Friday, August 21, 2009

Assessing the Gold Breakout

Gold has broken a major resistance line, now what? This blog will dissect the gold breakout and the strategies that have arisen. Lets look at four different cross-currents of technicals on the GLD.

1. Continuation/Bottoming Patterns.

2. The Throwback.

3. What it all means in the market.

4. How to trade it.

1. Continuation/Bottoming Patterns:

We'll first look at the different technical patterns that have been called on the current consolidation/bottoming pattern of the Gold, replicated by the GLD, and discuss their respective calculations for price points.

Head and Shoulder(they are not usually continuation patterns)

There are many out there who have seen the head and shoulders pattern in the GLD - although HnS formations are usually bottoming patterns, not continuation. Measure the height of the head at top/bottom and add/subtract that from the neckline. The current values and calculation for the GLD would be: {100(Neckline)-75(Head)}+ 100(neckline) = 125 or approximately $1,250 for one ounce of Gold.

Flag Pattern

The flag pattern is a continuation pattern. There have been many calls that the current consolidation is a flag pattern. The calculation is to subtract the breakout point price from the price at the top of the consolidation of the flag formation. Add that # to the breakout of the consolidated flag. The current values and calculations for GLD are: 100 -65 = 35. Add that to 80 which gives you 125, the same value as the H n S bottom.

2. The Throwback

When a stock breakouts through an old resistance price it will usually come back and test that resistance as support. This is known as a "throwback". Also notice that this breakout move could begin an Elliot Wave count.

3. What does it all mean for the market?

An important divergence that seems to have been developing - Gold/Gold stocks have been outperforming the early cycle sectors in the past 4-6 weeks. There is a 20% difference in the 6 month performance of the AMEX GOLD BUGS INDEX(AMEX: ^HUI) vs. Dow Jones Transportation Averag(DJI: ^DJT) and the (Philadelphia Semiconductor Index: ^SOXX).

Gold's breakout has also increased the volatility of the markets. This is usually indicative of tops and bottoms and means the markets will get more volatile in the short term. The market can thrust higher in this volatility - a blowoff top if you will, but the VIX, although it has been sleeping in its den, can wake up and give us a scare, albeit much less then the VIX during the market crash.

Also remember that in the economic cycle, commodities move last - this also backs up the theory that the market is nearing the end of its current trend, as commodities have been on fire. It doesnt mean we cant consolidate for 6-9 months with a 10-15 percent corrective range(which presents great opportunities as a trader)before making another leg higher sometime in the summer/fall of next year. Which would probably sit gold at 1400-1500 and ready for a large correction.

4. How to trade it.

The throwback in the price of gold could hold the crucial element for the soon coming "real" market correction. On the breakout of Gold we have seen the volatility of the market increase which is warning you of something to happen. This could mean another leap higher in the market on the current breakout of Gold prices - creating a blowoff top of some sort for the markets and finishing the Wave 1 and moving into the Wave 2(throwback) of its trend. When gold corrects at around 1200, the market should begin the correcting and stagnating phase of inflation.

A 2:1 long/short model weighted long gold/silver stocks and short early cycles like semis and banks could bode well for a managed risked portfolio. This strategy should work during the current breakout of gold to around 1200. Once that manifest's, you would want to be less long gold/gold stocks and tilted short on the early cycle sectors and shifting to a 1:1.5 long/short strategy.

A further strategy will have to be evaluated once and if we see any of the first 2 strategies manifest. You'll have to assess the inter-market relations at that time to see how to realign one's holdings.