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Expected Metals Corrections

Adam Hamilton
Jun 17, 2006

This past Tuesday the entire precious metals realm watched in stunned silence as gold plunged 7.3% and silver plummeted 10.8% in a single trading day. Not surprisingly with gold bleeding off $44.10 and silver $1.19 on that dark day, there was much wailing and gnashing of teeth amongst precious metals investors.

But what did surprise me about this whole fascinating, albeit brutal, episode was that it seemed to surprise many traders! This is strange because the corrections in gold and silver had been expected, not to mention discussed extensively, before they made their fearsome appearances. Students of the markets were ready and waiting for sharp precious metals declines. Our Zeal clients had been well prepared for this event.

Why did I think these corrections were coming? Speculation in the financial markets is the world's greatest game. Like most other games, it is governed by probabilities and heavily influenced by game theory. Precious metals are a small side game within this giant markets game, and they have to be approached as such if one wants to trade them successfully.

As in any other probabilities-based endeavor, astute and prudent speculators become students of the markets in order to increase their odds of winning. As they grow to understand how markets work, they are far more likely to trade near the right times than someone who does not study the markets. A good speculator only trades when he perceives his odds of success as being very high.

These odds are partially dependent on game theory. Game theory is a branch of psychological research that considers what other players are likely to do in a given situation. A speculator's (or investor's) decisions of when to buy and sell must be considered within the context of what other traders are likely to do. Game theory is one of the key foundations of contrarianism, ultimately the most successful trading strategy. Buy when others are selling and sell when others are buying.

Combining these basic areas of market studies led to a very ominous picture for gold and silver in April and early May. Students of the markets intimately know that all markets rise and fall, their prices flow and ebb even within powerful fundamentally driven secular trends. Gold and silver had both been powering higher for the better part of a year and one of their periodic corrections was certainly overdue.

Both gold and silver were also stretched to their most extreme technical levels in a quarter century, a warning sign that the probabilities favored a sharp temporary reversal to relieve these extremes. The odds were way out of favor for being long by early May. And from a game-theory standpoint, euphoria ran rampant. Most traders were wildly bullish right near the latest interim tops, as the majority always is, so there were few short-term buyers left.

Thus trading probabilities based on historical gold and silver precedent and game-theory psychological considerations were screaming six weeks ago that a major precious metals correction was almost certainly imminent. To paraphrase a Bible verse out of Proverbs, the prudent saw the coming short-term metals danger and took refuge, but the simple kept right on buying and suffered for it. Markets take no prisoners.

Now you are probably wondering what good it does to meditate on this ex post facto. To become a more successful speculator and investor, it is crucial to learn lessons from market pain. If you didn't see this coming and prepare your portfolio accordingly, this event is a great impetus to deepen your own studies of the markets so you aren't caught off guard next time.

And if you are paying someone to help you navigate through this powerful commodities bull, and your advisor didn't warn you beforehand in April and May about the ballooning odds and looming danger for a major interim correction in gold, silver, and the HUI, then you ought to fire him. There is no excuse, absolutely zero, for a professional to miss the ubiquitous warning signs before this recent selloff.

At Zeal we and our clients were long these latest awesome gold, silver, and HUI uplegs early and were blessed with fantastic realized profits even before the euphoria set in by April. Yet as we were stopped out or sold our PM trades, we remained in cash since the odds of a serious correction were getting so large. Since then we have been building up cash war chests to buy the feast to come of amazing PM bargains at the next major interim bottom.

If you were hurt this week in gold, silver, or the PM stocks, I feel bad for you because you didn't have to be. These corrections were anticipatable and expected. The best way I could figure out to illustrate this was to create some charts of the latest mighty gold, silver, and HUI uplegs and their young corrections. Superimposed on top of these charts are numbers that correspond to comments I wrote to our clients at specific points in time. There was no need for anyone to lose much money in precious metals in the last month or so.

All these quotations are easily verifiable. Actual links for web essays are provided. Zeal Intelligence subscribers can log into the Subscriber Charts section of our website and look in the ZI archives to verify any ZI citation. And Zeal Speculator subscribers can e-mail us to get any back copy of ZS they'd like in order to find the original quotation listed below.

Friends, believe me these metals corrections were expected! Anyone who tries to convince you otherwise is either naïve or hiding the truth.

Early on in this metals upleg last summer, we were very bullish when sentiment was rotten. In addition to being bullish on gold and silver, we were putting our capital where our mouths were and aggressively adding long positions in precious metals stocks and stock options.

1. Gold $427 "Contrary to popular belief driven by phenomenal pessimism in gold stocks, gold itself is looking fantastic technically. ... This leaves a strong base for a new gold upleg to ignite as soon as the dollar's bear rally fails. Such an event could happen today" - Zeal Speculator 5.11.2005

2. Gold $435 "Gold may very well be forging into Stage Two now, where it rises in all currencies at once. ... Stage Two also represents a much steeper upslope and bigger gains." - Zeal Intelligence 7/05

3. Gold $495 "Yet despite this gold bull, the metal remains really cheap relative to history. ... Investor demand will keep driving prices higher and these very higher prices will attract in increasing legions of global investors." - ZI 12/05

4. Gold $517 "Although its upleg does not appear to be over, it had become overbought on a short-term basis and needed a breather. While I know this pullback spooked a lot of investors, technically it turned out perfectly. Gold retreated to its upleg resistance which is fast becoming new support by the looks of things. Textbook-perfect bull-market behavior is manifesting itself in gold!" - ZI 1/06

By early February, gold's technicals had become quite overbought and the odds were no longer favorable to add new longs. So we ratcheted up our trailing stop losses just in case gold fell, which it ended up doing. But this strategy also enabled us to remain long until the last possible moment in case gold decided to shoot higher right there and surprise to the upside.

5. Gold $571 "traders must not forget that all bulls flow and ebb. In tactical terms it is quite apparent that gold, silver, and the HUI are stretched far above their respective 200dmas. Gold has surged so far so fast that it hit a bull-to-date record multiple of its 200dma. While I have been arguing for months now that the uplegs in Stage Two where gold moves independently of the dollar are bound to be larger than what we are used to, gold is looking increasingly overbought technically. I am going neutral on it for now. All neutral means is probabilities are favoring a normal healthy bull-market correction so it is not prudent to deploy new longs at the moment. But neither is it prudent to go short now since bull market surprises tend to the upside." - ZI 2/06

6. Gold $652 "While gold's fundamentals remain as sound as ever, global mined supplies are decreasing as the mines process low-grade ore and global investment demand is growing, remember that all bulls flow and ebb. Sooner or later a correction in gold is inevitable. With its 200dma now near $505, quite a selloff is certainly possible." - ZI 5/06

By early May when other folks had totally sold out to the euphoria and were labeling people who even discussed the possibility of a major correction as "morons" and "idiots", I was warning our clients that euphoria was extreme and the correction would come. This is the way all markets work in history so this was the position students of the markets should have been taking since the odds were out of our favor for PM longs. This warning to our ZS clients was published less than 48 hours before gold's latest interim closing high of $720.

7. Gold $700 "While my gold and silver-related investments are thriving, the speculator in me continues to believe that gold and silver have risen too rapidly lately and need to correct to rebalance sentiment. This viewpoint is extremely unpopular and it gets even more so every day that gold and silver continue to rise. ... Like all other bulls that came before them, they will rise and fall, periodically surging in mighty uplegs and then correcting down in order to rebalance sentiment when folks get too euphoric. One of the great paradoxes of the markets is euphoria is always the hardest to see when it surrounds us." - ZS 5.9.2006

After gold's initial break, one would think the overly euphoric would have quickly learned their lessons. But as usual they didn't. While others were proclaiming that gold's correction had to be over since it bounced, I was warning our clients at Zeal that it almost certainly was not over. I even warned that the odds looked highest for a rapid fall. This was published 9 trading days before gold's plunge this week, plenty of time to prepare.

8. Gold $651 "Since every bull I have ever studied in history has a strong tendency to revisit its 200dma when it corrects, and every single 1970s Stage Two gold upleg retreated back to its 200dma before bottoming, I think gold's 200dma remains the highest probability target for this correction. It remains a long way down from here though, near $534 today. There are two ways gold can return to its 200dma, either it rapidly falls or it slowly grinds sideways and waits for its 200dma to catch up. I'm betting on the former this time around. Once a sharp correction begins, it starts scaring people and gathers downside inertia. In a lot of cases this momentum actually carries it below its 200dma for a month or two. So I suspect gold has the highest probability of falling under its 200dma before this correction runs its course." - ZI 6/06

1. Silver $7.01 "When speculators get interested in silver it can rocket higher in a heartbeat, so there is no reason to be concerned about silver's lackadaisicalness." - ZI 7/05

At Zeal we were very bullish on silver late last summer when despair abounded. The lead article in the 9/05 ZI was called "A Silver Lining" and its core thesis was that silver looked fantastic fundamentally and technically and silver ought to surge once speculators returned from their summer vacations. The time to be bullish on anything is not when everyone else is like in early May 2006, but when barely anyone else is like in August 2005.

2. Silver $6.78 "No other major commodity has more potential for legendary gains in this ongoing primary commodities bull than silver. ... Sooner or later silver will resume trading in line with this commodities bull and its own fundamentals, and silver investors should earn great fortunes." - ZI 9/05

3. Silver $8.27 "Despite the strong runs in gold and silver last month, they're not yet looking toppy in a technical sense. ... The dawn of Stage Two could be catapulting us into a whole new ball game." - ZI 12/05

4. Silver $9.08 "The bottom line is silver is really looking fantastic technically. Its new bull-to-date highs this week confirm that its young secular bull is alive and well despite last year's naysayers. While silver's gains haven't leveraged gold's yet, they almost certainly will in the years to come yielding vast riches for prudent silver investors. ... And while silver is above its resistance now, today's upleg certainly has the potential to surge higher still especially if gold's own upleg persists." - Tactical Silver Trends 4 essay 1.6.2006

By early February silver, like gold, was starting to look overbought technically so I went neutral. I did not sell or recommend selling silver-related trades, I just ratcheted up our stop losses to realize more of our gains if the market indeed retreated. The odds were no longer favorable for adding new longs in silver-related trades. Existing investments and speculations were fine to hold for the ride, but it looked too risky to add new ones.

5. Silver $9.83 "traders must not forget that all bulls flow and ebb. In tactical terms it is quite apparent that gold, silver, and the HUI are stretched far above their respective 200dmas. I am going neutral on it for now. And since silver is indirectly driven by the fortunes of gold and the HUI is directly dependent on it, they demand neutrality too. All neutral means is probabilities are favoring a normal healthy bull-market correction so it is not prudent to deploy new longs at the moment. But neither is it prudent to go short now since bull market surprises tend to the upside." - ZI 2/06

Silver's ensuing parabola, while exciting, was very dangerous. I continually warned our Zeal clients about the immense risks inherent in buying into a parabola. Market history clearly teaches that the only way a parabolic ascent can end is badly. Fighting this silver euphoria made me very unpopular, but that was fine with me as I am playing the markets game to win, not to be loved.

6. Silver $11.49 "Then silver exploded up in a way that only speculators can drive. While exciting, such a surge demands extreme caution. Silver has stretched nearly as far over its key 200dma support now as it did back in April 2004 before a wickedly vicious crash. If you have leveraged silver longs do not forget that silver tends to fall faster than it rises and such corrections happen blisteringly fast with virtually zero warning. While I remain incredibly long-term bullish on silver, the short-term probabilities overwhelmingly favor a correction now. It makes no sense to add long positions at a time when the odds are stacked against us. Sooner or later, silver will inevitably converge with its 200dma again as it has without fail in the past and we will have far superior prices for entering trades. Contrarians avoid buying wild euphoria." - ZI 4/06

7. Silver $13.51 "Silver, which I warned about last month, blasted higher in a classic tactical parabolic ascent before crashing. Once parabolas fail, they have a really high probability of crashing into full-blown corrections that end near their 200dmas. Silver's is way down around $8.75, so please be careful here. Silver too needs a healthy correction to rebalance sentiment and lay the foundation for its next mighty upleg. Before it crashed it was up an astounding 118% in this upleg and stretched 70% above its 200dma. Such extremes are simply not sustainable." - ZI 5/06

Despite the odds, silver kept rising. But history shows that buying parabolic tops is the height of folly, so I kept warning our clients of the looming probability for a major correction. These were my final silver thoughts less than 48 hours before silver's latest interim top. The worst time to buy anything is when it is the most tempting, and silver was playing quite the temptress near $15. Like the mythical Sirens though, it was seducing newly-long silver traders to their deaths.

8. Silver $14.49 "With gold and silver both way overbought technically today, the odds are way out of our favor that they will continue surging. This is really the bottom line in my mind on gold and silver today. I love both metals and am very bullish on them in the long term. But as a rational speculator governed by the probabilities, I cannot violate my trading principles and buy now when gold and silver look so stretched. And if I cannot buy myself and place my own capital at risk right now in gold and silver, then I cannot recommend you take a big risk that I am not willing to take." - ZS 5.9.06

On an interesting sidenote, when silver closed at $12.42 on May 19th a popular silver commentator publicly wrote and published an essay that included the following quotations. "loads of so-called analysts are calling for a correction, or trying to describe this week's price action as a correction. Sigh." "The word 'correction' is the wrong word to use to describe a dip, or pause, in the gold price." "You should not try to predict short-term price movements. Upon what reliable indicator can you rely for short term price movements? There are none."

This gentleman continued, "Just think of the absurdity of trying to call a top in the middle of a bull market." "And I've never, ever, seen anyone successfully call the tops and dips in this bull market from 1999 onward. Many try, but none are successful. Furthermore, I've never seen anyone successfully call both a top and a bottom, to successfully trade a dip in the gold price."

Are any of these statements true? Nope. At Zeal we have been actively trading major gold and silver uplegs and corrections since these bulls began. I realize it is impossible to predict exact tops and bottoms, but we have tried and have been blessed with success in correctly riding the middle 80% or so of each major upleg and correction since 2000. I published an essay the same day as this quoted one above to refute the spurious arguments that markets can't be traded and gaming corrections is impossible. Nothing could be farther from the truth. Doing these very things is what speculation is all about!

As a speculator who loves this game, my favorite way to ride the gold and silver bulls is via elite leveraged gold and silver stocks as well as stock options on world-class producers. Hence this is where the rubber meets the road at Zeal, buying gold and silver stocks early in their uplegs and then letting them slide into their ratcheted-up stops when the uplegs grow mature. In this latest round, the upleg above, our realized gains on recommended stock trades ran as high as 116% while our realized PM-stock-options gains ran as high as 729%. We started buying low early last summer when folks were still pretty scared in general.

1. HUI 186 "With the HUI's correction just average so far, the currency countertrend reversals mature, and gold advancing modestly despite the dollar, I believe the probabilities are as high as we've seen them in a year that a major new PM-stock upleg is brewing." - ZI 6/05

2. HUI 196 "Gold stocks have been trending higher since May now and I still expect a major HUI upleg in the coming six months for all the technical reasons often discussed here." - ZS 7.20.2005

3. HUI 240 "The bottom line is the HUI technicals, despite its strong run since May, still remain very bullish. The index is definitely not overbought yet in light of past bull-to-date precedent and indeed it remains nearly oversold still by some measures. Major bull-market uplegs take some time to unfold and our current specimen continues to look technically young." - Bullish HUI Technicals essay 9.16.2005

4. HUI 245 "The bottom line is the technical indicators we have used to successfully trade the HUI for years are not yet showing a high probability of topping. The big selling season is not here. But until the selling signals start flashing, there is no sense worrying about a major HUI top. Odds are you can sell later at much higher profits." - ZI 10/05

5. HUI 243 "While this upleg is up 53% so far, it remains modest compared to the HUI's average upleg gain of 98% bull to date. If this upleg matures in line with the averages, 330 is the next target. I suspect this will prove conservative though. The combination of the HUI breaking decisively above its December 2003 bull highs near 257 and gold entering Stage Two could drive this upleg much higher." - ZI 12/05

6. HUI 261 "The bottom line is the HUI's leverage to gold looks just fine despite popular perceptions. ... In leverage terms the current HUI upleg looks modest so far, but this is par for the course. The HUI leverage to gold always looks anemic until the final euphoric surge to new interim tops that marks the end of major uplegs." - HUI Leverage to Gold 2 essay 12.9.2005

7. HUI 277 "One of the reasons gold-stock sentiment has been so rotten was because the HUI had been failing its long struggle to break above its two-year-old highs at 257. It is wonderful to see this index finally shoot above these levels to prove that its bull is still alive and kicking. I suspect these new highs combined with new gold and silver highs will lead to a surge in new PM-stock interest. This should drive a fast spike up to 330ish or so that may mark the end of this upleg." - ZI 1/06

Finally in early February when the HUI reached its initial interim top, I went neutral on it since our technical indicators suggested it was getting overbought. Indeed PM stocks did correct for the next couple months before gold's latest dollar-slide-driven surge dragged the HUI up higher to its latest May interim highs. While our short-term PM-stock speculations were largely stopped out with excellent realized profits after the February interim top, our long-term PM-stock investments that we do not trade enjoyed the awesome climb higher to the HUI's latest peak in May.

8. HUI 342 "traders must not forget that all bulls flow and ebb. In tactical terms it is quite apparent that gold, silver, and the HUI are stretched far above their respective 200dmas. I am going neutral on it for now. And since silver is indirectly driven by the fortunes of gold and the HUI is directly dependent on it, they demand neutrality too. All neutral means is probabilities are favoring a normal healthy bull-market correction so it is not prudent to deploy new longs at the moment. But neither is it prudent to go short now since bull market surprises tend to the upside." - ZI 2/06

As the HUI neared May's secondary top, I warned our clients at Zeal that corrections in commodities, dragging them all the way back down to their 200dmas, were growing more probable all the time. As I said at the time, this was not a fundamental argument, the fundamentals looked awesome. It was a pure technical argument since commodities looked so temporarily overbought. There is no inherent contradiction in being briefly short-term bearish while remaining rabidly bullish for the long term.

9. HUI 379 "We may be in for sharp corrections in major commodities in the months ahead. But regardless of how weak technicals become, commodities fundamentals remain rock solid. It takes many years to find deposits, build mines, and bring them into production. In light of a strong fundamental foundation, any 200dma approaches will be awesome buying opportunities." - ZI 5/06

And finally, in early June after the HUI had been climbing higher for over a week after its initial slide and many folks were claiming the PM-stock correction was over, I warned of just the opposite. Corrections tend to last quite some time because their job is to utterly destroy the wildly bullish sentiment that spawned the latest interim top from which the correction began. It takes longer than a mere couple weeks to crush the spirits of the overly enthusiastic bulls.

10. HUI 334 "And by bull-to-date standards, this correction has barely started. We are 14 days into it so far and down 21% at its worst point on a closing basis. The five previous major HUI corrections in this bull averaged 30% losses over 88 trading days. And the biggest uplegs tended to have deeper losses compared to the average. This recent upleg that just broke was up 137%. So odds are we are in for considerably lower HUI levels and months of grinding. If the HUI corrects at its 30% bull average, 275ish is where it will bottom. If it drops 35% like the comparable big uplegs that went before it, then we are looking at 255ish. Both are below the HUI's 200dma. Unfortunately, unlike gold, we're not able to rely on the HUI's 200dma holding as support. In both 2004 and 2005, the HUI spent four to five months or so in each year well below its 200dma. Its corrections in both of those cases each bottomed just under 0.80x its 200dma." - ZI 6/06

So why did I put this essay together? I want to combat the totally false notions so prominent in April and May that corrections aren't necessary and that even if they are they can't be anticipated or gamed. That is utter nonsense. The art of speculation is all about buying low and selling high, which requires diligent students of the markets to intensely study them and ferret out their rhythms in order to better understand their probabilities.

If any person or company you paid to help you navigate the markets did not at least warn you in April and early May that sharp gold, silver, and HUI corrections were at least possible, then perhaps your loyalties are misplaced. Serious students of the markets saw all kinds of warning signs leading up to these events, but careless cheerleaders blundered on through and got slaughtered since they have not respected market history.

At Zeal we are speculators. I love speculation. My business card says "Speculator" for my title. I study the markets because I want to make profitable trades in my own accounts and grow as a speculator. Since I play this game for trading profits, I couldn't care less how unpopular my contrary opinions are near major interim tops and bottoms. The markets are not where one should come if they seek acceptance.

My business partners act and feel the same way. While our research is designed to fuel our own personal trading, we sell our research because it helps us stay on task and maintain discipline. When our clients are relying on us to research and trade, we have to keep relentlessly studying the markets all the time which ultimately helps us grow into better speculators.

Our mission is to actively game the markets with the goal of launching profitable trades, both short-term speculations and long-term investments. Since we are playing this great game with our own precious capital, we strive darned hard to understand the probabilities and communicate them to our clients. If you weren't already in cash through the vast majority of these recent gold, silver, and HUI corrections and you got hurt, you certainly didn't need to absorb those losses.

Since we expected these corrections, we raised our trailing stop losses in anticipation and have built up big cash balances for the coming feast of bargains. The best times in a secular bull to buy elite gold and silver stocks, and stock options, are when the metals and stocks fall under their 200dmas for a period of time and destroy over-exuberant sentiment. If you are as excited about the next awesome gold and silver upleg as we are, you ought to join us for the coming ride.

Our primary research service is our monthly Zeal Intelligence newsletter, where most of the quotes in this essay came from. Subscribe today to see our coming specific PM-stock and options trades once the probabilities for success seem wildly in our favor again. We also recently published a Zeal Report detailing our favorite 20 gold stocks these days in fundamental terms. Read it before the coming awesome buying opportunities arise so you are comfortable with some of the most promising gold stocks prior to the actual technical buying signals arriving.

The bottom line is the recent sharp corrections in gold, silver, and the HUI were totally expected and anticipated. No mere mortal can see the future and know exactly when they were coming, but the ballooning probabilities in favor of major corrections leading up to these events were unmistakable. No student of the markets or serious speculator should have been at all surprised by these retreats.

Such corrections are totally necessary within a secular bull from time to time in order to keep sentiment balanced and prevent the bulls from going parabolic too early and ending prematurely. But just as in the previous five major PM corrections in this bull, the underlying PM fundamentals today remain awesome with the best of these bulls yet to come.

Adam Hamilton, CPA

June 16, 2006

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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