Wrong Call?

March 21, 2004

Normally, the most sensible thing one can do when one makes a wrong call is to admit it and move on. To err is human. To err twice is stupid.

Last week, my interpretation of the Relative Strength Charts led me to the conclusion that the Dow was not yet ready to go into free fall. On re-assessing the content of my last week's article I concluded that that there may indeed have been the potential for a significant error, which it is important to revisit.

The issue here is not "bruised ego". The issue is "accuracy".

The bottom line is that I am not yet ready to throw in the towel on these calls.

Price movements during the course of last week were not conclusive - particularly in light of the fact that many derivatives contracts expired during the week - and the important (relevant) chart patterns were NOT negated.

By way of example:

Volume of shares traded is not available on the $XAU chart, and I did make reference to this last week. Nevertheless, during the week I looked at the volume patterns of an $XAU "proxy", namely Newmont Mining, and the weekly chart is shown below (courtesy StockCharts.com):

The upward sloping Head and Shoulders pattern on this chart is clearly apparent - with the left hand shoulder commencing in July 2003. However, the volume patterns are also important:

"The first suggestion that a Head-and-Shoulders is really developing may come when the volume record shows activity accompanying the most recent top was somewhat less than on the one preceding it" (Technical Analysis of Stock Trends, Edwards and Magee, Fourth Edition, at page 53).

The volume patterns on the above chart are ambiguous. Note the "double" peak on the head above. On the FIRST peak, volume was higher than on the left shoulder, but on the SECOND peak, volume was significantly lower than on the left shoulder. It was THIS low volume that signalled a first possible warning.

However, again from Edwards and Magee: ".. such a preliminary warning does not always appear, nor should it be taken as conclusive when it does appear. Roughly estimated, about one third of all confirmed Head-And-Shoulders formations show more volume on the left shoulder than on the head, another third show about equal volume, and the final third show greater volume on the head than on the left hand shoulder" (not particularly helpful, so far)

"Another warning - or more often the first - comes when prices drop in the course of the second reaction (i.e. from the head) below the level of the top of the left shoulder"

Again, there is ambiguity on the NEM chart. It is not absolutely clear from the NEM chart above that its price fell below the level of the top of the left shoulder during the downward reaction from the head - because the top of the left shoulder - even though it was in fact higher than the price to which NEM fell in early 2004 - was very fleeting; lasting only one single week.

To shed further light on this issue, the comparable chart of the $XAU is reproduced below, including trendlines (the upward sloping trendline is the neckline of the Head and Shoulders formation):

On the $XAU chart there is no ambiguity, and no room for discussion. The downward reaction from the head certainly did culminate at a level below the peak of the left hand shoulder.

Another mistake often made by rookie analysts is that they ignore the need for a "cleanly drawn" neckline. However, in the case of both the NEM chart and the $XAU chart, the neckline is absolutely clean. By joining the bottoms (as has been done above), we find that the price has touched (and reacted upwards from this line) seven times.

Importantly, it is ONLY if the neckline is penetrated on the downside - ACCOMPANIED BY RISING VOLUME - that one can finally conclude that the "apparent" head and shoulders formation was indeed genuine.

The coming weeks are therefore likely to be critically important because the downward sloping trendline above holds the key. In both the NEM and $XAU cases above, if the price breaks up above the downward sloping trendlines then it could be argued that the head and shoulders patterns might have been negated.

Interim Conclusion

The rise in the $XAU during the past week, having failed to penetrate the resistance offered by the downward sloping trendline, has (so far) failed to negate the possibility that the apparent Head and Shoulders pattern on the weekly gold share charts may be genuine.

Another important observation that flows from the $XAU chart above is that the MACD histograms appear to have bottomed - indicating the possibility of further near term consolidation of gold share prices within the apex of the triangle formed by the two trendlines.

*****

Another important subject of focus last week was the Relative Strength Chart of the Commodities divided by the Dow Industrials. This week I want to look at this through a microscope - for the purpose of attempting to objectively determine whether an error of judgment has crept in.

The following is a DAILY chart of this relativity - which clearly shows that commodities have been strongly outperforming the Dow in recent weeks,

Two factors jump out:

  • There are significant gaps on the chart
  • The MACD of this chart is in seriously overbought territory.

Looking back into history on this same chart, we note the appearance of several gaps - all of which were subsequently covered. Of further interest is the position of the closing price on the most recent candlestick (where there was an accompanying gap) as compared with that in the candlestick where the previous gaps occurred.

Previously, the closing price was at the top of the vertical line, indicating further potential upside. This time it was at the bottom, indicating the possibility that the gap might soon be closed.

A clearer picture emerges from the following weekly relative strength chart of the $CRB divided by the $INDU:

Whilst the gap at the .030 level needs to be covered, such a rise will not (necessarily) take the relative relationship to a new high. BUT there is also a significant uncovered gap at the .023 level dating back to July 2002. It is conceivable that this was a runaway gap following a breakaway gap in May 2002 (and may therefore not necessarily need to be covered) but, more importantly, until the $CRB:$INDU rises to a new high, it does not seem likely that the Dow will enter a "free fall" phase - except if they BOTH enter free fall together; and this seems highly unlikely in context of the strength of the $CRB chart itself.

The picture becomes much clearer when one looks at the Relative Strength chart in a Point & Figure format. The following chart is up to date to Friday, March 19th 2004.

Importantly, the above chart shows that - despite the price volatility of last week - the volatility was not sufficient to give rise to any change being recorded on the chart itself. This chart is IDENTICAL to the one published last week.

Overall Conclusions

  1. The battle between the opposing forces continues unresolved. The rise in the gold price and in the $CRB last week, and the slight fall in the $INDU were not conclusive.
     
    • The Relative strength charts are still supporting an argument that the Dow may not be facing free fall;
    • The rise in the gold price last week did not give rise to a negation of the possible Head and Shoulders reversal pattern on the gold shares.

    • The weekly $CRB chart is looking overbought

2. Clearly, this is not a market for trading. One should hold long-term positions in line with the Primary Trends, namely OUT of Industrial Equities and IN gold and gold shares, and one should be prepared to sit tight during any volatility which might materialise.

 

 

3. Whilst the directions of the various Primary Trends are pointing to an eventual victory of the bearish camp and capitulation by the Establishment, we are facing an EXTREMELY dangerous market! The volatility seems likely to become vicious as the opposing forces throw their full weights behind their relative positions.

  1. In short: Do NOT try to outsmart this market by trading in and out!

 

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