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Adam Hamilton

Adam Hamilton

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing…

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Trading the Gold Bull

As the insta-bulls continue to frolic on Wall Street, blissfully oblivious to current valuation and sentiment extremes conspiring to deftly eviscerate their aging war rally, the stealth bull market in gold continues to gloriously unfold.

Unlike the troubled US equity markets, gold has been in a powerful bull market for over two years now. The Ancient Metal of Kings has managed to gallop up an impressive 48% from trough to peak while the S&P 500 has horrifically hemorrhaged 26% of investors' scarce capital over this same period.

The stocks of companies that chisel gold out of the bowels of the Earth have done even better as their earnings leverage to gold has greatly multiplied their gains. The HUI unhedged gold-stock index is up a phenomenal 322% trough to peak over the past thirty months, a breathtaking performance! By comparison, tech stocks as represented by the NASDAQ have plummeted a gut-wrenching 57% over the same period.

In light of these stunning numbers, it is amazing that gold and gold-stock investing and speculating remain almost exclusively black-sheep contrarian arenas today. A mere eight weeks or so of war rallying in general equities have seduced the majority into believing that the tech bubble is back, yet well over one hundred weeks of consistently stellar gold and gold-stock performance continue to be outright ignored. Incredible!

The psychological Tyranny of the Short-Term is an immensely powerful force, and yet again it has granted us belligerent contrarians fantastic current opportunities for capital deployment in gold and gold stocks.

In the past week, a couple of remarkable events have transpired relative to the Gold Bull that investors and speculators need to carefully ponder, one fundamental and one technical. The Golden Bull Buy Signals have finally been triggered!

Fundamentally, gold is the ultimate free-market currency. For six millennia gold has been the ultimate form of money, a rare and beautiful element of unquestioned intrinsic worth that doesn't merely represent someone else's promise to pay, nor an inherently worthless fiat-paper currency only accepted under an implied threat of force. Power-hungry and undisciplined governments have always fought against the absolute discipline of gold, but over the long-term their vain efforts have been easily crushed by gold 100% of the time.

As gold is true money, it is the real ultimate competitor to the current US dollar's waning global hegemony. As the dollar sinks in value in the international foreign-exchange markets, the price of gold denominated in dollars rises. And this dollar price of gold isn't only important to Americans, because at the moment the dollar dominates the global gold trade. It won't forever though if it keeps falling!

Last Thursday, May 1st, the US Dollar Index officially entered the dreaded bear-market territory with surprisingly little fanfare. As I discussed in "The US Dollar Bear", a bear market in the US dollar has staggering implications on multiple fronts.

Since we Americans have foolishly chosen to destroy our futures through endless debt-financed consumption of imported consumer junk, the US economy is desperately dependent on foreign capital inflows. As the now official US dollar primary bear market accelerates, foreign investors will be less likely to finance the American debt binge as they face rising currency losses.

In stock-market terms, since the dollar topped in mid-2001, there have been no major rallies on extreme dollar weakness, until this silly war rally. The plunging dollar we are witnessing today is incredibly ominous and dangerous for the US equity markets and could finally drive a sharp stake through the dying heart of the war rally in general equities. This unprecedented short-term disconnect between the war rally and the US dollar's dire straits is another glaring anomaly that the insta-bulls have conveniently chosen to ignore at their own peril.

While a primary dollar bear market is bad for US consumers and really dangerous for the US equity markets, it is wonderful news for gold since this noble metal is the paper dollar's ultimate nemesis. With the US Dollar Index bear now confirmed, it is important to note that major dollar bull and bear trends in the past tended to run about five to seven years or so.

We aren't even two years into this dollar bear yet, so odds are the process will continue to unfold in the coming years and the gold bull will continue to gallop higher. Dollar weakness isn't the only cause underlying the awesome bull market in gold, but it is certainly an important one.

Against this amazing fundamental backdrop for gold and gold stocks, we have continued to search for ways to attempt to trade the gold bull. As speculators our goal in the primary gold bull market is similar to our goal in the primary stock bear market, to ride the major swings to big profits. Unfortunately the hugely out-of-favor gold world lacks the extensive established sentiment indicators that stock speculators can rely upon, so an alternative trading approach has to be used.

In my "Golden Bull Buy Signals" and "Golden Bull Buy Signals 2" essays, I pointed out the interesting interaction between the 50-day moving averages and 200-day moving averages of both gold and gold stocks. When gold's 50dma and 200dma approach each other, so far in this gold bull it has signaled an excellent opportunity to deploy fresh new trades in gold and gold stocks in anticipation of another major upleg.

This is not surprising, as the convergence and divergence of 50dmas and 200dmas in price charts often mark major trading signals in both primary bull and primary bear markets. If you examine the S&P 500 bear-market chart with its own 50dma and 200dma in "R.I.P. Great Bear?" for example, you will note that a convergence of a 50dma and 200dma in a bear market is a warning to sell, not an opportunity to buy as in a bull market.

Short-term speculators have long used Moving Average Convergence and Divergence, or MACD, extensively. Using much shorter moving averages, an oscillator is created to help traders recognize short-term turning points in the markets. This approach I am proposing to trade the gold bull is similar in philosophy but a bit different in execution.

Instead of using the usual short-term MACDs to catch shorter swings, we would like to use longer-term MACDs to attempt to both catch the major uplegs of the gold bull market as well as to minimize our exposure in the inevitable normal healthy bull-market pullbacks that follow. In addition, these heavily modified MACDs discussed below are not calculated the same way as traditional short-term trading MACDs, although they certainly could be converted into true oscillators.

Our 50/200 MACD simply divides the 50dma by the 200dma of gold or gold stocks, and then converts the result into a percentage. A 50/200 MACD reading of 5%, for example, indicates that gold's 50dma is currently 5% over its 200dma. A negative 50/200 MACD reading of -1% would indicate that gold's 50dma was currently 1% under its 200dma.

When the 50 and 200dmas cross, they are graphed at an index level of 100 on our charts. If the 50dma is 5% greater than the 200dma, it is graphed at an index level of 105. Likewise, if the 50dma is 1% lower than the 200dma, it is graphed at an index level of 99. The red 50/200 MACD lines below simply show the convergence and divergence of the 50 and 200dmas of both gold and gold stocks.

These hard mathematical relationships allow us to formally quantify the visual chart phenomenon I discussed in the "Golden Bull Buy Signals" essays earlier this year.

As the following graphs illustrate, the Golden Bull Buy Signals in both gold and the HUI have recently been triggered per this 50/200 MACD. If the gold bull continues to unfold into the future as it has to date, both investors and speculators are now blessed with a wonderful opportunity to buy gold and gold stocks in anticipation of the next major upleg in gold!

There's certainly a lot going on in this chart, so it helps to focus in on the individual components in sequence and build the big picture from the ground up.

First, note the black 200dma and white 50dma of gold. Visually it is really obvious that so far in the gold bull market it has been a great time to go long gold whenever this 50/200 moving average convergence transpired. Each of the major uplegs in this bull market to date was shortly preceded by gold's faster 50dma heading back down and converging with its slower 200dma. This visual observation was what originally captured my attention in the earlier "Golden Bull Buy Signals" essays.

But, in order to convert a simple visual observation into a potentially profitable trading strategy, it needs to be quantified to remove as much of the inherent subjectivity as possible. The red Gold 50/200 MACD line in the graph above attempts to do this. This line is calculated by dividing gold's 50dma by its 200dma and then multiplying it by 100 to index the result. The resulting MACD fluctuates around a 100 baseline and is graphed on the right axis.

By monitoring the unfolding progress of this Gold 50/200 MACD, we can gain a good idea of when it is best to deploy new longs in anticipation of a new upleg and when it is best to ratchet up our stop-losses in anticipation of an inevitable bull-market pullback.

While there are countless possible permutations of strategic trading systems possible using gold's 50/200 MACD, we found one in particular that worked well in the gold bull to date. It involves an initial buy signal, an intermediate cautionary raise-stop-loss signal, and a final sell signal, all keyed off gold's 50/200 MACD. These three signals are shown above for each of the two major uplegs in the gold bull so far, and are marked accordingly.

Because gold stocks are ultimately merely leveraged plays on the price of gold, in the graph above we are using Gold 50/200 MACD signals to buy and sell both gold and the HUI. There is nothing more important for gold-stock price levels than the price of gold itself, so perhaps gold stocks can be profitably traded based on gold closes alone. The gold closes on the days these 50/200 MACD signals are triggered are noted above in yellow, while the HUI closes on these same gold signal days are noted in blue.

Our Gold 50/200 MACD buy signal used above is simple. After a major gold rally fades, on the first day that the Gold 50/200 MACD closes under 2%, or under 102 in indexed terms, both gold and gold stocks should be purchased on or right after that particular trading day. You will note three of these 2% Gold 50/200 MACD buy signals in the graph above, all marked with green Bs.

The reason we arbitrarily chose 2% rather than waiting for the narrowest convergence possible is two-pronged. First, moving averages are lagging indicators and the goal of speculation is to anticipate tradable moves before they happen. If we waited for the actual narrowest convergence we would probably miss the very interim bottoms that we are trying to catch.

Second, by only waiting for the first easy-to-spot sub-2% day rather than trying to pick the exact narrowest point of the 50/200 MACD, we don't have to guess how narrow it will get. Any useful strategic trading system seeks to minimize the guesswork and become as simple and mechanical as possible to suppress deadly emotions, the bane of speculation.

Our second intermediate signal is not the actual sell signal, but instead a warning signal to ratchet up stop-losses in anticipation of a coming interim top. I prefer to use stop-losses when trading a primary bull market rather than outright sell signals because bull markets can suddenly break out to the upside at any time without warning, and we don't want to miss these episodes. In addition, selling is far more emotional than buying since one's capital is already on the line and the practice of fanatically deploying and heeding stop-losses helps short-circuit these dangerous emotions.

Once the Gold 50/200 MACD moves back above 5% for the first time since a buy signal was triggered, or an indexed level of 105, it is time to start watching gold closely. So far in the gold bull, these initial 5% days have occurred near the final mini blow-off processes marking the end of each bull-market upleg.

When this 5% Gold 50/200 MACD day arrives, it is time to raise your trailing stop on gold to 2% or so on a closing basis. This means that if gold closes more than 2% under its latest closing high after this raise-stop signal was triggered, it is time to be stopped-out of all of your trading gold and gold-stock positions in the anticipation that an interim top has been reached and the 50/200 MACD will have to converge again before another upleg erupts.

There have been two of these raise-stop warning signals so far in the gold bull, marked with the yellow Ss above. They serve to alert gold speculators that a short-term interim top is likely near and it is time to ratchet up their stop-losses to maximize their realized profits on any particular gold upleg trade.

After this intermediate warning signal flashes, the sell signal is mechanical and easy to follow. After the raise-stop warning signal, the Gold 50/200 MACD sell signal is flashed when that tight trailing 2% stop-loss on gold itself is violated on a closing basis. When this day arrives, it is time to sell your speculative gold and gold-stock positions in the expectancy that the gold upleg you are trading has matured and run its course.

To summarize, here is how this Gold 50/200 MACD strategic trading idea works.

After a gold rally fades, a buy signal is triggered when the Gold 50/200 MACD moves under 2% on a pullback. Gold and quality unhedged gold stocks can be purchased on this trading day. These positions are held, preferably with loose trailing stops, until a second raise-stop warning signal is flashed the day that the Gold 50/200 MACD exceeds 5% again following the initial buy signal.

On this second warning signal, a tight trailing 2%-or-so closing-basis stop-loss is placed on gold. Once this 2% trailing stop is violated on a closing basis, all of one's speculative gold and gold-stock positions are liquidated. The cycle then begins anew at the next Gold 50/200 MACD buy signal.

Please note that this strategic trading idea is for the speculative portion of one's gold portfolio only, the short-term trading funds, and that core long-term gold and gold-stock holdings that are not traded are also very important as I mentioned in "Bear-Market Portfolio Design"!

So how has this trading strategy worked so far in the gold bull market? Pretty well!

In Rally 1, the gold-bull upleg in the first half of 2002, these Golden Bull Buy Signals based on the Gold 50/200 MACD yielded a 17% realized profit in gold itself and a breathtaking 121% realized profit in the HUI unhedged gold-stock index. As the labels on the graph above indicate, the buy signal was near major gold interim lows, the raise-stop warning signal was midway through the gold upleg, and the final stopped-out sell signal was the very day after the mid-2002 major interim top.

In Rally 2, the next gold-bull upleg that straddled year-end 2002 and the beginning of this year, the Gold 50/200 MACD signals yielded realized gold gains of 16% and HUI gains of 18%. This buy signal was right ahead of the biggest gold-bull upleg to date, exquisitely timed. Both the warning signal\ and the ultimate stop-out occurred reasonably close to the latest interim top as well.

So, historically in this gold bull to date, buying and selling both gold and gold stocks based on the Gold 50/200 MACD has proven profitable. Intriguingly a brand new Gold 50/200 MACD buy signal was just flashed last Thursday May 1st, fantastic news if you are long gold and gold stocks or would like to deploy some fresh positions today!

Will this same approach work on the HUI, running a HUI 50/200 MACD directly and ignoring gold? Yes, but not quite as well as on gold itself. The following graph outlines the same approach outlined above but in the HUI, except that the HUI's vastly greater volatility than gold increases our signal levels. A HUI buy occurs under 5%, the HUI warning over 10%, and the trailing stop is also much larger at 10%.

Using this 50/200 MACD approach on the HUI alone would have yielded a Rally 1 realized gain of 90% and a Rally 2 realized gain of 9%. This isn't bad, but it isn't as impressive as using this methodology on gold itself. As you can see on the red HUI 50/200 MACD line above, the HUI's enormous volatility hasn't been consistent enough to optimize entries and exits on both major rallies.

But, it is provocative to note on the graph that the buy signals, those rare moments when the HUI's 50 and 200dmas converge, have been excellent so far. Thus, even if the sell signals are problematic because of the HUI's ever-changing volatility profile, the HUI 50/200 MACD buy signals can be used as an excellent secondary confirmation of the Gold 50/200 MACD buy signals discussed above.

The latest HUI buy signal was triggered on March 28th at a HUI level of 123. As of May 8th, the data cutoff date for this essay, the HUI was already up 9% from this latest buy signal. So far, while no doubt still quite early in this third major gold upleg, the 50/200 MACD buy signals seem to be once again leading speculators in the right direction.

In our Zeal Intelligence monthly newsletter for our subscribers, on April 1st I recommended our current five favorite elite unhedged gold stocks to buy for this next expected gold upleg and so far we are blessed to see our picks up an average of 7%. We plan to once again ratchet up the stop-losses on these positions as the Gold 50/200 MACD warrants, as we did in the last gold upleg, Rally 2 above, when we were blessed with a final average realized gain of 31% in our Rally 2 gold-stock speculations.

In our new Zeal Speculator real-time e-mail alert/update service for active speculators, we were blessed with even more advantageous entry points in the last week of March as the latest HUI 50/200 MACD buy signal was triggering. Our ZS gold-stock trades are currently up an average of 17% since then and we plan to sell these too when the trades ripen based on the 50/200 MACD signals discussed in this essay.

While I limited this essay to analyzing the 50/200 MACD situation since the gold bull began, we decided to publish one of our internal research graphs that runs back to 1999, pre-bull-market days. It is larger and offers a more detailed strategic perspective on the relationship of gold, its 50 and 200dmas, and the HUI. This graph is posted at www.zealllc.com/charts/gold.htm if you are interested.

The bottom line is that the gold and gold-stock bull markets may indeed be tradable based on the convergence and divergence of their 50 and 200dmas. This methodology is promising since it grants speculators looking to catch major moves a potential mechanical way to try and accomplish this strategic speculation goal. We plan on continuing these longer-term gold and gold-stock MACD studies at Zeal to see what we can discover.

It is also exciting that both the Gold 50/200 MACD and the HUI 50/200 MACD buy signals have now triggered and suggest that the next gold upleg has already begun!

This awesome technical backdrop combined with the bullish gold fundamentals of a wounded US dollar plummeting like a meteor hint that another great feast approaches for gold and gold-stock investors and speculators.

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