Why Gold Dropped and What is to Come

The gold smashup - that's what gold bugs have faced over the past several weeks. Just two weeks ago gold appeared to be poised to breakout and begin another big bull run. Everything seemed to be lined up. The XAU and HUI had been consolidating for weeks, the dollar appeared to be weakening, the Fed reached the end of its cycle of interest rate hikes, gold stocks were outperforming the metal and we entered the historically bullish September gold season. I positioned myself accordingly, building a large position in gold stocks. The XAU broke through its 150 resistance point.

But instead of starting a new bull run we got a false breakout and gold stocks have been falling ever since. I sold most of my gold stocks two weeks ago in order to raise cash and play the next bottom. Although I am now getting ready to buy back in, I am also sitting back and evaluating things. I'm asking myself what happened and what went wrong.

There were a few gold newsletter writers who have been calling for giant corrections in gold all summer. Among the more intelligent writers, Jack Chan said gold was making a huge head and shoulders top and was heading for a smashup while Chris Laird was saying that gold stocks would get sucked down along with the broad market as everything falls due to a coming recession. The recent action seems to suggest that they are right, but I think gold stocks are near a bottom and will surprise the doubters with a surprising recovery. Just as the false breakout fooled bulls like me I think a rally will end up fooling the cautious gold writers, even some of the smartest ones.

More bullish gold newsletter writers are blaming this correction on gold manipulators. However, there is a lack of solid proof and a more logical explanation. As Brady Willett of Fallstreet.com writes:

"Nevertheless, the 'gold is manipulated' crowd needs to adapt to the reality in front of them and stop reading every price movement as being part of some secret master plan. In order to do this the manipulation crowd should consider the following two points:

"* On November 11, 2005 net commercial short interest reached a record 227,566 contracts and gold was trading at $475 an ounce."

"* Since November 11, 2005 gold has zoomed above $700 an ounce and currently sits around $600 an ounce."

"In other words, the commercials - which are currently only 133,812 contracts net short - have lost, and those that purchased gold as a safe haven investment prior to 2005 have profited."

"In short, if gold plummets below $550 (or dare I say $500 an ounce) it will be because the new demand that has swarmed into the precious metals market since mid-2005 has turned scared. Accordingly, whether or not the commercials try to nudge gold lower and start a potential tidal wave of selling is really quite irrelevant - the lesson since November 2005 is that if conditions are bullish enough manipulation efforts lose their effectiveness."

"As of yesterday gold is still up by 16.9% in 2006. Please show me another manipulated market that is primed for a similar boom."

Last week commercials actually covered short positions and opened long positions as gold fell. There is no sign that they were trying to smash the gold market last week. In fact the small retail speculators sold long positions and actually built short positions last week! I think gold fell simply because a lot of dumb money - read mutual fund, hedge fund, and the mindless mass followers of Jim Cramer, Tobin Smith CNBC, and Fox Business Block - bought in earlier this year near the top. They've been sitting on losses all year and undoubtedly some of the panic came from these people - and institutional players trying to play a drop in the dollar through buying gold who exited, because it didn't happen right now.

The false breakout came because there was a a large group of sellers who sold to get out of losses. Who would have sold? I think those sitting on losses from the top who bought never understanding gold in the first place. That momentum carried over into people like me trying to position themselves for a rally and things just snow balled from there. In the end this move down will flush all of the dumb money out of the market that got in earlier this year near the top and prevent people who would have participated in future rallies from doing so.

A week before the XAU moved above 150 Ike Iossif of Marketviews.tv told me that he and Frank Barbera were calling for a false breakout and then a drop in the XAU down into the 130's. He told me that they thought it would bottom there and begin its next bull run. I really respect both of their opinions. They have been spot on calling gold tops and bottoms over the past few years and Barbera has been following gold since the 1970's. However, I didn't know what they were looking at or why they were calling for a false breakout so waved off the warning and stuck with my own indicators.

After going back through some of Barbera's older articles I think I know now what indicator he was looking at and it provides important clues to the future.

This indicator is the 200-day and 50-week bollinger band. Barbera mentions it in these old articles:

http://financialsense.com/editorials/barbera/2005/0928.html

http://financialsense.com/editorials/barbera/2005/0519.html

I normally use a 10-day bollinger band. Using the 200-day bollinger band gives you a long-term view of the volatility of an index. The upper and lower bands also act as support and resistance. If you take a look at the XAU going back the past few years major bull runs in gold began when the XAU closed above the upper 200-day band at the end of a week. Before the XAU broke through 150 a few weeks ago it was clear it wasn't going to simultaneously go through the 200-day bollinger band and I think that is why Barbera was skeptical of the breakout.

Going into this year I had expected any gold corrections to be short, shallow, and sharp unlike the long 8-16 month consolidation periods we saw between 2001 and 2005. Quick corrections are typical of stage two gold bull markets. But it now appears we are going through one of these long consolidation periods once again.

Solid support on the XAU is around the 120 level. I'd expect a rally off of these levels to begin within the next two weeks that will take the XAU back up into the 140-150 area and most likely all of way up to the upper bollinger band around 160. It should then dip back down, possibly all of the way down to 130, or go sideways in the 150-160 area. It will then be poised to break out of the 200-day upper bollinger band and begin another bull run by the end of this year or in the first quarter of next year.

Even if the gold bears are right and the gold bull market is over the XAU has become so oversold that some sort of rally off the lower bollinger band is likely. If the bears are right though instead of breaking out by the end of the year the XAU will break below the 200-day bollinger band and begin a real bull market.

People trying to short here are playing with fire. I've just gone through the long-term technical picture with you, but right now I am really focusing on the short-term charts and indicators for a sign of a buyable bottom.

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