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The Gold sector has captivated the minds of investors since it is one of the few rising sectors in the market. The problem is that many technicians are confusing causality with reality. Many statistical correlations appear, but making statements such as "there’s more buying than selling based upon the increasing volume" can not only mislead investors but also prevents the true underlying mechanism from surfacing.

The Wykoff method of swing trading is a staple of technical analysis and is used by many to identify support and resistance areas. But what if other correlations can be made if more data is layered on top of prices? Perhaps increasing volume doesn’t represent more interest or an increased propensity to buy; perhaps it represents some other structural change in the market?

Recently the Philadelphia Exchange substantially changed the components of the Gold & Silver Index (XAU). On 8/18/03, the exchange increased the number of component issues from eleven to twelve and changed the composition of the companies in it. (XAU components )This of course affected the volume by increasing it since there are now twelve stocks instead of eleven. But where was the impact of this change noted or disclosed to investors?

Interestingly, this change coincidentally occurred as a previous high was being retested and a critical long term resistance level of 90 was being challenged. Technicians analyzing this sector are waiting for the next clue to this sector’s market direction, but nowhere is there any mention of how this sector responded to index changes in the past. It is as though, nothing else exists besides price and volume. So below is an examination of some other facts that produced high yielding correlations, which have had a direct impact on the volume’s studied by technicians.

The XAU index has grown from nine component issues to twelve since its inception and the index grew from 10 to 12 component issues since July 2002. As a curious coincidence, the June 2002 rally, which posted a high of 89.11, was made as the XAU increased from ten to eleven issues. Another rally, which peaked in June 2003, occurred when the American Stock Exchange’s Gold Bugs Index (HUI) increased the number of components from 12 to 15. And now, it appears that another rally has coincidentally materialized prior to the XAU increasing its component size from 11 to 12 stocks. There appears to be a strong correlation that these Gold indices rise prior to substantial changes. No further analysis is required. But, you may ask, what about the volume?

Volumes are generally updated daily and are traditionally presented as an unaltered sequence, but when it applies to an index, there has been no discussion regarding the validity of this generally accepted practice. If the index changes, is the volume simply another entry in the series or should the series be adjusted? The problem is that nobody is asking which series is valid. As previously mentioned, the XAU index changes are associated with rising index prices, and the daily trading volume made commensurate moves. But where is the discussion, or acknowledgement, that the volume increased due to a structural change in the index? The exchange increased in the number of stocks included in the index. What is the effect of this artifact?

As you can see below, there are two XAU volume graphs that show how differently volume can be plotted. In graph 2, notice how the higher high made on 8/19/03 and 8/20/03 was made with less volume than the highs of 8/8/03 and 8/9/03 when comparing the volume of the same 12 companies. And notice how in graph 3 the higher high made on 8/19/03 and 8/20/03 appears to be made with greater volume when comparing the index high on 8/8/03 and 8/9/03 using the unaltered sequential series that has only 11 stocks in the index on 8/8/03 and 8/9/03 and 12 stocks on the 19th and 20th. Which are you to believe, knowing that each view will lead you to the opposite conclusion?

For a detailed article that is meant for industry professionals and analysts, please refer to Five ways to calculate the XAU volume. It explains the calculations and the reasoning behind graphs 2 through 5, which are shown below.

Graph 1 – XAU daily candlestick chart of prices with 4 day simple moving average.

XAU daily prices

Graph 2 – XAU daily volume recalculated using the component issues.

XAU volume: revised

Graph 3 – XAU daily volume using an unaltered sequential series.

XAU daily volume: unaltered sequential

Graph 4 – XAU daily volume using a market capitalization weighting.

XAU daily volume: market capitalization weighted

Graph 5 – XAU daily volume using a fraction supply weighting.

$XAU daily volume: fractional supply weighted$

Another facet of the gold sector that causes more concern is with the supply of stock (Table 1). Below is a table of shares outstanding in the XAU over the past year. It's another odd coincidence that when the supply of stock in the index increases; prices rally. Economists should study this phenomenon since classic economics professes that if there is an increase in supply while demand is constant; prices should fall. But as you can see, the table below documents that when the supply is anticipated to increase "Wall street" bids up prices.

Table 1 – XAU total shares outstanding of the component issues

Date	Shares Outstanding (in millions)	Gold Market Rally
5/2/02	2000
7/1/02	2619	X
11/12/02	2691	X
2/5/03	2715
3/25/03	2776
5/30/03	2776
6/25/03	2778	X
7/3/03	2778
8/5/03	2783
8/20/03	3254	X
Comments: Between May and July 2002, XAU added GFI which accounted for 469.6 Million new shares added to the index. Component stocks increased in number from 10 to 11. December 2002 rally accompanied the new supply of stock. There was no increase in the number of components added to the XAU. June 2003 HUI increased number of components from 12 to 15 stocks. XAU component shares were unaffected. August 2003 XAU increased number of component stocks from 11 to 12. DROOY and KGC added 499.2 Million new shares to the index. SIL 36.4 Million were deleted from the index. If the supply of new shares were to be removed and the total shares outstanding were based on the same 10 companies over the past 15 months the supply of stock rose from 2,000 Million shares to 2,321 Million. But the street reacted to the impact of the changes in supply rather than the actual true increase in supply. The changes caused 4 significant changes to the supply of stock included in the indices (HUI & XAU) and this sector rallied when the supply increased.

Now if a technical analyst were to look at only price and volume, the conclusion is that the increase in volume shows an increase in demand, which is driving prices higher. But if the analyst were to expand their database to include the timing of these index changes along with the impact of increasing the supply of stock then it would be hard for the analyst to arrive at the same conclusion.

One could argue that the resulting bullish bias would be the same (buy increasing prices with increasing volume versus buy index changes or increases in stock supply), but the underlying premise of increased buying by investors is an illusion and misrepresents the true mechanism at work. The fact that the increased volume was demonstrated to be merely the result of increasing the number of stocks in the index rather than showing an increase in the propensity for investors to buy alters the interpretation of the facts and highlights how easily data can be misinterpreted.

Regarding supply, technical analysts generally don't analyze the supply side of the equation, because price is believed to be the current fulcrum of all factors known and unknown. Supply is considered irrelevant. But when this information is overlaid with price, an amazing coincidence emerges. So how can technical analysis lay claim to anticipating the future when the cause and effect are not known? In addition, how reliable can future predictions be if the true mechanism of the markets is not understood? If causality hasn't been established then how can one predict the future?

As it has been demonstrated, here are several correlations; 1.When the XAU index changes, prices rise; 2.When the XAU supply of stock increases prices rise; and 3. of course the technical analysts point of view that when volume increases making higher highs prices will rise. Which of these causes prices to rise? The presentation of these facts doesn't support a definitive conclusion, but these facts do serve to illustrate how easily it is to arrive at the wrong conclusion and potentially misinform clients.

These facts must be disseminated and debated before technical analysis can move forward as a science because correlations can easily be misinterpreted as causality. And if someone were to make this leap in logic then they would be wrong. Please review these facts and raise these concerns when discussing technical analysis with a friend, colleague, mentor, or professional. Perhaps then more accurate statements can be made regarding future correlations and predictive associations in the Gold market.

As a final thought, consider this. Regardless of whether one method is determined to be logical and correct, if the consensus ignores it, the current level of knowledge neither matures nor advances, and the majority of observers continue to react to misinformation, then when will this new knowledge become beneficial?