The Bubble is Bursting

For this past week, commodities corrected quite dramatically, which, I am sure, has left many commodity bulls feeling somewhat nervous. If this is the case, I hope that this post will help assuage any doubts.

The first chart is that of the XAU. It is a monthly chart that goes back until 1981:

In my view, the XAU is still in a very powerful bull market. This is evidenced by the fact that over the last 6 years, we can observe a series of higher highs and lower lows. Furthermore, all moving averages are also positively aligned at the moment.

It is often said on financial news stations that gold or commodities are in a bubble. I could not disagree more strongly with this type of statement. One reason for my view is that if you glance at the above chart, you will notice that gold stocks are still at approximately the same level that they were at 25 years ago. I cannot come up with many other asset classes that are in this position.

For a bubble to occur, the general public must become over zealously bullish on a sector. This has not even come close to happening with gold and silver. As an example, the bank I am employed at offers a precious metals mutual fund. This fund fully makes up 0.03% of assets under management. Contrast this number to the prevalence of high-tech holdings seen during the late 1990's.

The next chart also should support gold's case. It shows the Dow Jones divided by the value of the Gold since 1981:


In the early 1980's, the the Dow and an ounce of gold had roughly the same value. During the 1980's the Dow and the price of gold began to deviate, as the Dow rose, and gold fell. This trend continued well into the 1990's, where the pace began to accelerate, ballooning to the point where the Dow could buy over 40 ounces of gold.

This trend lasted for 20 years, and extended 4,000% against the price of gold. However, since the year 2000, this trend has changed directions, and has been deflating remorselessly since then. This is the real bubble that wall street does not mention.

Since I feel that this concept is so important to understand, I have included the opposite perspective of the chart below. It shows gold divided by the Dow:


A few weeks back, I was listening to an interview with investment guru, Peter Schiff. When pressed for an eventual upside target for the price of gold, Schiff said that he thought that the Dow and gold will eventually have the same value. If this is the case, and I believe that it is, then the chart above has a lot more climbing to do.

Anyway, here is a monthly chart of silver:

Silver is in a similar situation to the XAU mentioned above. Obviously, it is in a very strong bull market as well, and this correction is not unlike the corrections we've seen before.

Keep in mind that these charts present a bullish case for gold for the long-term. I am not suggesting that gold will necessarily rise next week. In fact, I have no idea what will happen next week. For the short term, gold has been in a a very clear downtrend, and following the rules outlined in my previous post, I had no choice but to short gold stocks over the last 2 weeks, and I will continue to hold my shorts for as long as the short-term trend persists.

Trading Stocks Without Predicting the Future

A few weeks ago, Stockcharts.com introduced Renko charts, and, since that time, I have really developed an appreciation for this charting style. Renko charts, like candle charts, are a Japanese charting style. Renko charts differ in that they do not factor in the passage of time, and, thus, only use price in their construction.

I feel that Renko charts can be used very effectively to determine trends. The chart below is a monthly Renko chart of the Canadian financial sector and goes back three and a half years:

Outlined in the chart above is a buy and sell system that I am using in my own trading. The system has the following rules:

• Buy signals are generated when the price is in a column of 4 white bricks or more and above the moving average line.
• Buy signals are removed when your long position moves against you by 4 bricks
• Sell signals are generated when the price is in a column of 4 dark bricks or more and below the moving average line
• Sell signals are removed when the short position moves 4 bricks against you

By following these simple rules, the areas shaded yellow you would be long, the areas shaded in orange you would be short, and the area where there is no shading you would be neither long or short.

Although these rules are simple, they allow a trader to gain an edge in that they will allow you to:

• Buy strength in bull markets
• Short sell weakness in bear markets
• Avoid getting involved with weak counter-trend moves (like what we have now in financials)
• Cut losses short
• Let winners run
• Separate emotions from decision making
• Avoid hours of analysis or try to predict the future

I sense that most traders are hesitant to following such a simple plan, as it is sometimes felt that making money in the market surely must involve more than this. However, after spending thousands of dollars on books, and years of research, there is no question in my mind that any trading method must involve these rules.

The Wisdom of Peter Schiff

With the last video I posted on this site, I recommended a weekly webcast called the Financial Sense News Hour. One of the advantages of listening to this program is that one can become exposed to the ideas of many different guest speakers.

Peter Schiff is a regular contributor to this internet radio show, and is where I first came across his ideologies. Peter Schiff is a stock broker, money manager, author, and, in my opinion, an expert in his field.

About 1 year ago, I read Schiff's book, Crash Proof. In it, he explains his outlook on the US economy, the housing market, the US dollar, and gold. Looking back now at this book, I am amazed at the clarity of wisdom, and the accuracy of his predictions. Most interesting of all, so far only half of his predications have come to pass, with the other half still in the pipeline, in my view.

Here is a video of Peter Schiff shot in November 2006:

Trading Gold Corp's Relative Strength

In the previous post, I mentioned the importance of managing risk by hedging. I also talked about how profitable traders tend to buy strength and short sell weakness. One way of following both principles is to buy a company that is showing strong relative strength, and short sell the index.

The following chart shows Gold Corp, symbol G.to, divided by an ETF that tracks the entire gold stocks sector, XGD.to:

The above chart shows how your profit and loss diagram would look like if you had bought shares of Gold Corp and short sold an equal dollar amount of XGD. With this type of strategy, you are not betting if the price of gold will rise or fall, since you could make money either way, so long as Gold Corp continues to outperform the index.

This type of strategy does not involve making forecasts or trying to predict what the future has in store. It only involves following the trend for as long as it lasts, and getting out when the trend ends.

The next charts show XGD by itself. As you can see, it is very choppy, trendless, and difficult to trade at this time:

One difficulty that trend traders sometimes face is that they need to wait for long periods of time before a major trend develops. But by using ratios, hundreds of combinations can be created, and trends can be found.

By trend trading hedges, I feel that I significantly reduce the level of risk, and at the same time, extract money from the hedge by following the trend. Reducing risk is important, especially if you are dealing with Horizon ETFs, since these products are exceptionally volatile.

The chart below shows an ETF a have talked about a few times before, HNU.to. This ETF tracks the price of natural gas, and, as you can see, is one of the riskiest funds out there:


If you had made a $10,000 investment in this fund three weeks ago, it would have dipped to nearly $4,000 in a matter of days. This is why it is essential the manage risk, and cut losses short if the trend moves against you.