pressure on price (assuming the open interest position is on the short side) or an enormous downside pressure on price (assuming the open interest position is on the long side).

But (there's always a but), I can also be a party pooper and highlight the following:

  • If the price fails to penetrate the third fan-line on the upside (which it has not yet done) then charting theory says that the attempt by Price to change the Primary/Intermediate Trend direction will abort, and the Bear Market will continue for the time being.
  • The "rim" of the saucer at around $325 could also be seen to be a "double top" - which is potentially bearish

And this potential for a continuation of the Bear Trend is precisely why one should not attempt to second guess the market at this juncture - if you buy at $325, and it fails to break through, you could be buying right at the top.

Are there any clues we can look for that could justify our taking a view?

Well, there is Dow Theory, which states that if BOTH the Dow Industrials AND the Dow Transports manifest tops that are higher than the previous tops, then we could be entering a bona fide Intermediate Bull Trend.

Note how neither the Industrials nor the Transports have yet bettered their July highs (although the Industrials are getting close)

So we are no nearer the truth. Without a confirmation by both the Transports and the Dow Industrials - which typically moves inversely to the Gold price - they could just as easily break down as continue upwards.

OK. Let's see if there are any other clues:

Looking at the same three charts on a monthly basis causes a warning bell to ring that all is possibly not what it seems. There has clearly been a lack of synchronicity:

Note how the Utilities have significantly under-performed both the Industrials and the Transports. This could mean one of two things:

  • The Utilities have been leading the way, and the other two may just dicker around before following suit, OR
  • The Utilities are due for a bounce, which - if it occurs - could coincide with both the Industrials and Transports rising sufficiently to confirm the Intermediate Trend Reversal; thereby giving a Dow Theory "Buy" signal.

i.e. From the above, all we can say definitively is that we are still in no-man's land

But there is another chart which IS offering a clue:

Note how the Nasdaq chart has clearly just recently broken UP from a declining trendline.

Now, if this turns out to be a leading indicator, it may have some SIGNIFICANT implications - which are evident from the following S&P chart.

What is so significant about this chart?

Technical analysts have been drawing attention to the "Head and Shoulders" breakdown that apparently manifested in the above chart when it broke down through the neckline - although it is critically important to point out that the chart does not show volume to validate that it was in fact a Head and Shoulders. The missing information should show rising volume on the Left Shoulder, Rising Volume on the Head (but slightly less than on the left shoulder), Falling volume on the Right Shoulder and rising volume on breakdown through the neckline.

Without the volume to confirm, it is possible that this has not in fact been a "true" Head and Shoulders chart.

Unfortunately, I don't have access to any S&P chart that reflects ALL the necessary information, but the following weekly chart shows a crucially important part of the information:

Note how there did not appear to be a contraction in volume on the Right Shoulder (which in fact showed a slight rise relative to the immediately preceding volume), and there did not appear to be a marked increase in volume when the price broke down through the "neckline".

Uh Oh! Maybe this wasn't really a Head & Shoulders formation after all.

More importantly, if the demonstrable break UP in the Nasdaq chart is leading the way, and the S&P rises from here, then the "neckline" could be penetrated on the upside - thereby ABORTING the so called Head and Shoulders formation.

If this should happen, (accompanied by a confirmation by the Industrials and Transports that the Intermediate Trend has changed to "up") then it is likely that the Gold price - which moves inversely - will not penetrate the third fan-line on the upside.

In turn, this would mean that the saucer's rim was really a "double top", and the failure of the Price to penetrate both the Third Fan-line and the double top will imply that the Intermediate downtrend in gold could resume for the time being.

Finally, it should be recognised that the failure of the Gold Price to penetrate the third fan line is not necessarily the "kiss of death".

  • There is still another uptrend line which offers support for Gold at around $290 per ounce.
  • A break-up to new intermediate highs by both the Industrials and Transports will only confirm an "Intermediate" trend change, and this, in turn, could reverse itself within the next couple of months before the Gold Price has a chance to"finally" break below the upward pointing trendline.

Of course, if the S&P rises to negate the Head & Shoulders formation, what we could be faced with is a "muddle through" market where BOTH Gold AND the equity markets trend basically sideways for some time (Although the Nasdaq could rise strongly in the short term - but that is a story for another day).

CONCLUSION

It is a high risk proposition to attempt to use Technical Analysis to second guess the market's direction before a breakout has actually occurred. What appeared to be a bullish pattern yesterday could equally be interpreted as a bearish pattern tomorrow and vice versa.

On the other hand, the value of Technical Analysis increases exponentially AFTER it has given a clear break-out signalwhich, unfortunately, is often too late to facilitate optimally profitable investment.

It is for this reason that a sensible analyst will make use of the entire workshop full of available tools, and act when BOTH technicals AND fundamentals are in sync.

Technically, Dow Theory has not yet confirmed an Intermediate Bull trend, and the Gold Price has yet to break either up or down. Fundamentally, the high P/E ratios on the industrial equity markets do not confirm that a new Primary uptrend in equities is emerging and, fundamentally, it defies common sense that Gold will fall to levels below which most mines will go into loss (causing many marginal mines to close down).

But this does not necessarily mean that prices in either the industrial equities markets or the Gold market will go straight up or straight down. Yes, we "could" have a break up in Gold as it enters a new, confirmed, Bull Trend - provided both the Dow Industrials and Transports pull back from here. However, in the event that the Head & Shoulders breakdown in the S&P aborts, there is always the possibility that we may be entering a period of sideways churning in both equities and Gold.

All of which goes to prove that interpretation of the markets can never be reduced to a mechanical, mindless exercise. If it was that easy, we would all be stinking rich.

The Federal Reserve Bank of New York holds the world's largest accumulation of monetary gold.

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