Gold/XAU Breakouts?

Adam Hamilton    March 9, 2001    3281 Words


We are truly blessed to live in extraordinary times.  As the wizardry of the infant Information Age slays many of the ancient limitations inherent in distance and geography, the pace of change in the world financial markets is accelerating to dizzying speeds.  Trying to stay abreast of global financial developments is more and more like trying to drink water slammed through a huge fire hose by high-performance industrial impeller pumps.  It is always a wild ride!  Even more difficult is trying to separate the truly valuable information from the effectively infinite amount of data chaff thrown up that muddies the true picture of what is occurring in the global markets.


With the NASDAQ gliding to its ultimate bottom as gracefully as a Boeing 747 with its wings shot off, more and more investors are being forced to reassess the common perceptions of where good information originates from in our perplexing world.  Conventional wisdom proved terrifyingly lethal to capital in the last 18 months as the tech bubble grew and grew like a malignant tumor and then exploded with a mighty roar.  Buy the dips?  In for the long haul?  Ignore the market?  Only if one takes some kind of perverse pleasure in throwing their scarce capital to the lions!


In the desolate aftermath of the tech bubble, the honor and integrity of Wall Street and the bubblevision establishment have rightfully come under increasingly heavy fire…  Why have virtually no professional warnings been sounded on the NASDAQ from the top one year ago to today?  Why did big Wall Street trading houses recommend that the small investor should buy and hold forever while the houses themselves were selling the very same stocks in their gargantuan portfolios into the rallies?  Why did analysts fail to downgrade companies until 75%-95% of investor capital had vaporized?  A “sell” recommendation after a company has lost 80% of its value is a cruel joke, not a useful piece of information.  These tough questions deserve answers.


In the ensuing melee since the NASDAQ pop, the timeless value of portfolio diversification once again became crystal clear.  Tech stocks, while sexy and intoxicating during the now infamous speculative mania of the NASDAQ bubble top, were and are still massively overvalued by all historical and fundamental measures.  More and more investors are cutting their losses while there is still time, and growing legions of wounded and bandaged tech investors are looking for other places to park what they have salvaged of their savaged capital.


The concept of not putting all one’s eggs in a single basket is ancient, and has protected capital and investments for millennia.  One brilliant example of everlasting wisdom on diversification comes from the revered Israeli king of antiquity, Solomon.  In his many writings, King Solomon exhibited super-human wisdom that has echoed through multiple dozens of centuries to strike a harmonious chord in the minds of prudent investors today.  On diversification, he said, “Give portions to seven, yes to eight, for you do not know what disaster may come upon the land.”


With the “disaster upon the land” du jour tech fires raging and no end in sight, investor interest in the global gold markets continues to grow dramatically.  Gold has stellar fundamentals, as insufficient gold is mined each year to meet world gold demand.  Gold stockpiles available for sale are dwindling dramatically as the raging demand burns through the accumulated available for sale above-ground gold hoards like Ebola Zaire.  In addition, a growing throng of elite smart money is pre-positioning itself for the inevitable end of gold’s brutal 21 year bear market.  The prudent investor recognizes that all investments are cyclical.  Just as tech stocks proved last March that they could not defy the immutable long-term laws of finance and rise forever, the gold price will not fall forever.  A stunning and very high-profile reversal of fortunes is rapidly approaching on the horizon.


As the implications of information overload, Wall Street disinformation, the NASDAQ debacle, and portfolio diversification violently converge in our markets and minds, the inevitable question that arises is… what about gold? 


With the ever-increasing general interest in the gold market, it is time to take another look at gold and the Philadelphia Stock Exchange Gold and Silver Index (XAU) from a short-term perspective, since last July, in this essay.  We will attempt to address the following questions…  Have important short-term breakouts occurred in gold and the XAU?  And is it high-time for the average investor to diversify his or her portfolio into gold and gold stocks to ride the coming gold tidal wave?


We begin with a simple graph of gold and the XAU.


The XAU is a basket of gold and silver mining stocks.  Unfortunately, the Philadelphia Stock Exchange has seriously hobbled the XAU in the last year.  Throwing logic to the winds, the wizards at the PSE came up with a wild idea and cryptically decided to add a huge copper mining company to the XAU and kick out some gold stocks.  The copper mining company, Phelps Dodge, produces trivial amounts of gold and silver as a byproduct of its primary copper operations.  It is the second largest copper producer on the planet.  No one in the gold industry would call Phelps Dodge a gold or silver miner in a million years, yet, to the best of our knowledge, the PSE never answered hard questions by gold analysts and investors about why they chose to water down the XAU.  Phelps Dodge itself was even dumbfounded, and released statements indicating it had no idea why it was inducted into the XAU as a make-believe gold and silver miner.


Nevertheless, all the valid criticisms of the XAU aside, it IS the most widely followed index of gold stocks.  Even with its significant limitations, the XAU is watched by traders like hawks and it will be one of the first signs to confirm a neo-gold rally.  There are some excellent proprietary gold stock indices created by various analysts, but none have yet prevailed in the battle for widespread respect and following.  The 22 year old XAU is still the most popular game in the house for tracking gold stock performance, so we use it here in our analysis.


In any type of financial analysis, perspective is absolutely crucial.  This first graph lays the foundation for the other two graphs in this essay, which are simply magnified versions of this initial graph to accent movements in prices.  With zeroed Y-axes for both gold and the XAU, the price action of both these investments is not skewed by odd scales in this first graph…



A couple important points leap out of this “big picture” perspective graph.  First, note the vast difference in volatility between gold itself (yellow) and the XAU (blue).  This is what we would expect, as the operating leverage of gold miners gives them vastly more price appreciation potential in a gold rally than for the ancient metal of kings itself.  Quantified statistically, the average of the absolute value of daily volatility for gold in the nine months in the graph is one half of one percent (0.50%).  The average interday volatility of the XAU itself weighs in at almost one and two-thirds percent (1.65%), over three times as volatile as gold itself.  As physical gold is much less risky and but offers much lower potential returns than gold stocks, this huge volatility delta between gold and the XAU makes perfect sense.


Second, note the linear trend lines of both data series.  They are the light dotted lines, yellow for gold and blue for the XAU, superimposed over the actual daily market close data series.  Note they are almost as parallel as railroad tracks across the endless flats of the Great Plains.  In the following graphs, these trend lines cross, but that is only an artifact of the degree of expansion of each independent Y-axis, and NOT a true absolute representation of the relative trend lines of gold and the XAU.  The expansions of the Y-axes of the following graphs are necessary to zoom in on price movements, but they should be viewed in the proper perspective offered by the graph above.


On to the second graph to search for breakouts!  This is a technical look at gold over the last nine months, with the XAU superimposed for comparison purposes…



The short-term trend channel for gold is really well defined, and it is quite obviously down.  The channel is bound by the red lines.  The bottom line shows the primary gold support line for the trend channel, and the top line the primary gold resistance.  Once again, it is important to keep in mind that this technical analysis is only valid for our short-term nine month perspective on gold.  If a chart encompassing a broader time-slice was employed, the trend channel would have a different slope and width.


Outside the gold trend channel, red arrowheads mark the times when gold bounced off support at the bottom or careened into resistance at the top.  On the support front, there were five primary times since last July when gold bounced off the line decisively.  Two times, gold fell through this short-term support rapidly, but the moment it crossed northwards back through the support line, a sharp rally carried it almost immediately to the top of the trend channel.  Both of these episodes are marked with light green dotted circles in the graph, along the bottom support line.  Technically, gold has not been comfortable underneath the support line shown above since last July, and it bursts forth from under the line if it is pushed too low.


One of the most perplexing mysteries of the recent gold market is the funny flatlined period of November 2000, ending at the first green dotted circle.  Note the incredibly odd holding pattern gold maintained for a month.  It sticks out of the graph like a grizzled gold prospector at a Wall Street bullion banker meeting.  This anomaly is so strange that we were compelled to write an essay on it as it occurred, called “November Gold”.


Gold is the most politically sensitive investment on the planet.  During times of uncertainty, gold demand tends to increase dramatically.  Looking at the flatlined portion of the graph above, November 2000 must have been a really quiet time in the world, eh?  Not exactly…  A legal total war was being mercilessly waged over the disputed US election, and international perceptions of the stability of the US and US dollar were deteriorating with each new legal salvo.  The NASDAQ was continuing its free-fall, and fear and despair continued to slowly grow and fester in the hearts of tech investors.  Oil was well above $30, and Saddam Hussein threatened to take Iraqi oil, a material percentage of global crude exports, offline.  In addition to these macro-factors, much very positive news on gold emerged in November 2000 that we discuss in our earlier “November Gold” essay.  Tremendous uncertainty, equities burning, and gold is trading like it is dead?  Hmmmm…


Many professionals and amateurs alike who have been studying and trading the gold market for the last six years have come to realize that there certainly appears to be a concerted international effort being made to suppress the price of gold.  We have searched and searched, but can find no viable free-market justification for the ethereal void in which gold prices hung suspended in November 2000.  Unless one can find a logical free-market explanation why a critical international market can simply enter stasis for a month with trivial price changes, they ought to carefully research and consider the voluminous evidence accumulating behind the assertion that an elite group of big money bullion banks and facets of a few Western governments have been playing artificial and anti-free market games in the global gold markets.  The November 2000 episode is very provocative, to say the least.


Back to the task at hand, the upper resistance line in the graph has also seen some minor piercing.  The first two episodes occurred immediately after gold was resurrected from its dead trading range in November of 2000.  Unfortunately, the fledgling breakouts were driven back by heavy selling from the usual suspects. 


The latest rally of gold in March, however, HAS blasted through the heavy top resistance line of the trend channel.  Although this short-term technical breakout (marked by the last green dotted circle) is too young to anticipate its staying power, it is very exciting.  Friday March 9 saw a sizeable move for gold, up $6.20 or 2.3%.  The resistance line drawn in the sand has tentatively been breached by the surging gold.  As the legendary GATA/Howe legal offensive plunges forward into financial history with guns blazing, this extremely encouraging initial breakout in gold could continue its assault upward in the near future.  It is most likely a harbinger of great gold fireworks to come.


Large marginal investor demand for gold, originating from anywhere on the globe, could cause gold to begin screaming vertically like an F-22 on full afterburners.  As evidenced by rocketing gold lease rates and increasingly bullish rumors and innuendo, something is definitely up in the secretive and incestuous gold world.  We believe it is very prudent to take advantage of low gold prices now to add physical gold to any investment or speculative portfolio.  As the gold info-war is being lost by the powerful anti-gold forces, the day of reckoning is fast approaching when gold will trade on pure free market supply/demand fundamentals… at prices MUCH higher than anything we have seen for decades, if not ever.


With the exciting initial evidence of an apparent gold breakout now established, we focus our attention on the XAU.  Has there been a short-term XAU breakout?



All the conventions of the previous graph apply here, except the red technicals apply to the XAU this time around.  One-upping gold, the recent XAU action is definitely a short-term breakout and is extremely encouraging!


The short-term primary XAU trend channel is not as well defined as gold, but it is still apparent.  There are three bounces off support and three repelled attacks on resistance noted in the graph above with the red arrowheads.  During the November gold suspended animation “miracle”, many gold investors and traders threw in the towel and heavy selling pushed the XAU far below its usual support line.  Like gold, however, when the XAU once again surfaced from the depths to punch through its old support line (marked by the first green dotted circle), the index rallied strongly and hesitantly breached the resistance line at the top of the channel before nosing over to drift.


The near vertical February XAU rally is the REALLY interesting bit of data on this graph!  Note the shattering of short-term resistance by a ballistic trajectoried XAU!  (the second green circle)  The top of the trend channel was aggressively burned through like an oxy-acetylene torch cutting through a newspaper.  It was very decisive and marked by ZERO hesitation as the XAU surged forth!


Rather than falling back down into the short-term trend channel, there has been little selling since this dramatic XAU rally.  On Thursday March 8, the XAU roared up another 6.2% to 56.79, lending significant further credibility to this breakout.  Within the time dimensionality bound in these graphs, there is no doubt that the XAU is pushing into technically important new territory.


Generally, we would expect gold stocks to begin to rally before the physical metal itself.  Smart money around the world is strategically flowing into gold investments.  Much more leverage (although at a higher risk) to the price of gold can be attained in a portfolio by investing in gold mines than in the yellow metal itself.  Also, the short-term equity markets are a pure emotional expectation game.  As the true record of the anomalous activities that have occurred in the gold market during the openly pro-manipulation Clinton Administration become more widely known, more investors are realizing that the current gold malaise is totally artificial and doomed to be shattered against the rocky shoals of fundamental reality by the mighty waves of free markets in the near future.  As fundamental expectations for higher gold prices spread, gold stocks are bought in anticipation by clever investors and speculators.


Interestingly, increasing investment demand in gold stocks OR gold forms a wonderful virtuous circle for gold bulls.  As more investors come to understand the current gold situation and ante-up their capital to buy, prices rise higher, which entices in new buyers, which drive prices higher, etc.  Besides the fearless gold liberators of the Gold Anti-Trust Action Committee (GATA …, the gold shorts fear NOTHING more than waking up one morning and realizing the thundering investing herd is buying gold en masse.  As the truth is spread through the fantastic technology of our Information Age, new investment demand will roar into gold equities and gold markets with the force of a hurricane.


Unfortunately for those who foolishly bet their futures on the fanciful prospect that the gold market is NOT cyclical and can be artificially suppressed forever, this hurricane of new gold investment demand will blow down their once strong fortresses as if they were made of straw.  As General Manager of Futures Nick Leeson of Barings Bank in Singapore so ably proved in the mid-1990s, when macro derivative bets move in the wrong direction, the forces of the free markets can slaughter even the mighty. 


Barings Bank was forced to declare bankruptcy because traders in a far-off branch made bad macro bets.  Barings traders bet that the Nikkei 225 stock index of Japan wouldn’t move, and simultaneously sold vast amounts of calls and puts on the index.  The profits would have been large if the bet would have paid off, but unlimited risk was exposed.  Unfortunately, the Nikkei soon fell 11% and eviscerated the highly leveraged trades.  Barings was a venerable 233 year old British investment bank that had helped finance the Napoleonic Wars and the Louisiana Purchase.  Over two centuries of hard work imploded because the markets did not move as expected.  The moral of the story… derivatives are exceedingly dangerous and can destroy the largest institutions in days when the markets don’t cooperate.


The gold shorts today are in the same precarious situation as Barings.  Important large money-center US bullion banks, named in the Howe/GATA lawsuit, have amassed outrageous derivatives positions in gold relative to their equity.  When the gold bear market ends one of these weeks, probably without warning, and gold runs north through $300 and $350, the mark-to-market losses in the minefields of these companies’ short gold derivatives books will be breath-taking.  As they desperately buy physical gold to maintain their delta hedges and cover gold shorts, the gold price will spiral higher and higher.  There will be lawsuits, much wailing and gnashing of teeth, and probably many bankruptcies as the tangled gold short web is forcibly unwound by the irresistible power of the free market.


While the large gold shorts are doomed, the average investor can reap fantastic profits through the coming gold bull.  Although gold itself has just tentatively broken out short-term, the XAU definitely has, and likely heralds great things to come.  EVERY investor, no matter how small or large, should have allocations of physical gold and gold mining equities in their portfolios.  The ends of multi-decade bear markets are exceedingly rare, and enough profits can be made in one of these mega-turns to provide for an entire lifetime. 


The coming appreciation in gold and gold stocks will be of legendary magnitude, and more and more investors are strategically allocating capital in anticipation of the rapidly approaching neo-gold bull.  Don’t miss this opportunity and be left behind!


Adam Hamilton, CPA     March 9, 2001     Subscribe