Tuesday, December 13, 2011

Santa Claus Rally

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The Story
Many people think charts are just lines drawn to make a picture.  Ask any nurse, or doctor and they will tell you there is a story behind every chart.  The reason we graph the data is to illustrate trends and to highlight relationships.  Few of us have the ability to look at the data and visualize the relationships in our head.  Yet, it is not the trends and relationships themselves, which we are looking for, but the story they tell us.

Golden Year
The chart above is a great example.  It is a chart of the price of gold during the last year, or so.  Each price candle represents one week's worth of price data.  The lines along the bottom of the chart represent the volume of transactions for each corresponding week.  It is immediately obvious the price of gold has done very well over the past year, as it starts from the bottom left and rises to the upper right. Then, the price drops considerably in September as it begins to form an interesting triangle pattern.

The story behind a triangle, such as this, applies very much to the type of market we currently find ourselves in.  Triangles develop in times of uncertainty.  The drop in September came as problems in Europe became more of a worry than the inflation story which had dominated up to that point.  Then, when it seemed the deleveraging was overdone, it was time to accumulate gold, again.  One day, Europe was going to collapse, and the next it wasn't.  One day, the Chinese economy was going to crash, and the next day it wasn't.  One day we were going to see the U.S. market decouple from the world economy, and the next it wasn't.  Whatever the causes, there has been no shortage of uncertainty of late.

Going Down?
Normally at this time, we see a rally going into the end of the year, hence the name Santa Claus rally.  It may still be too early to tell, but if next week starts below the bottom trend line of the triangle I drew on the chart above, I would say we can forget about any rally, this year.  This chart is a chart of gold prices, but this pattern is also showing up in the charts of many of the large equity markets.  One interesting thing about this chart is we can use this pattern of uncertainty to predict how much affect it will have.  I drew a blue line at the widest point.  I then took a line of the same length and extended it down from the apex of the triangle.  What that tells us is, if the price of gold continues to move down past the bottom line of the triangle, we are probably headed back to the low for the year - a point which is about 20 percent lower.

Historical Rhymes
Think of the price of gold going higher until the period of greatest uncertainty which caused those who were feeling too over leveraged (think hedge funds, and fund managers) to start selling gold to raise cash, only to start accumulating gold, again.  Based on the conflicting news, they would change their minds a few more times before deciding the need for cash was too great.  It is as if the bubble in July and August never happened, and the price has now started lower after climbing higher for a period of years.  Those holding gold have already tipped their hand as to how much selling they will need to do.

Probable Outcome
It does not mean the price of gold, and markets in general, will drop 20 percent in a straight line, but it does begin to look like the fund managers have given up on Santa's arrival this year.

Are you hoping for the Santa Claus rally?

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