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XAU Intermediate Term Analysis - Trading Strategy Revisited

At the end of March, I discussed the scenarios, strategies, and expectations I had with regards to gold and gold stocks, specifically the XAU. In the first report, I had stated the following:

March 2005: If gold and gold stocks remain in a bull market, the decline down to 89-84 zone ought to represent the last buying opportunity for gold and gold stocks prior to a spectacular bullish acceleration. If the XAU stays above 84 over the next 2-4 weeks and then it begins to accelerate to the upside, at this point in the bull market we ought to see a rise from its upcoming lows in the 89-85 zone in the next few weeks to a high in the 155-165 zone by the end of the year, which will represent an 100% gain.

If the XAU remains in a bull market, it ought not to violate support at 84 on a weekly basis. We would allow for an intra-day move to as low as 81. However, two consecutive weekly closes below 84, or even worse below 81, accompanied by gold closing below $400 for two consecutive weeks, would call the bull market assumption into serious question.

Now that we are in the middle of June, we can examine how things have unfolded so far, re-examine our assumptions, consider the possible scenarios going forward, adjust expectations, re-think and formulate strategies.

The first assumption that we need to examine is whether gold and gold stocks are still in a bull market. My conditions--strictly from a technical point of view--for concluding that the bull market in gold/gold stocks is still intact would be that in the worst case scenario the XAU didn't close below 81 for two consecutive weeks, and gold didn't close below $400 for two consecutive weeks. The XAU had one weekly close below 81 on 5-12-05, closing at 80.33. Since then it has rallied strongly, and gold itself never came close to $400.00, let alone closing below. Therefore, at the moment we must conclude that gold/gold stocks are probably still in a bull market. Why do I say "probably" and not "certainly?"

Take a look at gold/XAU/dollar from 1990 to 1997, and from 2000 to present. First of all, notice that from 1990 until the beginning of 1993, gold/gold stocks and the dollar moved in the same direction, down; then from early 1993 until very early 1994 they again moved in the same direction, up. Finally from early 1994 until late 1995, gold/gold stocks were flat, while the dollar lost almost 20% of its value. Thus, it is a myth that the two move in opposite directions; sometimes they do, but not always.

Second, notice that even when gold and the dollar were moving in the same direction, turns in the dollar preceded turns in gold/gold stocks like in the early '90s. The dollar bottomed in mid-1992, gold stocks bottomed in late 1992, and gold bottomed in very early 1993. In the mid-90s when they reversed directions, the US dollar bottomed in 1995, and gold/gold stocks topped out in 1996. However, since the new millennium started, turns in gold stocks have preceded turns in gold and in the dollar. Gold stocks bottomed in October of 2000, gold bottomed in the first quarter of 2001, and the dollar topped out in the first quarter of 2002. See the sequence of events labeled 1A-2A-3A. Subsequently, gold stocks topped out in the first week of January of 2004, gold topped out in mid-November of 2004, and the dollar bottomed six weeks later during the last week of December 2004. See the sequence of events labeled as 1B-2B-3B. In addition, it can be seen very clearly from the charts that in the last six months, the dollar is rallying and has broken above its long-term resistance line which had defined the downtrend since 2002; the XAU has broken below its long-term support line which had defined the uptrend since 2000, and gold itself has not broken above its short-term resistance line.

Bottom line: Although the XAU didn't have two consecutive weekly closes below 81, and gold didn't close below $400.00, the charts suggest that gold/gold stocks may have topped out in the short-term, and the rally of the last few weeks is the last "gasp" before a more serious decline takes place. On the other hand, it could very well be that the break of resistance by the dollar will turn out to be a "bull trap" in that case. If the negative correlation between gold/gold stocks and the dollar continues, then the break of support by the XAU will turn out to be a "bear trap."

I would like to believe that gold/gold stocks are still in a bull market. In my view, the fundamentals favor such belief. However, the charts are providing me with sufficient evidence to suggest that my view may be wrong. As a money manager I can't afford to be an "ideologue." I can't make decisions that place capital at risk based upon how I believe things "should be." I have to make decisions based upon how things "are."

At the moment, the evidence is telling me that I must consider both the bullish and the bearish case going forward and be prepared for either. In the rest of the report I will discuss in great detail the different scenarios that may take place, and the strategy that we will implement accordingly.

In terms of "scenarios" there are two types. Please try not to get confused, because I use the same numbering system on both. The first type is derived off the monthly/weekly charts and it tells us what we should expect from a "big picture" point of view. The second type is derived off the daily charts and guides on our trading decisions.

Three Scenarios to Consider
(Monthly Charts)

Scenario #1: The break-down at point "A" was a "bear trap." The XAU will continue its upward movement un-interrupted for the next 5-6 months. (If and when resistance is overcome, I will issue another detailed report discussing what we expect next. No major amount of capital will be put at risk on the long side until resistance at point "B" is broken.)

Scenario #2: The break-down at point "A" was a "bear trap." We can expect a pullback at resistance around the 94-96 level, but ultimately the XAU will get through it. (If and when resistance is overcome, I will issue another detailed report discussing what we expect next. No major amount of capital will be put at risk on the long side until resistance at point "B" is broken.)

Scenario #3: The break-down at point "A" was valid. The current rally will fail at resistance and it will be followed by a 25%-30% decline to point "C." (If and when that happens, I will issue another detailed report discussing what we expect next. No major amount of capital will be put at risk on the short side until support is broken.)

THE DEMARCATION POINT-QUADRUPLE RESISTANCE

The interesting thing from a money management point of view is that regardless of which scenario ultimately plays out, the price action in the very early stages is nearly identical in all three, thus, placing a major amount of capital at risk prior to having confirmation of which scenario is playing out can be disastrous.

In all three scenarios, price would rally back up to resistance. The question is, what happens next? Notice that  the 94-96 level represents quadruple resistance, which makes it rather significant from a bullish/bearish point of view. Not only it is where the short-term and intermediate-term support lines intersect (green, red line), it is also the point of intersection for the 50 and 100 WMAs. If the XAU is in bull market, it ought to be above all four of these benchmarks. And if it has entered a bear market, any initial rally ought to fail at any one of these benchmarks. The fact that all 4 are found within a 2-point interval makes the 94-96 zone a the "demarcation line" between a bull and a bear market.

In addition, notice that in the 94-96 zone we have a 61.8% fib level for the decline from B to C, and a 50% fib level for the decline from A to C. Therefore, even if the big picture is still bullish, we ought to get a pullback from this area on a short-term basis.

TRADING STRATEGY
SCENARIO#1

If scenario #1 is taking place in the big picture (see above), then in all likelihood this is what would take place on a daily basis (see chart below).

We would expect a pull-back from the 94-96 zone, which in all likelihood wouldn't even fill the gap at 90, because if the XAU is going to move straight up from here, then it means that the gap at 90 is a "run-away" one, which doesn't need to get filled.

If the XAU continues to push higher up to the 94-96 zone, then it pulls back, but it stays above the gap. Upon reversal to the upside, we will close the put positions we opened last week and switch to credit put spreads, which means we will make money on the upside, but we won't lose if the break-out is a fake out.

SCENARIO #2

If scenario #2 is taking place in the big picture (see above), then in all likelihood this is what would take place on a daily basis (see charts below).

Two possibilities based on scenario #2

A) The XAU will pull back to fill the gap at 90, and then reverse to the upside to attack resistance at 96 (see chart above). In that case we will sell the put options we bought last week, and we will switch to credit put spreads and add our favorite gold stocks, such us ABX, PDG, AU, with stops right under the entry point.

B) The XAU will fill the gap at 90, but it will not arrest its decline. It will continue lower and find support between 87 and 84 (see chart below). In that case we will sell the put options we bought last week, and we will switch to credit put spreads, and add our favorite gold stocks, such us ABX, PDG, AU, with stops right under the entry point.

Why am I expecting the XAU to find support between 87 and 84 if it doesn't arrest its decline after it fills the gap at 90? Because between 87 and 84 we have the fib retracement levels that correspond with the decline from March to May. If the XAU falls below 84, then we would have to consider that scenario #3 is probably playing out.

SCENARIO #3

If scenario #3 is taking place in the big picture (see above), then in all likelihood this is what would take place on a daily basis (see charts below).

Two possibilities based on scenario #3

A) The XAU will pull back to fill the gap at 90, and then it will reverse to the upside to attack resistance at 96. However, at 96 it will fail and reverse to the downside (see chart above). In that case we will liquidate long positions, bullish option spreads, and switch back to put positions.

B) The XAU will pull back to any of the fib retracement levels I mentioned, and then it will reverse to the upside to attack resistance at 96. However, at 96 it will fail and reverse to the downside (see chart above). In that case we will liquidate long positions, bullish option spreads, and switch back to put positions.

ADDITIONAL POINTS:

Bull-Bear Traps

I mentioned the terms "bull trap" and "bear trap." Some of you may not know what they are. A "bull trap" occurs when we get caught in a false break out, while a "bear trap" takes place when we get caught in a false break down. In both cases investors who opened positions because of the "break" get "trapped" in them when the market quickly reverses to the opposite direction of the break.

Traps can be simple like the case below on the left with only one false break, but they can also be complicated like the chart below on the right. In that case, we have two false breaks before the actual move takes place.

3-5 Wave Price Moves

Price never moves straight up or straight down. It usually moves in 3 or 5 waves.

In the case of the XAU, the low in May could represent the end of a 3-wave decline. However, we can't exclude the possibility of a 5-wave decline, and in that case the next reversal point is at 96. (Please note: My references to "waves"  are not in connection with Elliot Wave Theory.)

Downside Target

It is worth noting that if we measure the entire advance from 2000 until 2004, we have a fib 61.8% level at 69.40. The fifth wave of 5-wave decline tends to exceed in magnitude, waves 1 and 3. That means if we are dealing with a 5-wave type of decline, the fifth wave will be approximately 25% to 28%. Assuming the reversal takes place at 96, a 25%-27% decline will carry the XAU to 72-70, which is right above the 61.8% fib level. In other words, it is possible that the XAU will experience another decline, make a lower low, reverse to upside, and re-enter a bull cycle. In doing so, it will have formed a rather complex "bear trap" which is not atypical of gold stocks.

Ike Iossif

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