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.

With earnings season once again around the corner, this perspective on the market has extra relevance:

Source: Decision Point

Once in a blue moon, the market trades at prices which take it to a “value based buying opportunity”. But notice that looking back, it hasn’t for a long time. According to this chart, if we do revisit that scenario again, we would be at levels last seen in 1996 (S&P 500 ~650).

Which reminds me of this other chart, showing just how low a serious bear market can take prices.

I highly recommend Decision Point, the source of the chart above. Thanks to Dr. Brett, you can have free access to their great site until October 26th, 2008. Just login as a regular member would using User ID: magic55 and Password: moments.

Earlier this month I mentioned the IBES valuation model and how it was telling us that US equities are extremely undervalued. The Barnes Index is another valuation model which is similar to the IBES.

Keep in mind that these valuation models are really broad strokes. They are not meant for nimble, short term traders. They attempt to outline the general tone of the market and perhaps its long term trajectory.

So what is the Barnes Index? Like the IBES model it compares the stock market to the bond market. But unlike the IBES it considers both the short term yield and the long term yield (the yield curve in other words):

Barnes Index = (Treasury Bond Yield X Treasury Bill Yield) divided by (S&P 500 Dividend Yield X S&P 500 Earnings Yield)

So in essence it pits the “returns” from stocks, in the form of dividends and earnings versus the “return” (yield) from bonds. Market risk is highest when you can make more by investing in risk-free assets. The normalized chart below comes from Decision Point (the excellent technical analysis service run by Carl Swenlin).

Click to Enlarge Graph

Since it began in 1970, the Barnes Index gives us a few more years than the IBES model. The last buy signal was given in early 2003, at the bottom of the bear market. At its current level, it is neutral.

In 1973, when the Barnes Index was also at similar levels, the market topped. Also in 1981. But then again, in 1990-1 although it stood where it does now, the market went much higher.

Notice that similar to the IBES the model imploded into irrelevance due to the “bubble years”. In 1997 it crept into the redline and stayed there almost constantly until late 2001. Which proves that no model or forumla can ever predict or explain the market. All we can ever hope for is a crude approximation.