Thursday, April 19, 2007

The XAU/GOLD Ratio , a Lesson in Patience


The XAU/GOLD ratio chart has often been used and misused to find bottoms in the sector. I can understand the desire to call a bottom after a long correction. Somehow I think this desire is itself incompatible with the kind of sentiment marker we are looking for at a true bottom. The ratio trends down after a top is made and typically forms some kind of triangle as it falls. There are several characteristics worthy of consideration. First and most important, price will not reverse until its time. Time typically is up when there is no other choice for it to be up. Another way of saying this is that trends like to stay in place longer than we expect. Fortunately we usually have a triangle formation to help us understand when time is up (ie; near the apex of the triangle). That brings us to a second characteristic (the capitulation). Capitulations typically break the triangle in some fashion. This is the bulls in your face way of saying "no nellies allowed" . Capitulations in the ratio suggest the maximum share discount and mark the bottom of the correction. They print at the extreme of the correction and often look like a breakdown in the sector. With that background let's consider the current landscape as shown in the chart. The secular low was made in 2001. Since then a very shallow uptrend has been in place. The whole decade of price action has been very poor on a price relative basis compared to the whole of the bear market that preceded it. This is really amazing when you consider the potential for this bull market going forward. We essentially have 3 bottom formations and one additional one in the making. I like to use alternation in analyzing the bottoms. You can see that the alternate bottom has a series of hammers that ultimately formed the bottom. It is poor analysis to say a bottom is in place when you first see a .20 reading. What you need to see is a positive divergence (macd to price) and time to be up in the triangle formation or capitulation stage.
In terms of the current correction we have reached the bottom of the range and have been there for awhile. The problem with calling a bottom now is that the triangle formation is very shallow and thus there is no forcing function on the pattern yet. That doesn't mean we can't blast of now, it only suggests more time can elapse at this ratio level. This leads me to my next point. How do metal price, sentiment, and the ratio chart combine in the final phase of the correction. It is important that sentiment return to a negative level for a lasting bottom to be in place. It has been my view that the gold chart continues to stay strong at this stage, but develops a sneaky divergence near the end of the correction that creates a fear of breakdown in the gold bugs hearts. It's this bogus chart footprint that leads to the final bottom in the ratio chart. The typical arguments tend to lay in the wave count interpretations and misinterpretations. It is my view that the wrong count will become likely in the view of analysts at precisely the time when we need a capitulation in the ratio chart. Now considering the current pattern in the gold chart we have a powerful rising triangle, or do we. Absolutely nobody knows what will happen next. It is my opinion, however, that once the bulls are exhausted on the current run a negative pattern will present itself in the gold chart. This may have already started with the recent outside reversal. This will drive the ratio to its nadir as bulls prepare for the breakdown and get cashed up for the next great buy. I won't suggest a specific time and price level at this point where that might be, but I hope these fundamental concepts can help provide the tools to know when we are looking at the low.

S.M. Himes

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Today shape drop, would this be the fake down you are talking about...?

Frank

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