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July 13, 2007

The Three Faces of a Gold Stock Breakout
by Douglas V. Gnazzo

Honest Money Gold & Silver Report

The Three Faces

Of a Gold Stock Breakout

Abstract

The past year has been long and hard on gold stock investors. Our patience and resolve have been repeatedly put to the test. It took courage to hold one's ground when others were turning in the other direction, but nothing worth having is ever easy - it was never meant to be.

It appears that now the trial may almost be over, and to the brave of heart will go the victory. Those that have stood steadfast are beginning to reap the benefits thereof, as the gold shares turn and begin their lofty ascent.

This doesn't mean there isn't a great deal of hard work remaining, and lots of ground to be covered, but the view from the summit will make it all worthwhile.

How do we know it is safe to move on towards the summit, especially when sightings of bears have been reported? One can never be sure that the way ahead is without danger, but one can take prudent actions to manage and limit the risk.

The three faces of a gold stock breakout are:

• Overhead resistance line is substantially breached
• RSI, MACD, & STO are all aligned with the breakout
• Hui/Gold or Xau/Gold ratio also records a breakout

Overhead Resistance

There is a constant battle going on in the market between buyers and sellers. This interaction between the two sides creates a resistance and a support line or zone.

The resistance line is the highest price that buyers have been willing to pay for the stock in recent times. In the past, whenever the price got to this level, buyers were unwilling to pay up and went into hiding.

Hence this price denotes resistance, as the price has not had enough buying power behind it to propel it above this level. Often times a stock will hit a particular price and then retreat, and then try again to rise and break through, doing so several times in a row.

Obviously, this overhead line of price resistance is of significant importance, as it represents the highest price that buyers have so far been willing to pay.

Once this level is broken above it means that buyers definitely want to own the stock, and are willing to pay up for it. In other words, there is now a greater demand for the stock that is increasing the buying power, and thus higher prices result.

RSI, MACD, & STO

Relative strength (RSI), moving average convergence divergence (MACD), and stochastic (STO) readings are three of the most common stock indicators.

If all three indicators are positive and headed up at the same time that price breaks above its upper trend line (resistance) then the indicators are aligned with the bullish price action and are confirming its breakout above the overhead resistance trend line. The confirmation gives more substance to the breakout. It's not a guarantee but it does place more weight behind the move.

Additional confirmation is had when volume expands during the breakout and subsides during any correction or consolidation thereafter.

Besides the standard volume measure there are others such as the accumulation/distribution indicator; on balance volume; and the money flow indicator, etc.

Hui/Gold & Xau/Gold Ratio

The third face of a gold breakout is the Hui/Gold ratio or the Xau/Gold ratio, both of which compare the price action of their respective gold stock index with the price action of physical gold.

The most bullish scenario is when the gold stocks are outperforming the price of gold, especially if the price of gold is rising, but the price of the gold stocks are rising even faster.

A generally accepted ratio is about 3 to 1, meaning that the gold stocks, over time, usually perform or return on investment three times that of physical gold. But with increased profit potential comes increased risk as well.

Breakout Above Resistance

We have seen that a breakout above prior overhead resistance can be a powerful occurrence, indicating a new bullish move up is getting underway. However, false breakouts can occur as well, and recently gold stock investors have felt the angst of a failed breakout more than once.

Price would rally and close above the established overhead resistance line, but it could not hold the gain and eventually (within days) it closed back below the price level. Buying power was not yet strong enough to sustain the move.

It is this kind of price action that can try the mettle of the most ardent gold bug. Many have given up and thrown in the towel, behavior usually indicative that a big move is just around the corner.

Failed Breakout

Below are the charts of two recent failed breakouts by the Hui Index, as measured by a break above their upper falling trend line that did not hold but retreated to close back below (after a few days time).

Notice that in both instances, the breakout above the trend line occurred, but it failed to hold above the trend line.

Failed Breakout of December 2006

Failed Breakout of April 2007

Any investors that took a position based on either of the above two breakouts was sorely tested by the subsequent failure and collapse of the breakouts back below their trend lines.

To go through a year long correction in the gold stocks, and to then be subjected to one failed break out after another, is enough to make even hardened traders say enough is enough. Such is how the gold bull throws most riders off before the bell rings.

What's Needed

For a sustainable and profitable breakout to occur there are several factors that must be present, if any are missing they could end up resulting in a failed breakout, as pictured above.

We have already listed the three facets of a solid breakout, but let's review them again, and clarify them even further, now that we have become more familiar with the different factors involved.

• Overhead resistance line is broken above
• RSI, MACD, & STO are all aligned with the breakout
• Hui/Gold or Xau/Gold ratio breaks above its trend line

As we have seen, false breakouts can occur, which is why the following additional qualifiers are a good supplement to the above three main themes:

• Increase in volume on the break/rise
• At least a two day or weekly close above the trend line break
• A follow through rise past the initial break for a few days
• A test of the trend line break that holds as support

Volume

Increasing volume shows buyers are serious and confident buying with more conviction. The stronger the increase in volume the stronger is the buying power behind the move.

Higher Close

A two day, or better yet, a weekly close, improves the odds that the breakout is not just a shooting star that is going to fizzle out and implode (as failed breakouts do). As the duration of the breakout grows, so too does the likelihood that it is real and will not fail.

Follow Through Rise

A follow through rise after the initial breakout shows conviction of buyers to be willing to pay higher prices to get in and thus buying power increases. The longer and stronger the follow through the better is the confirmation of the breakout, however, often times after an initial breakout and a few days of follow through, the price will head back down to test the breakout level.

Resistance Becomes Support

This is why a test of the original trend line breakout is so important. Once the breakout is tested and holds, it now becomes support, where before it had been resistance.

Bull markets are constructed by a series of higher highs and higher lows that collectively rise up in a stair step manner. When a previous line of resistance becomes support a higher low is established. This builds another step up in the rising primary trend.

The changing of intermediate term resistance into intermediate term support is one of the most powerful and significant events that takes place during a bull market.

Now let's look at a chart of the Hui to see what is needed for a breakout to occur.

Break Above the Trend Line Would Establish A Breakout

A Breakout

The chart above shows the markers needed to be put in place to establish a breakout of the Hui Index. Two of the three facets or markers have already occurred:

• A break above the Hui/Gold ratio upper trend line
• RSI, MACD, & Histograms have all broken into positive territory

The third and final action that needs to occur is a closing price above overhead resistance as indicated by the upper falling trend line shown; which on the chart above is the downward sloping red line. It comes into play around the 362-365 level. Presently the Hui is at 353, so it is not very far from breaking out (approximately 3%).

The break, if and when it happens, should occur on an increase in average daily volume (which can be measured on the GDX Mining Index as it trades daily where the Hui does not).

Once the trend line is breached to the upside the additional factors that add further confirmation come into play:

• a two day or weekly close above the breakout level;
• a continuation move up in price for a number of days;
• and lastly the defining marker/occurrence for a breakout - is its being tested and holding, thus establishing what had previously been overhead resistance, as a new trend line of higher support.

Obviously more qualifiers could be listed, or the parameters of those listed could be increased or diminished. What has been provided is not written in stone; it is however, a viable set of tools for measuring the validity of a breakout.

Lastly I want to mention what many refer to as the next major leg up in the gold bull market, or the second phase, or next wave, etc. The name is not important, what is important is the price action, and that the direction of it is up, and the longevity or sustainability of it continuing up is present.

A breakout as defined by the above markers and parameters would not by themselves necessarily indicate that the advance occurring is of the magnitude or duration to constitute an intermediate term move.

Intermediate Term Breakout

Just by name alone, an intermediate term breakout signifies a much more powerful move up both in magnitude and in longevity. Such a move requires all of the previously mentioned markers as well as a couple of others needed to confirm its sustainability.

A rally of one or even a few weeks does NOT constitute an intermediate term move. Intermediate term moves are measured in months, not weeks. They are the stuff that makes bull markets.

One of the markers that need to be put in place before a sustainable intermediate term rally can take hold is a break in the Hui/Gold Ratio above its upper trend line on the daily chart below that encompasses the entire bull market to date.

Needed For Start of Next Phase of Bull Market

XAU GOLD/RATIO

Below is the monthly chart of the Xau/Gold Ratio that goes back to the start of the gold bull market. The upper trend line depicted in blue would be an important confirmation that an intermediate term move was in the making. It is one thing to break through resistance and another to turn such resistance into support. When resistance becomes support then confirmation will be given.

Note on the chart above where the blue circles indicate MACD & STO readings that marked significant intermediate term moves in the making. As the chart shows, one could be close at hand.

Below is the monthly Xau chart going back 20 years to 1988, which clearly shows the bull market's rise starting in 2001 and that the index is well within its rising channel.

There are several price levels that need to be taken out: 150, 155, 160, and the final all-time high at 171.71 (at the time of this writing 150 was just broken above).

From its present level (150.79) the Xau is about 13% from making a new all-time high. Obviously, before a new intermediate term rally can take hold, the old high will need to be broken through, and the break will have to hold and what is now resistance will need to become support.

Notice the very long term vertical resistance line at 155.61 that spans the entire 20 years of the chart. A twenty year trend line is not to be taken lightly if it holds, which I expect it to do. It has acted as definitive overhead resistance since 1996.

When 155.61 is broken above and then holds as support, the next intermediate term move will be beginning.

Invitation

Stop by our website and check out our complete market wrap, which covers most major markets. There is also a lot of information on gold and silver, not only from an investment point of view, but also from its position as being the mandated monetary system of our Constitution - Silver and Gold Coins as in Honest Weights and Measures.

There is also a live bulletin board where you can discuss the markets with people from around the world and many other resources too numerous to list. Drop by and check it out. Good luck. Good trading. Good health. And that's a wrap.

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And read the Open Letter to Congress

Douglas V. Gnazzo
Honest Money Gold & Silver Report

Douglas V. Gnazzo is the retired CEO of New England Renovation LLC, a historical restoration contractor that specialized in the restoration of older buildings and vintage historic landmarks. Mr. Gnazzo writes for numerous websites, and his work appears both here and abroad. Just recently, he was honored by being chosen as a Foundation Scholar for the Foundation of Monetary Education (FAME).

Disclaimer: The contents of this article represent the opinions of Douglas V. Gnazzo. Nothing contained herein is intended as investment advice or recommendations for specific investment decisions, and you should not rely on it as such. Douglas V. Gnazzo is not a registered investment advisor. Information and analysis above are derived from sources and using methods believed to be reliable, but Douglas. V. Gnazzo cannot accept responsibility for any trading losses you may incur as a result of your reliance on this analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions. This article may contain information that is confidential and/or protected by law. The purpose of this article is intended to be used as an educational discussion of the issues involved. Douglas V. Gnazzo is not a lawyer or a legal scholar. Information and analysis derived from the quoted sources are believed to be reliable and are offered in good faith. Only a highly trained and certified and registered legal professional should be regarded as an authority on the issues involved; and all those seeking such an authoritative opinion should do their own due diligence and seek out the advice of a legal professional. Lastly, Douglas V. Gnazzo believes that The United States of America is the greatest country on Earth, but that it can yet become greater. This article is written to help facilitate that greater becoming. God Bless America.

Douglas V. Gnazzo © 2005 - 2008
All Rights Reserved Without Prejudice

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