A Technical Analysis of Gold’s Secular Uptrend

 

Introduction:

Building upon the previous three studies on gold, we conclude with a technical analysis of gold’s secular bull market trend since 2001. We will use time series analysis to determine gold’s secular trend growth rate, and historical volatility to set the trend boundaries. The trend and its historical boundaries will offer a reference point for identifying where we are today – a first step in any decision making process.

Technical analysis, with its proclivity to market timing, is a critical part of the investment decision process regardless of methodology or time horizon. I hope that this article will make it increasingly obvious how closely related technical analysis is to fundamental analysis and how the two disciplines are indeed inseparable.

 

Scope:

As always, I want to first establish the scope of our discussion. In this article we will:

  1. Identify the trend growth rate of gold’s secular bull market since 2001.
  2. Set the historical boundaries of gold’s price swing around the trend growth rate.
  3. Observe where we are now in the context of the secular trend.

We begin by marking the start of the most recent secular bull market in gold using the monthly closing prices from our first article. Gold bottomed in July 1999 at $253.20. That bottom was retested 21 months later in April 2001 at $255.80. Our study will begin with the closing price as of December 2000.

The price action from the bottom in 1999 to the subsequent retest in 2001 comprises a bottoming pattern separating two trends, the new secular bull trend from the preceding secular bear trend. It is the nature of asset prices to take time to change their secular trend. Topping and bottoming patterns act to separate the old trend from the new.

 

Assembling the Data:

Having decided upon our data set, we then feed it into a time series analysis producing the following table. This is similar to the cross-sectional regression analysis we used in our first gold study, except that the independent variable is time.

 

 

where…

  • t : monthly time period 1-127, from December 2000 through June 2011
  • GLDt : observed monthly closing price of gold at the close of each period-t
  • Yt : time series regression, ln(Yt) = ln(b) + t * ln(m), where ln(m) = rate/mo
  • Resid : regression error term or residual, actual – regression,  Resid = GLDt – Yt
  • Ytlow: lower channel historical support line, Ytlow = Yt * (1+ %ResidMin)
  • Ytup: upper channel historical resistance line, Ytup = Yt * (1+ %ResidMax)

The error term is normally distributed about an expected value of zero, but it is serially correlated as is often the case with a financial series. I am primarily concerned with extracting the trend growth rate from this time series, and no further transformation is necessary. Note that this regression explains 98% gold’s price movement.

 

Identifying the Overall Trend Growth Rate:

A financial time series usually will exhibit an exponential path governed by its growth rate. Technical analysis is used to visually identify the trend direction and rate, and to observe when changes occur. This requires that asset prices be plotted on a log-linear scale with time. I cannot stress this point enough!

Our eyes, our minds, and our time can be put to better use by first translating the above data into pictures. In the following chart, we plot the price of gold on a log-linear scale overlaid with its time series regression line. This line describes the mean growth trend about which the price swings as it “reverts to the mean”. 1 The average trend growth rate for the overall secular bull market has been 1.42% per month or an annualized 18.4%. Pause and take that in for a moment.

 

 

“A financial time series usually will exhibit an exponential path governed by its growth rate. Technical analysis is used to visually identify the trend direction and rate, and to observe when changes occur. This requires that asset prices be plotted on a log-linear scale with time.”

 

Setting the Historical Boundaries:

The red and green dashed lines enveloping the price in the chart above depict the historical boundaries of the price swing around its mean trend. In technical analysis parlance, these boundaries define the price channel, the upper line being resistance, and the lower support.

There are many ways to describe price channels and more will be discovered I am sure. 2 Our channel lines are defined simply by the historically highest and lowest price swing around the mean trend, as given by the residual. Drawing the lines parallel to the mean on a log-linear chart creates a constant percentage rather than a constant price channel. The upper red channel line is a constant 22.2% above the mean, and the lower green channel line is a constant 18.0% below, as measured vertically from the mean.

 

Introducing High-Low-Close Charts:

Our time series so far has been plotted a line chart using only closing prices, a good starting point in helping to define the trend growth rate. But prices move every minute of every day, not just once per month. The preceding line chart has been reproduced below using a high-low-close chart (HLC) adding the intraday price range to the monthly close.

 

 

The blue dashed line is the same 18.4% secular time series regression line as before. But the channel lines on either side include the intraday price movement, and are incidentally an equidistant +/-26% about the mean, totaling 52% wide measured vertically.

We are now ready to consider “where we are today.”

 

Where We Are Today:

The preceding charts describe at a glance how that the price of gold has moved within a price channel +/-26% about its mean secular trend growth rate in excess of 18% annually. Three years ago, an eight month correction took gold down 34% across its entire channel. Since then, gold has been in a cyclical uptrend at a hot 26% annual rate and penetrated the upper channel resistance level this August. It was rudely slapped back to find support again at its cyclical trend line, where we are today.

So, let’s take a closer look at this cyclical uptrend that started in 2009. 3

 

 

This chart is identical to the one preceding it except that I have added a trend support line connecting the intra month lows of the cyclical trend. This support line functions like the lower support channel of our time series, but can be drawn visually in a matter of seconds without all the math.

A break of this trend line would be an early indication that the 2009 cyclical uptrend may be changing rate or direction. The probability of a trollop down to the lower channel support line increases significantly, especially if the regression line (blue) is also broken. 4 This early warning is something every investor should want to see, wouldn’t you?

Let’s take a closer look at our nearly three year uptrend.

 

 

This weekly HLC chart of the cyclical uptrend since 2009 shows our support line in more detail. The squiggly red line is an arithmetic 40-week moving average which can be automatically calculated and plotted by any charting application. It closely approximating our trend line, a reason why it is so popular in technical analysis. Notice the intra-month challenged of our support line and moving average in September as well as multiple other hits since 2009. That’s what makes it a support line.

Let’s add one more indicator to our preceding chart…

 

 

The three parallel blue lines on this chart represent the time series regression and channel lines of the three year cyclical uptrend. The trend’s 26% annual rate closely parallels the 40-week moving average and our green trend line, a break of which would be an early warning of a probable test of the lower (blue) support channel. The green trend line is the practical support level for a reversion to the cyclical mean.

Notice also that the upper channel resistance line has been tested three times since 2009, each time followed by a reversion to the mean. The price movement and support and resistance action which I have described are not just coincidence, but rather characteristic of price movement in a time series.

 

Decisions, Decisions:

So, should you add gold to your portfolio today? If you want to construct the best answer for your specific situation, then use technical analysis to know where we are today within the context of our eleven year secular bull market trend in gold. Here’s how.

The closer you buy to an upper channel or resistance of some kind, the greater the risk of a quick loss from a reversion to the mean or worse yet, a correction to the lower channel support line. You would be vindicated if the secular trend was to resume, but boy would it sting in the short term. And what if unable to tolerate the pain, you sell near the bottom of the of the 30-40% correction? 5

It stands to reason therefore that the closer you by to some support level, the lower the risk of loss because the quicker you can tell if you are wrong and modify your decision when support is broken. The less money you lose, the less you have to gain to break even. Profit and loss is an asymmetrical exercise. 6 The reverse is also true of selling near a resistance level. 7

This is why technical analysis!

 

Conclusion:

In the four articles on gold written this month of October 2011, we have learned that the data does not support a significant correlation between monthly returns in gold and inflation or equities. But there is a strong inverse relationship between the secular price trends of gold and equities. Therefore, adding gold to an equity portfolio significantly alters relative risk adjusted return. Meanwhile, technical analysis helps reduce the probability of sudden losses in absolute terms when we know where we are in relation to the overall secular trend.

Combining both fundamental and technical analysis techniques is critical to understanding financial markets. My primary application of “the technicals” has been to forth-tell where we are in the trend using sound techniques supported by reasonable basis, rather than fore-tell where we will be.

 

Thank you for reading this article. Your comments are welcomed!

 

Related articles suggested for your reading:

Adding Gold To An Equity Portfolio

Relationship Between Gold, Inflation, and Equities II

Relationship Between Gold, Inflation, and Equities

Merging Fundamental and Technical Analysis

 


Footnotes:

  1. I am not implying that prices must revert to the mean. I am simply acknowledging that “reversion to the mean” is a popular belief with reference a financial time series.
  2. Other methods of describing price boundaries include: Bollinger Bands, Keltner Channels, Moving Average Envelopes, Parabolic SAR, Pivot Points, Price Channels (Turtles), and the well known statistical standard error of the estimate and predictive interval. Some methods are more grounded in a reasonable basis than others.
  3. Within the 11 year secular trend, there are three distinct cyclical trend growth rates: 13.5% between 2001-2005, 18.0% between 2006-2008, and 25.8% between 2009-2011-1/2.
  4. Using the 2008 correction as a guide, an eight month correction from August 2011 to April 2012 would put the lower channel at $1307.4, which is a 24% drop from the end of October, and a 32% drop from the high of August, an annualized rate of -44% .
  5. Buying at the top and selling at the bottom is a reason often quoted by opponents of market timing and by implication of technical analysis. And I would agree if the so called market timing were attempted with complete ignorance of technical analysis. The alternative to this haphazard emotional response is to use sound technical analysis technique to mitigate risk of loss. Another oft quoted myth is that a market timer must be right twice. Serious practitioners know that the more right you are the first time, the more room there is for error the second time (see note-6).
  6. A 33% loss requires a subsequent 50% gain to break even, this is elementary. A market decline can take out years of gains in a few months, which only exacerbates the first problem. Thus profit and loss are an asymmetrical exercise in the sense of both price movement and time.
  7. When support areas are broken, they often switch roles and serve as psychological resistance or areas. The same is true of resistance areas. A successful break above our upper channel resistance line can be an indication that the uptrend has become steeper. This happened to the equity market in the late 1990′s just before the secular bull market ended. This price behaviour pattern is often referred to as a “blow-off” implying that the trend growth rate is unsustainable in the long term.

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Other Links to this Post

  1. Adding Gold To An Equity Portfolio | Sargon Y. Zia, merging fundamental analysis with technical analysis — November 2, 2011 @ 5:50 pm

  2. Relationship Between Gold, Inflation, and Equities II | Sargon Y. Zia, merging fundamental analysis with technical analysis — November 2, 2011 @ 5:52 pm

  3. Relationship Between Gold, Inflation, and Equities | Sargon Y. Zia, merging fundamental analysis with technical analysis — November 2, 2011 @ 5:57 pm

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