Trader’s Narrative

Wow, what a ride! The AMEX Gold Bugs Index (HUI) rallied 100% within two months. I was bearish on gold in October 2008 but saw technical support around 175 which is where the most recent rally lifted off from.

The funny thing is that gold has clearly shown itself to be just another commodity to be traded and not “real money” during this crisis. You can’t but help notice the resemblance of gold stock prices to general stock market prices. If you are still a dyed in the wool $2000 an oz. gold bug, then you have to re-examine your stance when the threat of total global credit and financial meltdown can’t push gold up.

In any case, looking at gold sentiment, it seems that this recent rally has given too many, too much optimism about the metal. And this usually means that it is the end of the ride.

According to the Hulbert Gold Newsletter Sentiment Index (HGNSI), the average exposure that market timing newsletters are suggesting for gold is 75.2%. To put that in perspective, that’s an almost 4 year high. It is even more gloomy when you consider that when gold was nearing $1000, this same sentiment measure was only 64.3%. Obviously gold is now much lower, but this 100% rally has made many people become “believers” yet again.

Another sentiment measure is also finding too much excitement for gold. The chart below shows the Central Gold Trust (GTU) share price with the premium/discount to NAV plotted below. Since the trust simply holds gold and silver, it is easy to calculate what it should be trading at. But right now, people are paying astronomical amounts over and above the real value of this security:

You can read more about Decision Point’s discussion of gold here.

A quick follow up to gold and gold stocks:

Although both the yellow metal and related equities have continued to rise, something is conspiring to keep a tight lid on the rally. And no, it isn’t a wide reaching and vast conspiracy involving central banks, hedge funds, the Easter Bunny and Mossad.

Last week, gold sentiment skyrocketed to 81% - as measured by MarketVane’s Bullish Consensus. That is the highest it has been this year and not too far off historic extremes.

According to contrarian analysis, there is way too much excitement about this little latest rally. When the vast majority of those who are interested are bullish (and act on the opinion by buying) the tragic conclusion is that there isn’t any real buying pressure left to propel prices higher.

This is what happened last May when bullish gold sentiment reached a crescendo of +90%. Gold peaked at $725 and the AMEX Gold Bugs Index (HUI) at 400. Neither have seen those levels again. And if the bullish sentiment continues, there is less and less probability they will.

The only argument that I can see for a continued rally in gold is the bullish percent index for the sector. According to the BP index kept by Dorsey, Wright & Associates, there is a possibility that we could see gold break out from this multi-year trading range.

In mid August, along with the rest of the market, gold got clobbered. That caused the bullish percent for the index to fall to 16% - a very, very low number. So far, it has recovered from this depth to 30%. As you can see from the chart (below), the BP index has quite a ways to go before it reaches overbought territory.

So take your pick: keep gold longs because bullish percent is still quite low or pare positions and tighten stops because sentiment is getting too bullish. Personally, I’m going with sentiment - via contrarian avenue.

Click To Enlarge Graph:

Graph Credit:Technical Watch

Thanks to Moises, a reader in Barcelona for the link (please have a bocatta on me and don’t forget the tomate drenched pan)

There is an inter-market relationship between bonds and gold which may not be evident at first glance. The reason why the two disparate markets are connected is that they both rely on one factor: inflation. Or the expectation of future inflation.

For this reason, it is very rare for these two markets to go in different directions in the long run. Instead, they tend to dance around each other.

When the market expects future inflation to be higher, gold mining stocks rise and bond prices fall (yields rise). So in effect, by watching one market, we can attempt to gain insight into the other.

Jay Kaeppel developed a simple system to do just that. He looked at the 12 month rate of change (ROC) in the GMI (Barron’s Gold Mining Index) and compared it to the 12 month performance of bond prices going forward. We can substitute the Amex Gold BUGS Index (HUI) for GMI.

When the ROC for the gold index is positive and high, we would expect bond prices to decline going forward (next 12 months). Conversely, when the rate of change for HUI is negative or low, we’d expect it to be a great time to buy bonds. And this is generally what happens according to historical data.

Be sure to check out Kaeppel’s original article on this: Maximizing Bond Fund Profits. You can find it in the Reports & Articles section of my free trading resource “goodies box”.

So what is this simple intermarket relationship telling us now?

Well, as far as I can tell, the bond market and the gold market have decoupled. I can’t seem to find any meaningful relationship between them now. Kaeppel’s article was written in 1994 so it only included data until then. By looking at data from the late 1990’s to today, it seems that the two markets have gone their separate ways. Atleast for now.

For example, in the summer of 2002 when the 12 month ROC for the HUI index was astronomically high, bond prices actually were higher a year later. And in the summer of 2005 (see graph below), when the 12 month ROC was negative (-40%), bond prices actually peaked and were lower a year later.

Click to Enlarge Graph

Strange. As I’ve mentioned before, although the bond market is pricing in future expectations of inflation, other markets, like gold, silver, and the CRB commodities index are breaking down and not confirming this. What to make of this?

On April 25th 2007, I wrote that gold bulls would be disappointed (again). Lets take a look to see what happened since then and what we can tell for the sector going forward.

I pointed to the Commitment of Traders report, which showed the “smart money” commercials being markedly net short. Since then that lopsided situation worked itself out.

On April 17th 2007, the commercials position was: long 79,882 and short 254,480, which is a net short position of 174,598 contracts. From the previous week (April 10th 2007) the commercials had reduced their longs (-7,564) and added considerably to their shorts (+13,830). Meanwhile, the small speculators were long 54,973 and short 15,733, for a net long position of 39,240 (on April 17th 2007).

Now compare that to the COT on May 29th 2007. The commercials had a long position 125,989 of and a short position of 244,684 for a net short position of 118,695 contracts. And the small speculators were long 57,428, and short 33,630 for a net long position of 23,798 contracts.

An important metric to watch for the COT is the open interest. Currently it is at 425,688 contracts, a 12 month high. Usually important changes in trend develop when the market is positioned lopsided (commercials vs. speculators) and when the open interest reaches significant levels. We saw this happen in late February 2007 where the commercials had been increasing their net short position while the small and large speculators were going more more long. With the open interest at around 415,000 contracts, things hit their climax and it started to unwind.

As well, the Rydex sentiment measure was flashing a caution sign. Considering also that the gold index fell to an area of previosu support, it wasn’t surprising to see it rally last week. It started with hammer on Wednsday and then two back to back long range up days:

Last week may have gotten the gold bugs rejoicing. But when you step back and look at the larger picture you see a very lackluster performance. Relative to the general stock market, the gold sector has lagged significantly. It is stuck in a wide trading range and is no where near break out levels. If it does approach the 370 level without looking too overbought and if the k-ratio is low enough, then I might change my overall outlook on this sector.