Caution Still Warranted

I once heard an interviewer at a day trading firm tell a prospective trader that it would take at least two years to master trading. "Master,"I laughed to myself. "In time, with solid resources and proper dedication, a certain proficiency, a familiarity of sorts, may be obtained. Nothing more. Fortunately, just that may serve one well enough."

Where we find ourselves now…

After gold’s peaking around 1030 USD/ounce on Sunday night in Japan, March 17, 2008, it has suffered a severe correction in excess of 17%. Silver too, has fallen sharply, registering a decline of over 24%. The critical question at this point is "What's next?" Is gold going to simply shrug of the technical damage it has suffered and begin a new drive to all-time highs, or is it getting ready to bounce around in a range. Even worse, could it be ready to embark on its first multi-year push lower here. It doesn’t take long to scroll through a gold website to realize that opinions are as varied as the fruits at my farmer’s market - you’ve got bottom calls at $850-$830, $800, $770, $730, even $600 and lower. At this point, we are only sure that those calling for a bottom at $900, $880, and $865-$860 were wrong. Most everyone is anxious, balancing their desire to avoid losses with their fear of missing the bottom. Gold itself is flashing many mixed signals. The rally that started with the Fed has ended with the widespread perception that aggressive Fed cuts are behind us. We continue to have gold caught between persistent credit market fears and the consequent intermittent deleveraging that has been playing itself out in most markets. You have a rallying dollar, but who says gold can’t rally with it? You have oil continuing to defy gravity, but a gold market that is no longer moving lockstep with energy. Heck, if you ask most economists, they’re not even sure if its inflation or deflation that the markets are currently pricing in. When things get this confusing, it’s no wonder that investing in gold and silver, investing in anything really, has become so difficult and mired in risk. Who are we to believe, how much of our security are we willing to hinge on the predictions of others, how much are we willing to wager on our own beliefs? Let’s turn to the current risk/reward model to help us answer these questions.

The bigger picture…

I am going to be frank about where gold seems to be sitting here. It is impossible to have been witness to the price of the yellow metal over the last seven years and be overly optimistic about the next year or so. Gold is going to have to break from a pattern it seems quite comfortable with - namely using long, eighteen month consolatory periods between impulse waves (those strong advances where corrections do not exceed 10% for a lengthy period of time) to essentially knock around and 'prove' its merit at a generally higher range of prices.

Any call here for a new all time high this summer or even as "late" as this fall, which is typically a strong period as we know, is asking for gold to get its motor running again in a far shorter period of time that it has needed coming off the back of a strong, nine month drive. The reason why neither gold, nor silver, have been able to start a new surge without a lengthy consolidation in the past is obviously related to some necessity to smack the over speculation (open interest) and volatility out of these commodities prior to a fresh advance to new highs. It also has a great deal to do with the nature of most bottoms, in that prices need to "prove" they do not want to be at certain levels. This can only be accomplished by multiple periods of pressure and subsequent recovery. There are formidable layers of resistance that get carved out as commodities correct that take time, more than anything else, to ultimately overcome. Now, simply because gold has needed lengthy periods in the past is not reason enough to completely rule the possibility of new all-time highs this fall, especially since we are currently still holding above the former all time high of $845. But we must at least be realistic in understanding that if it is able to accomplish this, it will be no small feat.  With this said, prudent traders will adjust their objectives accordingly.

The big one…

Much like with horseracing, there is a legion of gold investors who are lured to the arena by the potential for spectacular speculation. Most horse owners don’t want a horse that can simply win allowance races, though those in the business long enough know that having a horse that is profitable on any level is a major accomplishment. No, most want a horse that is going to win them the Kentucky Derby. As such, many gold investors balk at using the commodity to hit singles and doubles in the futures market, but rather hold on long past proper due with an undying hesitation to ever sell the metal in fear that "the big one" is just around the corner. It is specifically during a time like we face now, where the likely outcome at best will be a consolidation at these historically high levels, that prudent investors will downgrade their expectations for the metals complex and redefine their objectives. Staying proficient and hitting singles is possible in all markets, bull or bear, volatile or not. And while there is always a chance that those individuals expecting an imminent super-surge in metals prices will be significantly rewarded for their deeply-entrenched faith, history suggests that they will undergo a fairly routine pain and general disappointment over the intermediate term. Especially those that chase strength and/or are over-leveraged at this juncture. 

Many things have to happen in order to make big profits in this world. First, you must correctly identify a market’s future direction. Second, you need to have and deploy capital. Finally, after the bets are placed the investor will undergo a series of challenges to hold on, an almost continual test of belief that fresh highs are around the corner, before ultimately letting go. More than anything else, this notion of believing is critical. It is what we must have to keep us at sea long enough to hoist the big fish over the side of the boat. It is exceedingly rare as investors that we simply place a bet and watch it move in the right direction day after day. Most of us understand this; we know that we will be challenged. There will be breaks in the action, prices will turn lower, conviction will be tested. In order to be successful, one must resist being shaken out. It is difficult to imagine traders having the necessary fortitude to press for anything more than a quick trading profit here. This recognition also serves to help define our objectives.

Being able to tell the difference between an oversold bounce like the one gold is most likely experiencing now, and the beginning of a major rally is of great importance. When leverage is employed, buying too early can be a true disaster. By the time the bottom finally comes, the early buyer is poorer, frustrated, and in many cases simply looking to break even. Part of the challenge with gold and silver is just how many times we must distinguish this difference. It is a commodity constantly in flux, trading all hours of the day and night, by people of almost every nation in the world. This can be very dangerous and exceedingly frustrating. I have never been involved in anything that requires one to have such a firm sense of the prevailing psychology not only in New York, but in Japan and London and India amongst others. Misunderstanding what the market intends to do next has and will continue to sink even the smartest boats that just happen to make the wrong bet at the wrong time. Too much, too soon, too bad…

Let the charts do the talking…

Looking at the technical picture we see again see a difficult situation to make definitive predictions about. True gold has fallen deeper than it has in almost two years. It has also held on a first approach at its former all time high of $845. This too is good. But we mustn’t be too confident. Technical analysis 101 will tell you that there is a sizeable risk of continued lower pricing. We have gold’s 300-day moving averages and major, long term uptrend lines sitting well below $800 an ounce. One can make a clear case that the major uptrend would not be violated by a move to the low $700s and beyond! With this in mind, we must discount the fact that nothing about our relatively shared belief that gold and silver are in long term bull markets would be violated by a sideways market of even one that continues lower over the course of the year. Clearly, we must account for this risk, especially now that we are beyond our impulse rise. My rule has always been that gold will not correct more than 10% during an impulse rise. Once a correction greater than 10% magnitude arrives, I consider the impulse rise over. It is then that we have witnessed those prolonged periods, typically 18-month events of sideways confusion. Looking back at any chart of gold and silver, we can find 3 distinct impulse rises, the first two followed by these extensive consolidations. We now find ourselves 6 weeks into such a period. In my opinion then, based on the technical similarity to prior up moves and consolidations, it would be very foolish to overplay the long side here. History tells us that our rallies at this point will meet dramatic and swift terminations for the foreseeable future. We know it is entirely possible that we may even go on to establish lower lows. Consequently, to me, it is only reasonable to take a small position at this juncture relative to what we are willing to take when we are most optimistic. Even still, the objective should be more geared towards trading profits as opposed to a major accumulative operation. Thirty to fifty points, even though it’s entirely possible we could rally as much as one hundred off our lows should be the hope. Long term investors, having been in the practice of buying these deep corrections for the future can pick confidently in a scale-down manner and over time. This is a strategy that has and will, most likely, continue to work well as we move towards the end of this decade.

The technicals should impose a discipline on us that, as we took out 700USD/ounce in September 2007, we were not forced to have. We must now be price selective. Under no circumstances can we overly chase strength. We must take our sales when they come. We cannot be greedy here. We also must not give the market a chance to put us in bad positions, because we have already established that, at least until gold breaks $800 to the downside, there is still significant risk in this marketplace and as responsible traders, we need to respect that reality. It has become more difficult to play hero and hold when we are challenged. This will not change until the market either moves into the $700s concurrently lowering our risk, or enough time passes (and by this I mean many, many months) as the market successfully defends its former all-time high of $845. Of course the market could turn on the dime that some are predicting here and stage an amazing rally to the upside, but my experience thinks this unlikely. As a younger trader, I was so worried about missing "the big one," that I refused to stay defensive for any period. I found that you can lose a great deal of money during consolidations if you are trading them like you would an impulse phase.

A possible bottom…

All is not horrible. As we just mentioned, gold did just hold at our previous all-time highs as gold and silver’s daily RSI, relative strength index, simultaneously reached strongly oversold around 30. Technically, silver did slip a bit beneath its intermediate uptrend line dating back to last summer and the beginning of its strong advance. We do know, however, that silver gives false signals routinely going back seven years or so; it is often regarded as the "evil brother" to gold by the traders I know. This breech, to me, is consequently of little significance. With both RSI’s having bottomed at 30, there is a sizeable probability of a move higher here (some of which we have been experiencing as I write). Silver is knocking on the door of pushing past resistance at $17.1. We have failed here several times and a break above now would also break the downtrend line drawn by connecting the March 14,2008 and April 16, 2008 peaks. I think, in the end silver pushes through this level which would be a positive for the complex and could translate into higher pricing for both metals as we move through the first couple weeks of May. We must also however, not be too optimistic on such a break above as we have already established that silver provides false signals often to trigger stops that don’t work out very well. In addition, silver’s former uptrend line that is now running above current prices will serve as resistance. It is, unfortunately for the bulls, not much higher, currently at $17.75 or so and rising.

Let’s quickly turn to gold. It has taken out and tested from the top side its most immediate downtrend line on Friday May 2. The next resistance is I see is just beneath $898 an ounce, which if breached, will break the major downtrend from the top. In such a case, all is still not clear, as old support will serve as new, psychological resistance at $910. I suspect it will be a process in taking out these levels if that’s even possible. A break there could lead to a secondary peak somewhere in the 930-955 vicinity.

As cautious as I find myself here, my gut also tells me the gold market is not willing to break materially beneath its recent low of $846 in the very short term either, largely due to the oversold readings on the RSI and MACD. Therefore, I am set to play the next bit with caution. Buying breaks at the lower end of such range and taking profits at the higher level. We could battle this out for some time.

My thesis and objectives…

As traders, we must construct a thesis of future price movements which then set our profit expectations and define our investing objectives and strategies. Without a thesis, we become traders without a purpose, mindlessly whacking a keyboard. Defining objectives transforms our market expectations into prudent strategy and trading rules. Our objectives must always be reflective of the type of trader we are. Being in tune with our ability to absorb loss, for instance, or our ability to stay patient if we are underexposed in rising markets will mold exactly what strategies we must employ to accomplish our goals. Proper strategies that we are comfortable with introduce a proactive element to our trading. We don’t bite off more than can be swallowed.

I will leave you this. I am a trader that understands my desires and objectives in relation to investing. I believe that a great up move in gold and silver await us at some juncture down the road. I remain committed to being reasonably heavily invested in such commodities at that time. I also know that we just had a major rally. History dictates we should consolidate here at best, and possibly move lower still. Take a quick look at the price of gold during the period 1975-1976.

That was a year and a half where gold lost almost 50% of its value with the context of a bull market that would later peak at much higher levels. For now, my objective is to hit some singles. I will add to my physical stockpile in bits and pieces. I suspect this method will work very well if the eighteen months to come are reminiscent of the eighteen months that preceded August 2007. I will wait for a break of $800 before I do any major accumulation for the long term. I will retain full faith that should gold not ever journey down to those levels, that I will at the very least be able to buy it between $850 and $900 at some point much further down the road, when say, it’s 300-day moving average moves up to that level. And if gold, that tricky beast, proves me wrong on both accounts, then I will be forced to swallow the fact that I was too cautious. My thesis will have been proved wrong. I will need to adapt on the fly. It would take a break of $960 gold to make me question my patience. Even still, the market would most likely be overbought on any such breach, and I would still potentially have a chance to accumulate in the low $900 if desired. Yes, patience is the main word for me. I really want to avoid driving myself crazy by chasing a market for the rest of this year against my better judgment - a market that same judgment thinks that may very well struggle to break 1000USD/ounce for quite some time. With proper discipline and respect, it will not matter which pundit accurately guesses gold’s eventual low. Gold and silver’s bottoming will be a process - most likely a lengthy one. And even though our hesitation may prevent us from catching the exact bottom, there should be plenty of time to accumulate at very attractive levels down the road.

John Cassimatis

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John Cassimatis has been managing his own capital for 14 years in various markets.