Aegean Capital Group, Quantitative Analysis, Asset Management

XAU-YEARLY ANALYSIS

By Ike Iossif

Posted on 2-16-07

Overview:

The performance of gold stocks in 2006 was greatly influenced by the introduction of two "variables" which previously had not been a part of the market "equation." The presence of these new elements altered some of the "known" trading characteristics of the sector, necessitating a re-examination of our assumptions, and outlook. The following comments represent our view going forward after taking into consideration the changes we witnessed in 2006 (please see the expected price behavior as constructed by our pattern recognition models at the bottom of this page)

1. Price Pattern:

1a. The first significant change that took place last year, had to do with the "price pattern" of the XAU. The current bull market started in November of 2000 with the XAU bottoming out at 41. Since then, the bull market has unfolded with price oscillating within a well defined rising channel which is still intact ( see thick blue channel in the chart below)

1b. A complete "cycle" is a price oscillation from the bottom of the channel to the top, and back to the bottom. The end of one cycle marks the beginning of another. Notice that we have had four such cycles, three completed ones, and one that is currently unfolding. The first cycle (Cycle#1) started with price rallying from the bottom of the channel at point "A" to the top of the channel at point "B", and then back down to the bottom of the channel at point "C." The second cycle (CYCLE#2) started with price rallying from the bottom of the channel at point "C" to the top of the channel at point "D", and then back down to the bottom of the channel at point "E." The third cycle (CYCLE#3) started with price rallying from the bottom of the channel at point "E" to the top of the channel at point "F" Notice that the third cycle did not conclude with a test of support, like the previous two. At its conclusion we had an inversion, instead of a cycle low we got a cycle high.

CYCLE#1: (A-B-C) CYCLE#2 : (C-D-E) CYCLE#3: (E-F-)

	CYCLE#1:	CYCLE#2 :	CYCLE#3:
	(A-B-C)	(C-D-E)	(E-F)
GAINS	111%	102%	126%

CHART#1 PRICE PATTERN

Notice that the first three cycles have identical price patterns, which can be described as follows:

When the XAU starts a new cycle, it spends the first half of the cycle trading from channel support, up to the middle of the channel, and back down to channel support (see points I, II, and III) After re-testing channel support, it blasts off like a ballistic missile straight up from the bottom of its rising channel to the top (see rally#1 identified by points I-B, rally #2 identified by points II-D, and rally#3 identified by points III-F.

Each cycle is characterized by an identical sharp decline which takes place almost immediately after the XAU reaches the top of the channel. The decline takes price back down to test support at the break-out point, which in the first two cycles also represented a Fib. retracement level of .618

So, given the pattern of the last six years, one would have expected two things in 2006:

The XAU to conclude its previous cycle with a low, and to spend the first 10-12 months of the new cycle (all of 2006) trading in the bottom half of its long-term channel.

However, in 2006 that is not what happened, instead of a cycle low, we got a cycle high, and the XAU spent the entire year trading in the upper half of its long-term rising channel.

The fact that the XAU reversed its pattern behavior in 2006 has significant implications for how price may behave in 2007. There are only two possible explanations why it spent 2006 in the upper half of the channel instead of the bottom half:

1c. Either, the overall pattern is still intact and the XAU ultimately will re-test channel support -as it has done during the previous cycles- before it embarks on its next mega-rally. Thus, over the next 90-120 days the XAU can be expected to fall to the 114-110 zone, and then to start its next up-leg rallying up to the 200 level within the following 4-6 months (see illustration below)

CHART#2 (DECLINE TO 114-110)

1d. Or, The bull market in gold/gold stocks is about to accelerate, and thus, the slope of the channel that defines the primary trend will get steeper. In the new up-leg, the highs, and lows will be defined by the green channel, which is rising at a steeper angle than the blue one. Thus, over the next 1-2 weeks, we can expect testing support in the 140-137 zone, and then a rally up to 240-250 over the next several months. (see illustration below)

CHART#3 (DECLINE TO 140-137,THEN RALLY TO 240-250)

Technically speaking, notice that currently the XAU is at the apex of a symmetrical triangle, which within two weeks -at most- will result in either a break-down, or, a break-out. In other words, the technical pattern is ideal for enabling/accommodating either of the two outcomes we discussed, which increases the odds that ultimately one of the two expected outcomes will indeed materialize. (see illustration below)

CHART#4 (SYMMETRICAL TRIANGLE)

2. The underperformance of gold stocks versus the bullion:

2a. The second element of surprise thru-out 2006 was the gross underperformance of gold stocks versus the bullion. Gold stocks have lagged for the past 16 months, and they have done so by a wide margin. In the past, gold stocks have lead the metal both on the upside and on the downside. Consequently, anyone who is trading gold stocks, ought -at least- to give the matter some thought, and determine the reasons behind it.

	2/16/06	2/16/07	GAIN
GOLD	547	668	22%
XAU	137	143	4.0%
HUI	306	349	15%

Obviously, one reason may be that the gold stocks are doing their job -as they always have- giving us an advanced notice of an implosion in the price of gold/gold stocks sometime in the future. Judging from the length and the size of the under-performance and comparing it to previous similar "signals" that foretold the demise of gold, the XAU is telling us that sometime in the near future gold will lose about 30%-40% of its value. Although it is possible, we do not think it is very probable.

We believe that the under-performance has to do with the introduction of the GLD. Take a look at the chart below. It shows the cumulative ROC of the daily trading volume of GLD, XAU, HUI, and GDX. Notice that for the last 2 years, trading volume in GLD has been increasing at a rate that is five times bigger than the rate of either HUI, or, XAU. Prior to the introduction of the GLD, the only way for ordinary investors to have some exposure to gold was thru the ownership of gold stocks which tend to be rather volatile, and require some degree of knowledge about individual gold stocks. The GLD simplified the process and made it very attractive and hassle free for people to own gold. Consequently, there has been a migration from gold stocks to GLD by investors who simply care to own some gold for "safety" and diversification purposes.

However, gold stocks are about to benefit from the introduction GDX, the same way gold benefited from GLD. Notice that since GDX started trading, 10 months ago, its trading volume has been increasing at a rate higher than GLD's. Most investors are opting to create exposure to gold, by putting half of the capital that is designated for gold allocation in GLD, and the other half in GDX, in order to enhance returns. So far, the evidence suggests that the demand for GDX will continue un-abated, and we believe over the next two years -assuming the bull market in gold is still intact- gold stocks will reverse the under-performance of the last two years.

CHART#5 (VOLUME ROC)

3.Technical Indicators:

3a. The pattern of the McClellan Oscillator suggests that we can get a "pop" within the next 1-3 trading days.

3b. The Summation Index has been making higher lows, confirming the higher lows by the XAU.

3c. The A/D line has diverged positively, which is always a "good thing."

3d. The pattern of the McClellan Oscillator suggests that we can get a "pop" within the next 1-3 trading days.

3e. The Summation Index has been making higher lows, confirming the higher lows by the XAU.

3f. Cumulative volume line has formed a triple bottom.

3g. The price T.O. has formed an inverted "head and shoulders" suggesting higher prices for the near-term.

3h. The volume T.O. has formed an inverted "head and shoulders" suggesting higher prices for the near-term.

3i. The trend is up for the XAU.

THE PATTERN IN GOLD SUGGESTS AN UPSIDE TARGET OF $725

3j. If gold stays above $660, the pattern would suggest an upside target of $730 over the next 2-4 weeks. If it breaks below $660, the next support is at $650, and at $615.

THE PATTERN IN GOLD SUGGESTS AN UPSIDE TARGET OF $725

3k. If gold stays above $660, this pattern also would suggest an upside target of $730 over the next 2-4 weeks. If it breaks below $660, the next support is at $650, and at $615.

4. Expected price patterns suggested by our Pattern Recognition Models.

Scenario#1

4a. Scenario#1: Expect a rally to 152-153, a decline to 114, and rally up to 205/210. If the pattern of the last six years is still intact, then the XAU will make contact with channel support before it starts a multi-week rally. Signs that this scenario may be unfolding, would be a failure around 153, followed by a close below 140 within 2-3 trading days. A close below 130 would provide confirmation.

Scenario#2

4b. Scenario#2: Expect a test of the 140-137 level 2-3 times, each time rallying to a higher level. A close above 157, after 2-3 successful tests of support at 140-137 would indicate that this scenario is unfolding, a close above 175, would provide confirmation.

Scenario#3

4c. Scenario#3: This represents a rather extreme bearish outcome, but it doesn't hurt to be aware of it. Look for a rally above 155, followed by a close below 130 within 5-7 trading days. A close below 110 would provide confirmation that this is not a good time to be in gold stocks!

*For those readers who are not familiar with our Yearly Reports on various market sectors, may want to read the previous Yearly Report on gold/gold stocks by visiting this link: XAU(2005/2006)

Below is the "key" conclusion of that report, and the price pattern suggested by our pattern recognition models.

"If gold and gold stocks remain in a bull market, the decline down to 89-84 zone ought to represent the last buying opportunity for gold and gold stocks, prior to a spectacular bullish acceleration. At this point in the bull market, If the XAU stays above 84 over the next 2-4 weeks and then it begins to accelerate to the upside, then we ought to see a rise from its upcoming lows in the 89-85 zone -in the next few weeks- to a high in the 155-165 zone by the end of the year, which will represent an 100% gain."

3-24-2005

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