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March 31, 2008

Chaos and Order in the Gold Market
by David Nichols

It is widely-accepted that financial markets are made up of individuals acting according to self-interest and free will.

But there really isn't free will in markets. It's a fallacy.

Granted, it's not a complete fallacy. There is one decision that is made entirely of our own accord, with pure and utter free will, and that is the decision to enter a market, either long or short.

The split-second after we enter a market, our decisions are no longer our own. We become reactive to what is happening to our position. We don't "happen" to a market; the market "happens" to us.

It may sound like a simple idea, but it's actually a topic worthy of careful consideration. Because this is why there is recurring and predictable structure in markets. This is why markets are "fractal", and why there is order hidden within the seeming chaos -- because people are forced by a market's movements to adapt and react, and invariably people respond in similar ways when presented with similar circumstances.

One of the most predictable of all market structures is the parabolic growth pattern, which has been the story in gold since the bottom in 2001. Such patterns are phenomenal for generating quick profits during the hyper-growth phases, but when such a pattern is not in a growth period -- but is instead in a consolidation period -- they can be especially tricky to handle.

The main point of a consolidation period is to shake the confidence of even the staunchest bulls. It looks like gold is now embarking on just such a consolidation period, which could last well over a year, and leave a trail of exasperation in its wake.

Below is a sample issue of the daily Fractal Gold Report. This issue highlights the recommended course right after the recent top in gold -- a top that could very well be the high for the year.

I had the $1,010 area pre-identified as a potentially major top for this stage of the bull market fractal pattern in gold, and even though we didn't get out right at the top, we were able to identify the precise moment when gold changed character, on the strong slicing move under $992.

There has since been even more confirmation that a big new corrective pattern is underway, and it looks like the second chance to get out has already come and gone. The rebound could not even make it to the $966 area, which suggests a particularly nasty corrective period is now in store. The initial move down in this corrective pattern should carry gold down to at least $850, and more likely all the way back down to $730.

I realize this is not what gold bulls want to hear, but the main point of this coming corrective period is to force gold bulls to sell out at lower levels. So if your idea is to eventually take profits at some anticipated future target up in the thousands, then you have to realize that your resolve on this could now be severely tested.

There is a "breaking point" down there at lower levels that will force each individual to react. Some will sell, while others will hold on during the initial thrusts down, only to be forced out at even lower levels. Others will hold on no matter what, and will eventually be rewarded, but it will not be an easy ride.

But throughout this corrective process, the gold market should react in predictable ways, according to a pre-determined fractal pattern launched at the recent top, like ripples spreading out in a pond.

Over the longer-term, I'm still extremely bullish on gold, expecting a 3x to 5x move up off the next bottom. But the job over the coming months is to keep the recent profits intact, and remain poised and ready to load back into long positions at lower levels.

Fractal Gold Report (published after the close on March 18th, 2008)
By David Nichols

According to the old Wall Street cliché, they "don't ring a bell at the top." But on Tuesday it sure sounded like a bell was ringing loudly in just about every market, including gold. While we may see a few more gyrations over the rest of this week, it definitely looks like the markets have already made the big turn near the scheduled March date.

So equity markets are now set to go up strongly, and gold is set to go down for a dramatic-but-necessary correction.

The main indication that something different was playing out this time was the clear slicing move under $992 late in the trading day. Gold had been holding up well at equivalent hourly levels throughout this long uptrend, so Tuesday's breakdown looks like an important change of character.

So as I've been recommending, this breakdown below $992 was our cue to take profits on all long trading positions.

We didn't get out at the absolute top, or even at the $1,010 target, but I thought it was worth it to hang on for a potential blow-off move this week. Of course it's easy to second-guess that decision in hind-sight, but in real-time it looked like there was a good chance for $50+ more in quick profits.

Since our last entries came down at $873 and $903, we're still sitting on very nice profits. If you didn't get out on Tuesday's slicing move under $992, there is a good chance that we'll get one more rally up to $992 to "kiss goodbye" this level before more dramatic weakness kicks in.

Sometimes these farewell moves can extend higher than the last breakdown level -- sometimes they make it back to the first breakdown level, or even all the way up to a double top -- but there's never a guarantee of that. I've found it's better to not get "too cute" in this type of situation, but to instead just get out at the $992 level and assess the situation from a neutral vantage point.

If there is no rally back up to $992 for a more graceful exit, then I recommend getting completely out if gold moves back under the important $974 energy level. The selling could accelerate from there.

So again, this is the time to clear out of long positions in gold and see how this correction develops. At a major top, it is typical to see a few up-and-down gyrations prior to the major price damage, so we could see a period now where gold tries to "buck off" everybody -- both the bulls and the bears.

At the most significant tops, there is a lot of complex up-and-down movement, as we've been seeing in equity markets over the last few months. That's a subtle clue that this could be a major bottom in equities.

But I don't think gold will make a complex top now, as we're not even close to the end of gold's bull market. This should instead be a swift and dramatic correction that carries gold down to $850, or perhaps even as far down as $730.

I should be able to come up with a much more specific road-map for a correction once I see how the initial moves develop. It's likely to be a very broad and dramatic "triangle" correction, as this is typically how parabolic growth patterns re-energize.

From a trading standpoint, a great strategy right now is to switch from long positions in gold to long positions in equities. It's generally easier to make money in an uptrend, so that would be the simplest way to trade it.

We may also want to consider small short positions in gold, at least during the first part of the correction, as the initial move down in gold following a spike top is often quite large. I'll know more about the strategy on this as soon as we get a bit more information on the reversal pattern in gold. As always, I'll keep subscribers updated in my daily reports if there are any changes in this outlook.

David Nichols
email: editorial@fractalgoldreport.com
Fractal Gold Report

David Nichols publishes the Fractal Gold Report, a daily report covering the gold market using proprietary techniques that go beyond technical and fundamental analysis. The Fractal Gold Report is available by subscription here. Fractal Gold Report Disclosure.

David Nichols is a graduate of Yale University and a leader in the emerging field of fractal market analysis. This pioneering analytical approach studies the markets as chaotic, non-linear systems, addressing the predictability in financial markets. Fractal market analysis discovers the order hidden within the seemingly random chaos of the markets.

David is the editor of the Fractal Market Report and the Fractal Gold Report, daily subscription newsletters written in an easy-to-understand style that cover the markets using his proprietary techniques that go beyond technical and fundamental analysis.

Copyright © 2008 Fractal Gold Report. All Rights Reserved.

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