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A New Twist On Gold’s K-Ratio at Trader’s Narrative

A New Twist On Gold’s K-Ratio

The price of gold decisively broke out of its cup and handle formation, hitting a high of $1264 before closing at $1258.

Gold’s K-Ratio
As long time readers know, I like to use the K-ratio to time the gold market. The K-ratio is the index of gold stocks divided by the price of gold. Named after its founder, Jay Kaeppel, it was originally calculated using the Barron’s Gold Mining Index and the Handy Harmon price of gold. But since the concept holds true, you can use any reasonable index and closing price for gold, as long as you are consistent.

I use the AMEX Gold Bugs index (HUI) since it is a true proxy for gold stocks and excludes other metal miners (like silver, copper, etc.). The only problem with the K-Ratio is that is helps us to put the gold market in its proper long term perspective. The gold bull market is not in its 10th year and for the most part, the K-ratio hasn’t been very helpful.

One exception was in October 2008 when the K-ratio fell to levels last seen at the first years of the secular bull market. As I wrote at the time, expecting it to fall any lower was unrealistic because the last time it had done so was when gold stocks were trampled to death as investors stampeded into sexy stocks amid the tech bubble.

Click to see larger chart in a new tab:
K-ratio long term chart Jun 2010

amex gold bugs index HUI long term chart Jun 2010

As you can see, from 2004 to 2008, if you allowed the K-ratio to talk you out of opportunities in gold, you lost money or at least an opportunity cost (like yours truly). While the k-ratio remained elevated, gold doubled from $400 to $800. Gold stocks underperformed the commodity persistently and by a significant degree. And they continue to do so since they have not broken above the high they set in 2008.

Gold vs. Gold Stocks
One possible lesson is to ignore gold stocks altogether and just focus on gold itself. Right now, the technical picture would tell you that it is acting very strong. And on the plus side, gold sentiment is still relatively subdued considering that strong price momentum.

According to Mark Hulbert, the recent Hulbert Gold Newsletter Sentiment index (HGNSI) is at +30.6%. To put that in perspective, that’s close to the ‘average’ bullish sentiment. At the end of March 2010, when gold was at a low, the HGNSI was at +18% and in early May (a short term top) it was 47%. Historically, this sentiment gauge is the most volatile of the Hulbert newsletter indexes and it has reached highs of +90%. So be careful because within a very short time it can jump in either direction.

Short Term Timing
If you don’t want to ignore gold stocks altogether, there is a way to use the K-ratio to time this market within a short term time frame. First, take the K-ratio and then plot it relative to a medium term moving average. I used the 30 day moving average as an example in my chart below.

k-ratio short term Jun 2010

You can see that it generates fairly good - but not perfect - entry signals. Another method is to time your entries with the bullish percent index for gold stocks. Neither of these two simple trading methodologies is showing an opportune entry for gold stocks right now. And, let’s not forget the overhead resistance that is close at hand.

The action is, as it has been for a while, in the metal itself. But keep watching for a chance when gold stocks sell off too much relative to gold.

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One Response to “A New Twist On Gold’s K-Ratio”  

  1. 1 Mike C

    I’m not following you at all here. Are you trying to time entries into gold STOCKS or gold the underlying COMMODITY. It is clear to me that for several years now it has been a mistake to view them as one in the same from the perspective of likely forward performance. They can diverge for a very long time.

    I’m curious how you would weigh the technical breakout versus what SHOULD BE a seasonal flatness:

    From my previous comments, I’ve have been and continue to be in the long-term secular bull camp, but I’m just trying to figure out if the next big upleg is right now or if it is more likely to begin in late summer/early fall

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