Relative Gold Bulls 2

Adam Hamilton
Archives
May 19, 2006

This past week has been rather traumatic for gold investors. Just two days after achieving dazzling quarter-century nominal highs above $720, gold had fallen 5%. Retreating prices irritate investors to no end, so there is now an increasingly vitriolic war of words underway in the contrarian community about whether we are now witnessing the early days of a full-blown correction, merely a minor pullback, or an irrelevant blip.

While my long-term gold-heavy investment portfolio is certainly feeling the pain, the speculator in me loves volatility regardless of its direction. Volatility is the lifeblood of speculation, it grants us priceless opportunities to buy low and sell high. If markets ever only rose in a slow and perfectly orderly manner, speculation would cease to exist as only investment would be possible. What a boring and dreary soul-crushing world that would be!

Investors, and indeed most folks, generally view speculators with scorn. Whenever prices move in any direction they don't like, speculators get the blame. A decade ago this used to bother me, but now I love telling people I am a speculator just to savor their reaction. After finding out what I do they'll often say something like, "So, high gas prices are your fault." To which I reply, "Darned right amigo! I own the best oil companies pumping the oil, I own the elite refineries distilling it into gasoline, and I think gas is way too cheap at $3." Perhaps this is why speculators aren't popular at cocktail parties.

In reality prices are not "the fault of" speculators. We are the most essential lubricant to the free markets, willingly putting our hard-earned capital and necks on the line time and time again to provide critical liquidity when no one else will. Who was buying gold last June when it languished under its 200dma and threatened to fall under $400? Speculators. Who cares if we are despised as long as we are earning huge profits!

Why am I leading off with this discussion? In the last week a pernicious campaign is taking shape to ridicule every speculator who even believes a correction in gold is merely possible. We speculators are being called idiots and morons. It is pretty funny really. The most amusing and comical part is that the opposing position, that a gold correction is impossible, is sheer lunacy based on market history. No bull markets, no matter how powerful or how compelling their fundamentals, ever advance up in an accelerating uninterrupted line.

Another new fallacious assault on speculators claims successful speculation in gold is impossible. Lies, damned lies! I've written several hundred essays in the past six years mostly about commodities including gold and have accurately called most of gold's major interim tops and bottoms in real-time near where they happened. My record is public and can easily be compared to gold's major uplegs and corrections so far. The late 2004 gold top? The early 2003 gold bottom? Last week's dollar-rally-driven gold selloff? All anticipated in advance. Speculators were all over these tactical reversals and earned fortunes trading them.

So whether you are an investor or speculator, and each approach to the markets has advantages and disadvantages, realize that it is just plain silly to make foolish statements totally unsupported by history such as "corrections are impossible" or "successful gold speculation is impossible". Making any such absolute statement in a purely probabilistic market environment where anything can happen at any time simply highlights the naivety of those who dare utter such nonsense.

If you are a speculator you realize the huge importance of analyzing markets and looking for corrections. We live for volatility and love corrections as they provide us a dazzling buying opportunity for gold, silver, and PM stocks once they fully run their courses. But investors benefit tremendously from corrections too. If you are a pure long-term investor and you want to add more capital to these precious metals bulls, the ideal time to do it is right after a correction when prices are relatively low. Anticipating corrections greatly benefits investors.

With this background in mind and ignoring the fools who think markets rise in straight lines forever, two important questions about gold occupied my mind this week. First, and most importantly, is another major gold correction likely now underway as we have seen about a half-dozen times before in this gold bull or are we just witnessing a minor pullback?

Second, with gold the most technically overextended last week that it has been since its last Stage Three blowoff in early 1980, what are the odds Stage Three is here again? This is a crucial question with double-edged implications. If we are now in Stage Three, gold could continue blasting straight up to $5000 or so, but that would be it, this gold bull would be over. But if we aren't in Stage Three yet, then gold is not going to continue its vertical ascent, it will correct, but on the bright side there will probably be many more years left in this bull.

In order to frame my inquiry into these questions, I decided to view it in Relativity terms. Relativity is a trading theory I developed after spending many years studying current and historical markets. All secular bull markets in history flow and ebb, experiencing awesome uplegs followed by sharp corrections. Mathematically the uplegs stretch prices far above their 200-day moving averages and then the following corrections drag them back down to their 200dmas.

This perpetual oscillation away from and back to a bull's 200dma can be quantified by dividing a price, the gold price, by its 200dma. The resulting relative trading range expresses gold as a constant multiple of its 200dma over time. Charting this creates a probabilistic trading band showing how likely gold is to surge or correct at any given time. By comparing Relative Gold today with rGold in the early 1970s, the last time gold was transitioning into Stage Two, we can gain an idea of how today's gold bull is faring relative to history.

The last time I wrote on the entire modern history of rGold was over two years ago. If you read that earlier essay and compare it to this one, you may notice slight differences in extreme rGold highs and lows. This is because I am now using a new daily gold dataset we hadn't yet purchased the first time I did this study. Believe it or not all historical datasets, regardless of their price, contain some dirty and incorrect data. I think this new dataset is cleaner than our old one though so I am using it for historical gold analysis going forward.

For both investors and speculators perspective is absolutely crucial, and this long-term gold chart with over 65,000 individual data points graphed really puts gold's latest fantastic upleg into context. The red numbers are extreme rGold values at various points in time while the blue numbers mark the three major stages of each great gold bull.

The first thing about this chart that is striking is how high gold looks today compared to its late 1970s super spike. This is quite deceiving though. If you adjust gold for inflation and chart it in real terms, gold is now merely trading at its same levels of the late 1980s. Gold's all-time nominal high in January 1980 expressed in today's increasingly inflated US dollars is near $2200. So within the scope of an entire secular bull, $700 gold today is nothing and not even close yet to the real highs of a quarter century ago.

Nevertheless, except during its final terminal blowoff in Stage Three of the 1970s gold superbull, gold certainly didn't move up in a straight line without interruption and neither has our current specimen. Check out the red rGold line in the 1970s. Gold alternatively rocketed higher in uplegs that utterly dwarf anything we have seen so far today but then it collapsed back down to its 200dma (1.00 rGold) in brutal corrections. Even despite this extreme volatility, the 1970s bull is still fondly remembered today as the greatest gold bull in history.

What really captured my attention last week, and I wrote a Zeal Speculator Update on it at the time for our ZS subscribers, was how far gold had soared above its 200dma lately. On Thursday May 11th gold closed at 1.389x its 200dma. Students of the markets who understand gold's behavior over the last 35 years or so were stunned. Gold hadn't extended anywhere close to this far above its 200dma since its 1979 Stage-Three-blowoff super spike!

This was very concerning. Every week I get e-mails from folks who want Stage Three to be here, to see the mainstream public rush into gold like they did into the NASDAQ in 1999 and drive it to the moon. Yes it would be fun and we would all earn fortunes, but the problem with a premature Stage Three terminal parabola is that it will mark the end of this secular gold bull. Once the entire public buys gold, there will be no one left to buy and gold prices will collapse like they did in the early 1980s.

Another problem is that the earlier a bull transitions into Stage Three, the smaller its final Stage Three spike will be. Most secular bulls run a decade to 17 years in duration, which is plenty of time for average folks to become aware of the vast riches that are being won in them. The longer a bull lingers in Stage Two, the investment-driven stage, the more people will become aware enough of it to ultimately buy in eventually driving a far higher Stage Three blowoff. The later that Stage Three drives gold terminal this time around, the exponentially higher the profits we will earn. We don't want a premature and anemic Stage Three.

And with our current gold bull just 5 years old, very young still, there are major fundamental and psychological reasons why Stage Three should be many years away yet. Fundamentally Stage Three typically doesn't happen until worldwide mined-gold supply exceeds demand, and we aren't even close yet. It takes many years for gold miners to bring new gold to market to respond to rising prices, it is a very slow process. And psychologically gold remains unpopular among mainstreamers. Until we hear everyone talking about gold all the time like they talked about tech stocks all the time in late 1999, it is too early psychologically for Stage Three.

When all these factors are added to the key fact that inflation-adjusted gold is still less than one-third of its way to its all-time January 1980 real highs, the odds of this latest gold surge being early Stage Three days are phenomenally low. But if Stage Three isn't upon us, then why is rGold stretched to unbelievable Stage Three levels? This question was bothering me until I created this chart.

It turns out, amazingly enough, that three decades ago in the last great gold bull's own early Stage Two years, rGold soared above today's levels three times in three different major uplegs! Thus enormously stretched rGold extremes are not only witnessed in Stage Three, but in Stage Two as well. I was really excited to learn this because it not only corroborates other technical evidence that we are indeed in Stage Two, but it shows that this degree of huge upleg is normal in Stage Two!

Huge rGold spikes do not only happen during the Stage Three parabolic blowoff! This next chart zooms into the early and mid-1970s gold data and really illustrates this fascinating and encouraging point. While our current gold bull certainly won't unfold exactly like the last one, more often than not current market events at least rhyme with history so history helps us understand what kind of volatility we should expect.

In the early 1970s gold languished in a modest Stage One uptrend, not doing much of anything. Of course it was illegal for American investors to own bullion gold until early 1975 which certainly put a damper on gold's early 1970s progress. But in mid-1972, less than a year after Nixon reneged on the international dollar gold standard, gold gloriously broke out of its Stage One channel. Its first Stage Two upleg drove it up 36% after this breakout in just 43 trading days, blasting gold up to 1.390x its 200dma.

These numbers are just wild technically. Why? Our latest gold upleg today, which is no doubt the first in Stage Two of our current bull market, is up 34% from its March lows, after its breakout, over 43 trading days. This unprecedented surge, for this bull at least, catapulted gold up to 1.389x its 200dma. Déjà vu? While I am going to discuss this more after the next chart, drink in these two separate initial-Stage-Two-upleg metrics separated by nearly a quarter century and marvel at how technically close they are statistically. Wow.

And for those who think gold is going terminally parabolic today, I really doubt it. I made another chart, which didn't make the cut for this essay, which graphs gold's Stage One run in the early 1970s up until the end of its first major Stage Two upleg in mid-1972. That chart looked almost identical in slope terms to the chart below of our current gold bull. Thus what may look like a parabolic gain now will probably look as small a few years from now as this 1972 upleg does in the context of the early Stage Two years of the 1970s gold bull.

Incredibly in the 1970s the Stage Two uplegs got even better after the initial one in 1972. The next upleg in 1973 blasted 108% higher, the following one ending in early 1974 advanced another 94%, and the last one in this series ending in late 1974 was still up 46%. The 108% and 94% uplegs were so fast and volatile that they dragged gold over 1.50x above its 200dma!

So today's stellar rGold levels may very well be handily exceeded in the coming Stage Two uplegs in the years ahead. Talk about big gains, if gold continues following its early-1970s script this time around then we ain't seen nothing yet!

Now these gigantic Stage Two uplegs last time around created a hyper-volatile Stage Two uptrend channel vastly steeper than anything that came before it. And while it is certainly fun to examine the 1970s Stage Two uplegs and imagine what wonders probably lay before us in Stage Two of our own gold bull, there is one crucial point that neither investors nor speculators should overlook.

After every single massive Stage Two upleg in what is today universally considered the greatest gold bull ever, gold corrected back down to its 200dma. Yes I used the c-word! Correction. These healthy plunges necessary to rebalance sentiment and prolong the bull's ultimate life were roughly proportionate with the uplegs that went immediately before them. The bigger the preceding upleg, generally the sharper and more vicious the following correction.

Thus in Stage Two, while we can expect far bigger uplegs than anything we have yet witnessed, the cost of these uplegs is the sharp corrections on the other side. These corrections do not hurt the bull and gold should continue to march higher on balance, but it will not march up in a straight line. No bull market in history ever has until its final terminal parabola.

So the folks today calling speculators who expected a gold correction idiots or morons have really misplaced their vitriol. Rather than wasting time attacking speculators just as bullish on gold as they are, they ought to be studying market history so they don't make fools of themselves.

The next crucial point from the lessons of the last Stage Two gold bull involves the depth of these periodic corrections. Every single one saw gold return all the way back down near its 200dma. Sometimes gold bounced right above its 200dma to launch its next upleg and other times it sank a bit under its 200dma, but overall the 200dma was a good correction target during the last Stage Two.

Now since I apparently have to be an idiot and moron to actually expect markets today to work like markets always do, perpetually driven by the same competing emotions of greed and fear, let me escalate my blasphemy. If gold corrected to near its 200dma in the last Stage Two no less than every single time, isn't there at least some small chance that it will correct to its 200dma today after its first Stage Two upleg this time around? If so, then we are in for one wicked correction, because today gold's 200dma is under $525!

Now check out gold's Stage Two transition today after understanding how Stage Two worked a quarter of a century ago. From the initial modest Stage One uptrend to the dazzling breakout to the amazing initial Stage Two upleg, the similarities here are uncanny. So far gold is pretty much doing what it did last time around.

Measuring this first dazzling Stage Two upleg is somewhat ambiguous. If we consider it as beginning way back at its 200dma last summer when gold threatened to plunge below $400 and investors were scared, it is up 74%. But if we instead just measure it from its latest mid-March lows after its breakout before it rocketed vertical, it is up 34% and in line with its 1972 initial-Stage-Two-upleg ancestor. Either way, this first Stage Two upleg is obviously vastly different in magnitude from its Stage One predecessors.

One key implication for speculators is this new Stage Two has just shattered our existing rGold trading range. For years now at Zeal we have been watching an rGold range running between 0.99 on the low side to 1.14 on the high side. When gold fell near the bottom of this range near its 200dma it had been an awesome buy for both investors and speculators and when gold hit or exceeded the top it was time to expect a correction and trade accordingly for speculators.

Based on my look at the Stage Two of the 1970s I think our lower rGold strong-buy zone of 0.99 is just fine going forward, but obviously gold trading at 1.14x its 200dma on the top end is far too conservative. I'll be closely watching gold's coming uplegs and using them to attempt to recalibrate the top of our rGold scale for Stage Two. With only one Stage Two upleg under our belts it is too early yet to make a guess, but the new Stage Two rGold neutral zone is no doubt going to be much higher than it was in Stage One.

This rGold trading range in Stage One rendered above is one of the key tools we used at Zeal to trade gold stocks over the past five years. We generally bought gold stocks when gold was near its 200dma and ratcheted up our trailing stops when gold was stretched far above its 200dma, with great success.

While we certainly didn't catch major interim tops and bottoms to the very day, we were pretty close most of the time and our subscribers thrived. They bought low and got stopped out high for big realized profits, over and over again. People today who say it is impossible to trade gold apparently weren't successfully doing it throughout this entire bull, they are flat-out wrong. Periodic corrections in powerful bulls are normal, healthy, inevitable, and anticipatable and it flabbergasts me when investors refuse to acknowledge this.

One of the most common anti-correction arguments is the Black Swan. In trading, a black swan is an ultra-rare event that radically moves markets but cannot be anticipated. Think 9/11 for example. People always tell me that if X happens then gold is going to the moon. I almost always agree with them. If X happens, if Washington is nuked, if the dollar hyper-inflates, if Martians invade, if whatever, gold will indeed go to the moon. But the problem is X is always an ultra-low-probability black-swan event.

Prudent speculators trade based on high-probability events like the normal flowing and ebbing of the markets for sentiment reasons, not worst-case scenarios. All prudent speculators also have long-term gold investments in a separate portfolio that they don't actively trade just in case, but they never bet their speculative capital on ultra-low-probability black-swan events. These just don't happen often enough to actively game.

At Zeal we intimately understand the markets are governed by probabilities so we align our trades and trading recommendations for our subscribers with the strongest prevailing probabilities. After gold rockets vertically at the end of a massive year-long upleg, the odds definitely favor a correction. These corrections are huge opportunities though as the bargains at their ends are the best deals investors and speculators alike are ever going to see in the midst of a powerful secular bull market.

While we have successfully traded every major gold and gold-stock upleg in this bull to date, we have never spent as much time preparing for the next buying opportunities near 200dmas as we have in recent months. If you want to buy the next round of elite gold miners with awesome fundamentals near their technical bottoms after this correction runs its course, please subscribe to our acclaimed monthly Zeal Intelligence newsletter today. And make sure you have cash in your trading accounts for the feast to come!

The bottom line is all bull markets, no matter how powerful they are or how compelling their fundamentals happen to be, flow and ebb. Periodic corrections are just as inevitable as massive uplegs and they must be expected from time to time. These episodes of weakness are very important for the bull's ultimate health and longevity as they keep greed in check and rebalance sentiment.

If someone has duped you into believing that corrections in gold are impossible, you are likely going to lose money and burn out fast. Corrections will indeed arrive anyway and can rip your psyche apart if you weren't expecting them from time to time. Please study market history to gird yourself against the rantings of ignorant fools, for the markets take no prisoners.

Adam Hamilton, CPA

May 19, 2006

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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