Signs of an Emotional Market

A gap occurs on a bar chart in a bull market when the low for any period (day, week, month) is higher than the high for the immediately preceding period.

Gaps are typically signs of high emotion in a thin market when brokers are instructed to buy "at best", and are forced to bid the price up to secure supply. This may be sign of an absence of sellers rather than a presence of buyers but, in gold's case, we cannot be sure because volume numbers are not published.

Careful scrutiny of the weekly gold chart below (courtesy DecisionPoint.com) shows that - three weeks ago - the gold price gapped up through the resistance level of the upper trendline as it shot up briefly to well over $525. The following week the gold price retraced its steps to below the trendline (thereby covering the gap) and, this week, the gold price has once again gapped up through the same trendline.

What does this mean?

Gaps occur at psychologically important points, and the following are some examples of when they occur:

• As "knee jerk" reactions to published news of perceived significance
• When a previous move is "exhausted" and the last participants in the race use up their last stores of adrenalin to fling themselves over the finishing line - thereby finally exhausting demand (or supply) as the case may be. Exhaustion gaps are typically caused by investors who have been watching prices rise (or fall) and who have not done anything about it to date. They finally lose control and throw themselves into (out of) the market just as the market reaches its peak (nadir)
• On reversal of a trend, a "gap island" sometimes occurs following and exhaustion gap as sellers (or buyers) who have been waiting to sell (or buy) give a "sell at best" instruction after the market has peaked and the last buying pressure has exhausted itself - thereby causing another gap on the way down.
• As resistance levels and trendline resistances are overcome
• As "congestion" areas are overcome (following trading indecision which is finally resolved).

A common denominator to most of the above is "emotion" as opposed to "logic".

Most gaps are subsequently covered as the market finally comes to its senses regarding underlying "fundamental value".

There are two exceptions to this general rule:

1. A "Breakaway Gap" is usually a sign of a structural change in the underlying fundamental value perception. In this event, the gap is a logical reaction to structural change, and - because it has been driven by logic - will probably not be covered in the foreseeable future.
2. A "Runaway Gap" occurs subsequent to the manifestation of the Breakaway Gap, and validates that there has indeed been a structural change in market perceptions of underlying value. As an aside, and of significant interest, the distance between the midpoints of a breakaway gap and a runaway gap usually has fairly reliable measuring implications regarding the coming subsequent move.

So, the question arises: Is the gap on the weekly bar chart above based on emotion or logic?

The following factors need to be taken into account:

• We are currently in the end-of-year silly season, where many people are on holidays between Christmas and New Year. (In the southern hemisphere many businesses either close or operate on skeleton staff)
• The availability of gold inventory is typically ramped up prior to Christmas (to supply the Jewellery trade) and the flow of supply slows down immediately following Christmas - in response to a drying up of industrial demand.
• The oscillator on the chart above is in "overbought" area, and the gold price (from a trading perspective) is due to pull back.

Clearly, according to conventional technical analysis, there is a justification for arguing that the gaps are based on emotion.

But what about the "structural change" argument?

Surely, if demand manifests when it usually abates - and it manifests repeatedly (evidenced by two gaps) it could be argued that this is ipso facto a sign of a structural change?

In this analyst's view, the issue revolves around fundamental value in general and, in particular, the thorny arguments surrounding gold's fundamental value.

Fundamentally, gold is one of those rare objects that has more than one paradigm of value assessment.

On one hand, it has value flowing from supply of and demand for industrial uses including jewellery. Based on this paradigm, demand at this point within the calendar year will undoubtedly be waning and the price of gold should be falling.

On the other hand, it has a "perceived" value based on its apparent stability as a currency of last resort. When faith starts to waiver in Fiat currencies, the demand for gold rises.

The most important Fiat currency in the world is undoubtedly the US Dollar. The US Economy accounts for roughly 25% - 30% of world GDP, and many, if not most, international transactions are denominated in US Dollars.

Logically, it therefore follows that if the gold price were to be rising because of a structural deterioration in the way the market perceives the "integrity" of the US Dollar, we should be seeing a deterioration in the price of the US Dollar relative to all other currencies - including gold.

The following are the daily, weekly and monthly charts of the US Dollar Index:

Clearly, based on all three charts, the level of 90 is significant from both a support and resistance perspective. Going back to 1988, 90 was a support level. In 1990, the 90 level was penetrated on the downside, and it took until 1997 for this level to be convincingly penetrated on the upside. Here we are in 2006, and the US Dollar Index appears to have once again reached a decision point. Will it break up above the 90 level or will it fail to do so?

The position is hardly clarified by the daily and weekly charts which appear to be in stark contrast with each other:

The oscillator on the daily chart is pointing to further short term upside potential, whilst the same oscillator on the weekly chart could be argued to be in intermediate term overbought territory.

But there is a paradox here.

Why would the US Dollar Index be showing strength at the same time that the gold price is showing strength? Surely such a state of affairs is contra-indicated?

A "technical" answer lies in the following chart of the Goldollar Index:

Three important observations flow from the goldollar chart above:

1. The Index "gapped" up through the 4,000 level a few weeks ago, and it looks very much like that was a "breakaway" gap - implying that there is now a fundamentally different perception in the market (a structural shift) regarding the relationship between gold and the US Dollar.
2. There is some resistance at the 4,750 level which - if it cannot be overcome - will imply that either or both of the Gold Price and/or the US Dollar Index should encounter resistance
3. If the 4,750 level above is penetrated on the upside, we will probably witness the emergence of rampant optimism in the world's financial markets.

The trained chartist's eye sees a higher probability of consolidation at this level - with the most likely outcome being a consolidation of the US Dollar (possibly a slight rise) and a pullback (temporarily) of the gold price within a bull market for the Goldollar Index.

What does that word "temporarily" mean?

In the context of the "scale" of the chart, and the distance of the current goldollar index price from its rising trendline, it might take anything up to 12-18 months for the emotion to dissipate.

Having said this, the very fact that the Goldollar Index is in a bull trend has some important connotations:

• Despite all the angst and hype regarding a world economy that seems at risk of implosion because of the US Fed's predisposition to print money, the technical evidence seems to support the conclusion that the market is not particularly concerned about such an outcome.
• Indeed, the opposite outcome seems to offer a reasonable associated probability of occurrence. The only logical basis for the goldollar index to be in a bull trend is that the market is sensing an improvement in the underlying economic fundamentals.

How can this be? Blind Freddy can see we are in deep doo doo. The Fed is manning the printing presses, the US Government is in deficit (and debt) up to its eyeballs, the real estate market looks like it has peaked, private debt is at historically stratospheric levels. On top of this we have the risks associated with Global Warming, and of a possible outbreak of Bird Flu. Furthermore, China is experiencing growing pains as evidenced by more than one industrial chemical spill, and Mr Putin's economic adviser has just resigned because he believes that the Russian economy is no longer free of external interference.

Yes, all this is true, and yet the following chart of the NYSE Index is showing no signs of fear, and is not overbought relative to historical levels from an oscillator perspective.

Logic dictates that there is one (and only one) conceptual scenario that can validate why both the US Dollar Index and the Gold Price are rising:

The market is anticipating a buoyant economy, and the associated demand for gold will rise in the face of slowing supply.

Let's examine the one other argument that could be put forward as an explanation:

The Fed has printed so much money that it has nowhere else to go other than commodities (including gold) the stock markets, the property markets, and the bond markets. Prices of all assets - world wide - are rising on a sea of liquidity.

Whilst this may indeed be a contributory cause, it defies logic that in addition to the price of all dollar denominated assets rising, the price of the US Dollar as expressed in other currencies is also rising. It is for that single reason that there has been so much bearishness regarding the US Dollar.

And yet THE MARKET appears to be taking a different view relative to the US Dollar. The level of (approximately) 90 seems to be offering some strong support.

Is it possible that The Market is sensing a structural improvement in the world economy?

Because it is the Silly Season, and people are in a relaxed frame of mind, the following joke can appropriately be put forward as a humorous attempt to crystallise the core issue:

At one end of the spectrum there will be those people who are adamant that the World Economy must implode, and that it's only a matter of time. They will find the above joke funny, but a bit unnerving. After all, we are apparently defying the laws of Nature.

At the other end of the spectrum there will be those people who genuinely believe that mankind has progressed to a level where, through the emergence of such revolutionary progressive understanding related to DNA mapping and Nano technology, we are ready to break through historical barriers to human progress. They will find the above joke irrelevant.

In the middle of the spectrum there will be those people - like myself - who struggle to have a balanced view, and can embrace the concept of scientific evolution sitting alongside the concept of "Intelligent Design" (To be perfectly PC). They will argue that the two views as articulated above are not mutually exclusive.

It is these people who will be open to the idea that, maybe, this time around things are really different, and that The Markets have not taken leave of their senses.

Conclusions

The evidence seems to be pointing to the following conclusions:

1. Gold is overbought, and the gapping up of its price through the upper trendline resistance on the weekly charts is a sign of emotion, which may take upwards of a year to unwind
2. Notwithstanding this, both the gold price - and in particular the Goldollar Index - are clearly in bull trends, indicating that the rising gold price has not been caused by "fear" of economic implosion
3. The only logical scenario that can be put forward to validate 2 above is that The Market seems to be anticipating an improvement in economic conditions.
4. Such an outcome will be contra-indicated in terms of historical experience, and one will have to take a view that "this time it really is different" if one is to be able to embrace 3 above.

My own view is to play it safe. I am not relying on an improving economic environment, but will be not be at all surprised if it manifests. Indeed, I am behaving in all areas of my own activities (except listed investments) as if the economy is about to improve, and I have at the same time put a safety net under me. I have a significant investment in gold and silver related counters, and this is giving me peace of mind to go about my normal day-to-day activities. In the event that the economy implodes, my investments in gold/silver will protect my capital base. In the event it grows, the demand for "precious metals" for industrial applications will grow with it.

It's called a win/win scenario, and that's comfortable.

Happy New Year to all