Trader’s Narrative

Market strategists have drawn a line and taken sides: is gold in a bubble? Jim Rogers and Nouriel Roubini had a verbal smack down via respective media interviews with the former manager of the Quantum Fund being the believer he’s always been in the power of commodities while the prophet of doom and gloom used the “b” word to describe the precious metal.

Now another pair of strategists have taken sides - although not as personal as Rogers and Roubini. Dennis Gartman, believes not only that gold is in a bubble, but that it should be obvious to everyone. But that doesn’t mean he’s necessarily climbing off the trend:

Meanwhile, David Rosenberg featured this chart to argue not only is gold not in a bubble, it is actually “cheap”:

Leaving aside the obvious arithmetic (instead of logarithmic) scale, comparing the S&P 500 index to the price of gold is a non sequitur. This is due to the incessant rise of the equity index, with that itself due to the survival bias built into the constituents that make up the S&P 500 index. And don’t forget a dash of inflation which pumps up stock prices and therefore, stock indexes. So a ratio of gold to equity prices will for the most part look like a ski hill - and be as meaningful.

I’m also puzzled why Rosenberg is so bullish on gold since he has been one of the prescient strategists who has beaten the deflation drum the loudest.

Market Measure of Forward Inflation
Other than the CPI figures from the US government sources, there is a market determined inflation measure. It is the implicit inflation as per the Treasury Inflation Protected Securities (TIPS). The TIPS data that I showed back in 2008 is no longer published by the Fed. Thankfully, Bloomberg disseminates a metric based on the nominal forward 5 years minus US inflation-linked bonds forward 5 years. So basically, this is the average inflation that the bond market expects from 2010 to 2015:

Source: Bloomberg

In the final days of last year, inflation expectations were the lowest in a very long time, fallin to just 0.41%. Earlier this month they reached 2.89% but today’s forward inflation expectation was still a muted 2.68%. Clearly, the bond vigilantes are not signaling a runaway inflation debacle in the near term future for the US.

So can it be that gold is in an honest to goodness bubble?

Gold Sentiment
Here are two measures of sentiment for the precious metal. The recent survey of Bloomberg terminal users on their conviction for gold found a remarkable 94% to be bullish.

That is a new record high since the survey started in 2004. Unfortunately, Bloomberg’s survey hasn’t been very good as a contrarian indicator. But it has rarely been above 90%. The closest it has gotten to this level was at the start of the year in January 2009 when it reached 91% bullish. Back then, gold was $900/oz. While there is a short history, the sheer lopsidedness of the recent consensus makes it noteworthy.

Courtesy of Elliott Wave, we get another measure of gold sentiment:

The Daily Sentiment Index (trade-futures.com) has been at, or above 90 percent gold bulls since November 3, a string of 10 straight days. The only other comparable streak of optimism over the past 22 years of data is leading up to the December 2, 2004 gold high when the DSI was at, or above 90 percent for 20 consecutive days. At that time, prices made a high at $458.70, declined over 10 percent, and did not exceed the December 2004 high again for the next 10 months. But during this entire 20 day stretch, optimism never reached the single day extreme that today did, with fully 97 percent of traders optimistic on gold’s future prospects. This time, we expect a larger decline, one that lasts longer too.

The US financial system was resuscitated by the largess of the taxpayer. Without any real quid pro quo, transparency nor discussion, they were made whole. Their losses made public while their profits were guaranteed to remain private (as the recent obscene bonuses attest).

So now that the US economy is still on the ropes, fighting for its very survival and in dire need of a liquidity transfusion of its own via the credit markets, where are the banks?

Surely they are pumping the lifeblood they received from the US treasury and the Fed back into large and small businesses that are the engines of growth to allow the economy the same recovery they enjoyed. Right? right? Well, no. In fact, if you assumed that you couldn’t be more wrong.

As you can see from the chart above, bank lending in the US has contracted to an unprecedented degree. You may notice that a contraction of some shape or form happens each time we have a recession (the dark bars). And you would be right. But we are not taking a random walk down Wall Street these days. These are extraordinary times, which required extraordinary measures - whether rightly or wrongly.

So what are the banks doing with all the cash they received from the hard working American Joe and Jane Sixpack?

Hoarding it like a miser:

So we have banks flush with cash, not lending to those who need it and deserve it, but rather sitting on the cash or in Goldman’s case, using it to generate billions of dollars in profit which then is promptly cut in half to be paid as bonuses.

As David Rosenberg of the Toronto boutique firm, Gluskin Sheff posits, this may be why the US government bond market is so subdued:

The banks are deploying the cash in the government bond market, buying a net
$27 billion in the latest week and $130 billion in the past 18 weeks. Meanwhile, cash reserves keep piling up and just reached an all-time high of $1.2 trillion — enough to finance the entire U.S. fiscal deficit. This is a nice back-of-the-door mechanism for how the Fed is monetizing the government’s endless need for money: bolster reserves at the big commercial banks and have these banks buy the bonds that Uncle Sam sells in order to raise the capital needed to fund all the government’s fiscal stimulus measures.

Here is a very long term chart of the US 30 year bond yield:

The Chinese have a saying: ‘May you live in interesting times.‘ All I dare hope is that things don’t get any more interesting than this.

By the way, here is an almost too good to be true offer for my US readers. For a limited time, you can get a complimentary subscription (aka FREE) to SFO magazine (Stocks, Futures, and Options).

It takes less than a minute to sign up and you need to provide some basic information. But as I mentioned, you need to be a resident of the US (because you need to provide a US address). Enjoy!

A quick summary of all things sentiment-wise for the stock market this past week:

Sentiment Surveys
The mind set of the retail investors as measured by the weekly AAII sentiment survey shows little change. We had an increase of 7% points for the bearish camp to 46% and a decline of 6% points for the bulls to 33%. Which is not very helpful as it leaves us mired in “no man’s land” - exactly where we’ve been for the past few months.

In contrast, the Investors Intelligence weekly survey of newsletter editors continues to be dominated by optimism. This week we had a small reduction in the bullish camp to 44.8% and a small increase in the bearish camp to 26.4%.

Bond Bears
For what is happening in terms of sentiment in bonds, check out the post from a few days ago: bond sentiment.

Options Sentiment
CBOE put call equity ratio: We got a slight ‘blip’ on Thursday (June 17th 2009) when this ratio hit 0.88. That’s not even close to a level which would get any contrarian excited. But it is the highest level of fear shown in this indicator since early March 2009. Keep in mind though that this trusty indicator has been firing blanks throughout this bear market.

ISEE Sentiment index: the equity only call put option ratio from the ISE reached a low this week we haven’t seen since November 2008. Remember, this is inverse to the usual put call ratio so a large number denotes optimism and a low number fear. On Thursday the ISEE Sentiment index reached 92 (meaning 92 calls purchased for every 100 puts purchased to open a retail options position).

This dovetails with the technical indicators that are also showing a very short term oversold condition in the market. The key is how the market reacts as a result: will it use it to bounce strongly higher? or collapse lower in spite of it?

Secondary Market
The doors of the IPO market have been shut tight for many months now. And although we are seeing the door budge open again slightly, the real action has been in the secondary market.

According to TrimTabs, last month saw a record shattering $64 billion dollars of IPO and secondary market offerings combined. To put that in perspective the previous monthly record was just $38 billion. While TrimTabs didn’t provide a sector breakdown, I suspect that most if not the vast majority of the record issuance was in the financial sector.

Historically, there is an inverse relationship between the primary and secondary market activity and forward market performance. This isn’t surprising since at the heart of the market, once you remove all the noise, is a simple supply and demand equation. There are a finite number of dollars chasing a finite number of shares. If you tip the balance in one direction, the market will react eventually.

According to two methods of analysis (from TrimTabs and Ned Davis Research) we are seeing a historical extreme that has only been seen before quite rarely. For more details, check out this article by Mark Hulbert. My only criticism of this analysis is that they use nominal numbers instead of ratios.

Since the market generally rises over time (recent history excluded), it isn’t helpful to compare the secondary market in say 1998 in dollar terms to that of today. The way we can equalize it is to look at the ratio of the secondary market to the total market (for example, the total equity value of the S&P 500). In this way we can easily compare across decades and get a more accurate idea.

This criticism notwithstanding, since the other extreme readings come from relatively recent years (2000, 2008, etc.) we can conclude that a ratio analysis would yield little improvement. The conclusion stands that Wall Street is suddenly awash in ‘paper’. I’m sure some will come up with conspiracy theories of this spring rally being rigged to allow for the recapitalization of the ailing US banks. But remember what Ben Graham said about the stock market: “In the short run it’s a voting machine, but in the long run it’s a weighing machine.”

Late last week we got the latest figures from the Reuters/University of Michigan survey. Consumer sentiment continues to recover with the preliminary June 2009 number at 69% - compared to 68.7% for May 2009. The consensus of economists was for a larger recovery but there is no doubt that US consumer sentiment is slowly recovering from the drubbing it got a few months back. Things were so extreme that we hadn’t seen such low consumer sentiment since 1980!

But there was another data point that got my attention from the Reuters/University of Michigan survey. There was an increase in the number of people expecting an increase in interest rates from 36% in May to 53% in June.

With those that expecting the opposite shrinking from 19% last month to just 10% now. This differential is the largest since August 2007 (red arrows in chart):

Keep in mind that bond yields and bond prices move inversely. So a fall in yield would be accompanied by higher bond prices.

As you can see in the chart, the red arrow doesn’t coincide exactly with the 2007 summer peak in yields but then again, if we go back we find that the chart consistently trends downwards. In fact we could look back 10, 15, 25 years and more and still find that yields in a downtrend. Of course within this macro-trend there have been some very sharp counter rallies - of which the early 2009 rally stands out.

The weekend is here. Kick back and catch up with these links from this weekend’s reading list at news.tradersnarrative.com:

• Using the PPO to Measure Extremes
• Bank bailout: The greatest swindle ever sold
• Flatland - Not a Stockpicker’s Market
• Gold Lacks Intrinsic Strength
• Get a FREE Subscription to Financial Magazines
• Barrons interview with Bob Prechter
• S&P 500’s 17 week cycle
• An Unparalleled Array of Free Corporate Data
• The Big Inflation Scare - Paul Krugman
• Contrarian signs for gold sentiment point down
• Bonds Fall Jolts Stock Market
• Gold on verge of historic breakout?

Follow the link below to get more:

And remember to check regularly since there are new links added continuously.

Week Ahead: GM’s Bankruptcy