I have been chatting a lot recently with Kevin Vecmanis who is the founder of Vanaurum. Vanaurum is a service that uses AI to play out a wide range of scenarios focused on gold, silver and GDX. From these thousands of results his system develops a 21 trading day outlook for the 2 markets. When analyzing his system Kevin also writes some interesting articles with his findings. The article below caught my attention and I think is a good start to understand a bit about his system. Be sure to click the link below for another article that is a bit more technical but explains a bit more what his system is able to do.
Here is the initial article focused on gold and a “neckline” on the chart.
I’m going to dedicate time in this article to discuss some of the real-world mechanisms underlying chart patterns and price movements. Some view technical patterns as merely shapes, but these shapes are representing real underlying supply and demand characteristics. There has been a lot of discussion recently regarding the basing formation in the gold price and I want to dive into the mechanics of how these structures work, how they form, and how the implication of their resolution is derived.
Price is the Intersection of Supply & Demand:
It’s easy to look at market prices and forget what’s actually going on behind the scenes. Buying or selling a stock, ETF, commodity, or any other financial instrument involves dealing with another person (or algorithm acting on behalf of a person). There can be any number of reasons for selling something:
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You think the instrument is expensive
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You need to liquidate the investment for other non-investment purposes
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You fear the price falling
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You think something else has more value
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Your expectations of the instrument have changed
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etc…
The reasons for buying a financial instrument are often fewer. Typically one buys a financial instrument because they expect to make a profit in the future – whether through cash flow or price appreciation. There can be other reasons – diversification or status, to name two.
With commodities like gold, more often than not the interaction between buyers and sellers is predicated upon one party thinking it’s cheap and the other thinking it’s expensive. At certain price levels, there may be nobody that thinks it’s cheap enough to buy so the price falls until ‘bids’ start entering the market. Conversely, there may be times when everybody thinks the price is too cheap to sell so the price rises until an ‘ask’ (offer) enters the market.
“Cheap” and “expensive” are often the wrong paradigms to view the market through, especially with gold. What’s normally prevailing is expectations. If the number of people expecting the price to rise equals the number of people expecting the price to fall, typically you have reached a price equilibrium in the market. But we live in a dynamic world and the expectations of the investing public are always changing. Prices are always moving to reflect the prevailing expectations of those purchasing a specific asset.
Because investors are people, and the thoughts and behaviour of people are affected by time, the importance of price levels also becomes a function of time. Why is this the case? A person may sell a security now out of fear. Six months from now, if the price of that security has remained unchanged (or even appreciated), the emotional impact of that fear may have subsided and that same person may be inclined to purchase the security again without any fundamental aspects changing. This is a connection that was made by an economist named Edwin Coppock, who did investment work for the Episcopal Church and noted that there was connection between human bereavement cycles and the recovery period of markets.
Bull markets are characterized by consistently lobsided expectations of a market’s prospects. As a bull market progresses through time, the memory of downward price trajectory begins to fade and people become comfortable and accustomed to upward price trajectories. More buyers move into the market expecting higher prices. Higher prices end up validating their expectations and this becomes reflected in the bid stack – more bids than offers. There becomes a point in time when, despite the expectations of market participants, the majority of those able to buy have accumulated long positions. Transactional volumes decline as people hold their positions expecting further rises, and those that didn’t participate in the rally bid for fewer and fewer shares.
The longer this process continues, the greater the disparity in unrealized gains between the investors that have participated in the bull market. Those that purchased most recently are sitting on small gains or no gains, expecting more. Those that purchased earlier are sitting on larger gains and have more to lose if the trend reverses.
Intelligent investors sitting on large gains begin to introduce offers into the market to book their gains (selling shares). Those selling at the top are competing for buyers in a diminished bid stack. Eventually, the amount of offers overwhelms the amount of bids and the price begins to fall so that there’s equilibrium between the supply and demand of shares.
However, as we discussed the supply and demand of shares is dependent on expectations. Fear grips both those who are sitting on sizeable gains and small gains. Expectations of higher prices transform into the immediate expectation of lower prices and the dynamics of the bid stack collapse. Because not enough time has elapsed for the people involved to forget the upward price trend, they view the dip as a buying opportunity. The emotional selling quickly depletes the offers in the bid stack and bids reassert themselves. This causes a sharp snap-back rally which affords those who missed the first opportunity to sell a second opportunity to realize profits with a bid stack now flush with bids.
Profit booking overwhelms the bid stick once again, and by now enough time has elapsed for most market participants to forget the upward trend that once persisted. Offers dominate the bid stack until irreparable damage is done to the bull-market psychology. At this point, as Edwin Coppock discovered, only time can heal the wounds.
Sound like a fictional tale? This is the story of the gold market from 2002-2013, and every bull market that has come and will come. See below:
Anatomy of a Neckline:
After the sell-off in gold accelerated in 2013, the highest level the market was able to rally to was a shade under $1450 in the summer of 2013. Every rally from that date to the bear-market low in December 2015 reached a lower and lower price level. The opposite psychology that we discussed earlier took hold. But what’s happening here?
As time goes buy and emotions dissipate, supply begins to get absorbed by those with expectations that the price will rise. Gold changes hands from those that are fearful and bearish to those that are optimistic and bullish. A percentage of those that are optimistic and bullish will be easily frightened during price declines because the memory of a downward trend is still fresh in their memories (remember Coppock’s bereavement cycle).
On price declines a percentage of these investors will sell to optimistic and bullish investors that are not so easily discouraged. This cyclical process continues until, quite literally, there is nobody left willing to sell at the low price level. This process reached its terminus in December of 2015, almost four and a half years after the peak.
At this point, with a bid stack depleted of offers, the price rose dramatically so that supply and demand could reach equilibrium. With little-to-no offers, it doesn’t take many bids to move the price significantly. Some of those “strong hands” booked significant profit when price matched the January 2015 high, and then more in the late summer of 2016. This wave of profit-taking sent a surge of fear into the market, with many in the space predicting a continuation of gold’s bear-market decline. At this point it has only been 6-8 months since the last memories of relentless selling.
This selling arrested itself at $1150, a higher low by almost $100. Memories of the bear market are diminishing, and expectations of higher prices are returning. Remember that as a market bases and declines there are people accumulating along the way that seek to either profit or jettison their positions as soon as price moves back to their break even point. The more time an asset spends within a specific price range the more galvanized the holders of the asset become. Some of the accumulators on the way down shift to become “weak hands” as soon as their trade becomes profitable. Their selling goes into the hands of strong hands with longer term expectations, even on the way up.
We’re seeing the offers in the bid stack become depleted at higher and higher levels. This is representative of strong hands with bullish expectations beginning to dominate the supply. $1370 and $1450 will be formidable resistance levels in this market. There are still those who are underwater on their investment below these levels that will be whole when these prices get reached. However, because so much time has elapsed it could also be the case that their expectations have reversed. One should expect strong waves of selling at these levels as the last hold-outs from the prior bear market dump their holdings to more bullish participants. It remains to be seen how large this selling is and how well it gets absorbed.
A breach of the neckline of any bottoming formation represents an end to the bereavement cycle of the prior down move. The more time that elapses, the longer the churning process becomes. Memories fade, optimism rises, and the story starts from the beginning.
About the Author:
Kevin Vecmanis is a professional engineer, quantitative market analyst, machine learning practitioner, and a candidate in the CFA program. He graduated from the University of Western Ontario with a degree in Electrical & Computer engineering in 2008 and currently lives and works in Vancouver, British Columbia.
Click here to read a more in depth article about Kevin’s system and checkout the rest of his site.