Gold's Last Gasp? Part II

The Second Wave X: Let's recap the wave patterns as they have appeared during gold's secular bear market. The initial 1980-82 decline was, in the context of a complex double 3, a W wave. For those less familiar with wave types and wave personalities, consider a W wave to be similar in sentiment to an A wave in an orthodox correction. By this, I mean that while initial corrective waves can be steep and destructive, they tend to take market participants by surprise. And because so many participants don't know what hit them, they can be particularly susceptible to "experts" who were wrong at the top, but are now declaring that the market has become a bargain. For example, the cover story of Commodities magazine in November 1982, mere months after gold's wave W bottom near $300, was titled "Goldbugs: Picking up the pieces again?" Inside, the article was supertitled "Many agree it's time to buy for the long haul."

This was the beginning of more than a few disappointments for gold bulls and gold bugs. Gold rallied, retested the 1982 low, and then rallied again in a wave X that peaked in late 1987. Had gold bulls who had been battered by wave W (from 1980 to 1982) and then put in a spin cycle by wave X (from 1982 to 1987) finally learned their lesson? While the bull market in financial assets that began in the early 1980s — as well as a host of new trading products — helped bump commodities in general and gold in specific off the front pages (Commodities magazine changed its name to Futures magazine in its September 1983 issue), the "old magic of gold" was still capable of casting a spell or two — if only briefly. One article in the aforementioned publication circa November 1987 — with gold still deep in the third and final stage of the wave X countertrend rally — made reference to "the pandemonious gold fever that swept commodity markets, trading floors and newsrooms" in September 1987, and it was during the summer of 1987 that the Chicago Mercantile Exchange (CME) introduced a "solid alternative for the gold futures trader" in the form of IMM gold, a new gold-based futures contract.

I wanted to spend some time on this first wave X, because if the wave count suggested here for the secular bear market is accurate, the rally in gold that began late in 1999 and continued into 2004 is little more than another coming of wave X.

Recall that after the first wave X topped late in 1987, the gold market went on a long extended resumption of the bearish trend that began in 1980. With a final bottom in 1999 near $250, gold had lost about 50% of its value in dollars in roughly 12 years. This period was the wave Y of the decline, a decline which, had it moved farther down to the $150-100 level, might have been reasonably considered not just a true low in the bear market, but the actual bottom.

Figure 1: The rally into the second X peak drew more goldbugs out of the woodwork than did the previous wave X rally in the mid-1980s. Both wave X rallies lasted about five years.

Those who insist that the now-five-year rally in gold is the beginning of a new bull market should keep in mind the previous wave X from 1982 to 87. In both instances, the wave X had a difficult time sustaining a move above previously significant highs. In the case of the first wave X, the critical resistance area was the top of the wave a "bounce" from the 1982 lows — near $525. In the case of the second wave X, the critical resistance area appears to be the peak of the wave b rally off the lows of the early 1990s — near $425. True enough, the first wave X did not surpass its resistance point, whereas the second wave X has. But those looking to get long in gold in a major way might be well served to wait for a test of the $425 level as support once gold rises above that level. As of this writing, $425 gold appears to have been a one-time affair.

As was the case with the first wave X, the final stage of the second wave x just ended (the wave c of the larger wave X) was a powerful rally. In 1985, the wave c carried gold up more than 66% by December 1987. In 2001, the wave c launched gold on a 72% rally in just under three years. So the strength and speed of the wave X rally over the past five years, true as it was, should not, in and of itself, be treated as overwhelming evidence that a new bull market has been born. At a minimum, gold traders and investors should be vigilant to the possibility that this five-year rally in gold — like the five-year rally in gold 20 years ago — is just another late, great fake.

Up for the downstroke?

If wave W was a zigzag and wave Y a flat, then the rule of alternation suggests that, should the 1999-2004 rally prove to be the second wave X, the subsequent (and likely final) wave Z will be a zigzag. A look back at the 1980-82 zigzag correction in gold is all anyone even mildly persuaded by this argument — and those similarly bearish gold forecasts — need see. In a nutshell, wave Z should be relatively short and relatively severe — and the move to the final low in gold could last as little as two or as long as four or five years. The initial wave W zigzag was completed in two years, but the development of a lower low during the wave b of the larger wave X I mentioned previously gives me some pause that the final move down in the bear market could be worse than the initial move.

It is also worth pointing out that as a zigzag, wave Z will begin with a five-wave impulse decline, followed by a three-wave corrective "bounce," and then conclude with a final five-wave impulse move to the final bottom. From the point of view of monitoring wave Z, this is extremely helpful insofar as patterns like zigzags that consist mostly of impulse waves can be significantly easier to count and chart.

Figure 2: Wave 2 has been a complicated, double-3-type affair. The current rally off of the September lows should bring gold to a final wave c, wave Y, wave 2 top near the upper band of the trend channel.

Looking at the gold chart since the beginning of 2004, we can locate the wave X peak on, interestingly enough, the closing high on April 1 at 431.80 (basis continuous futures). From this point, gold — I believe — began the last cyclic phase of its secular bear market. The wave 1 decline (again, we are dealing initially with a five-wave wave a in the larger wave Z zigzag) was clearly an impulse move to the closing low of 378.30 on May 13. Since that date, the gold market has been moving upward in a relatively complex double three that should complete a countertrend wave 2 this fall. The components of this wave 2 appear to be a wave w rally from the mid-May low to the closing high at 408.40 on July 12. The rally was followed by a wave x decline over the course of July, bottoming roughly on the 27th and 29th days of the month.

Since that wave x bottom in wave 2, the gold market appears to have completed two waves (the a and b) of the three that will complete the double three and form a wave y and wave 2 top. In the provided chart, there is a trend channel that suggests that insofar as the wave b of wave y didn't reach the bottom of the channel, the resulting wave c of wave y might in fact penetrate the trend channel to the upside by a small margin. Second waves — like gold's move from $378 in mid-May to the present — tend to retrace significantly more than 61.8% of wave 1, and the current second wave is no exception, having breached the 0.618 retracement level near $411 during wave a of wave y.

Even if gold topped in April 2004, enjoyed a bear market rally over the balance of the year to date, and was now about to reembark upon its bearish journey downward, how can traders and investors be so sure that gold will fall as far as $150 an ounce? Other than the wave 4 rule already discussed, we can use the impulsive five-wave character of the initial A wave to give sense of the caliber of the coming declines. Fischer's projection rule, which uses the amplitude of waves 1 and 3 to provide price projections for a wave 5 top (or bottom, in this case), can be helpful here.

Wave 1 appears to begin in April at 431.80, and to end in May at 378.30 for an amplitude of 53.50. If we multiply that value by 1.618 (we would use 0.618 for a projection based on the wave 3 amplitude), we then get 86.56. This is the number we subtract from the value at the end of wave 1. So, 378.30 - 86.56 gives us a projected bottom for wave 5 and wave A of the zigzag at $291.74.

In addition, we know that in a zigzag, the wave B can retrace no more than 61.8% of the preceding move. So, even if we don't know the size of wave B, we can posit the most extreme case of a sizable wave B. If wave B were to retrace just shy of 61.8% of a wave A with an amplitude of about 140 (431.80 - 291.74), then a wave B might be expected to advance from near $290 to the $375 area. A weaker wave B could fall considerably short of that mark.

But let's assume that wave B does rally to $375 — what might that suggest of the final wave C? Insofar as zigzags typically feature a wave C that is at least as long as the previous wave A, then subtracting the amplitude of wave A from our assumed wave B peak would give us a potential wave C bottom near $235.

This guesstimation, I should add, is the milder scenario. If the wave B does not rally to retrace just shy of 61.8%, if instead the wave B only retraced perhaps 38.2% of wave A, then a wave C bottom would be significantly lower. A wave B that topped out at $343 — from a fully 38.2% retracement of wave A — would likely be followed by a wave C that would bottom closer to $203. These projections still don't put us at $150 gold. But they take us far closer to that mark than most gold bugs dare believe.

There is a broader picture in a bearish gold forecast, one with implications for the US dollar (see my previous Working-Money.com article of August 4, "The Dollar Also Rises" for the latest on the bullish case for the greenback), as well as for international currencies like the euro and precious metals like silver. At the risk of adding to an already extended discussion, consider that silver has been making a similar wave 2 pattern from its May 11th bottom near $5.55. In contrast to gold, which I suspect still has some short-term upside potential, I am increasingly convinced that silver has seen its highs in mid-August and has already begun a new impulse move toward major historic lows.

David Penn may be reached at DPenn@Traders.com.

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Charts courtesy of Prophet Financial Systems

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