Trader’s Narrative

Maybe my problem is that I try to understand things. So here I am, amid all this hue and cry about interest rates shooting to the moon in order to contain rapidly rising inflation and I find myself asking, inflation? what inflation?

The CRB commodities index broke down from its long term uptrend line last year and has been going lower since. And gold, probably the most watched gauge of inflationary expectations, has just done the same.

Last friday gold didn’t hold the $665 level which was support provided by the long term trendline (see graph). Instead it easily sliced through in a wide range bar and reached a low of $647.80.

Not the sort of price action that is congruent with an inflationary scenario, wouldn’t you think?

I’ve been wary of gold for a while now. But in any case, bonds have been taken to the back alley and beaten to a pulp. Time to buy the panic?

If there is an opportunity, it’s between now and Friday morning - when the CPI numbers will be released. You know the drill: buy the rumour, sell the news.

The AMEX gold bugs index has bounced back, finding support at the 280 level exactly where it did so before in March 2006. This caught me off guard since I was bearish on the sector. But there’s been a concomitant rise in bullish sentiment which does not bode well for the gold sector; atleast in the short term.

According to Mark Hulbert, the sentiment picture has changed too quickly for this bounce to have any more legs. His Hulbert Gold Newsletter Sentiment Index - a calculation of the average recommended exposure in the sector by gold timing newsletters - shows a jump of more than 70 percentage points in only nine trading sessions. This is the biggest nine day jump in many years.

With such a rush to get back into gold just as it has bounced off intermediate support, things don’t look that good. Bulls should ideally see a skepticism if this rally is to have any endurance.

As well, the k-ratio has increased to levels where gold stocks have hit resistance in the past. Here’s an explanation of the k-ratio, in case you’re not familiar with it.

One of the reasons why I was bearish on the sector was breadth. At that time, the % of gold stocks above their long term moving average was still quite high. But immediately after I wrote that, that percentage fell very quickly from 75% to 20%. This breadth washout was so rapid it took me by surprise. So it was understandable that with such a dramatic deterioration in breadth and with gold itself kissing its 200 day moving average we would see a swing bottom in the middle of June.

But similar to the sentiment picture, this metric has turned around just as quickly as it fell. Now just a few trading days after, we again see the breadth showing 100% of stocks above their 200 moving average. The probability of a rally continuing with such an overstretched breadth is extremely low.

In fact, the probability is that we’ll see either a pause here or a retrace. If HUI does fall from these levels, it could carve out an almost perfect head and shoulders with the 280 level being the neckline:

Unless you’ve been hiding under a rock lately, you know that gold has been on a tear, hitting multi-decade highs and that gold stocks have been one of the highlights of the stock market. So, you might be pondering, should I buy some gold stocks? or is it too late?

Well, I’m here to tell you… it depends.

On your time horizon, that is. If you’re a nimble trader and will be in and out within a short timer period, then sure, go ahead. Follow your methodology (you do have one, right?) and don’t forget risk management.

If, on the other hand you’re more of an investor and less of a twitchy trigger fingered trader, then based on the k-ratio, I would recommend you stick to watching reruns of Goldfinger. What’s the k-ratio you ask?

It is the ratio of gold stocks divided by the commodity itself. the “k” stands for Kaeppal since it was put forward as a timing indicator for gold stocks in 1993 by Jay Kaeppel in The Technical Analysis of Stocks and Commodities magazine.

In that original article, Kaeppel used Barron’s Gold Mining Index and the Handy & Harman price of gold. Both can be found each week deep in the entrails of Barron’s. But eventhough he used the GMI, you can use any gold equity proxy like the AMEX or CBOE gold indices or even an individual gold stock. I would recommend against using the XAU Phili index since it has a lot of base metals mixed in.

So anyway, why does it make sense to look at this ratio as a timing tool? Well, think of it this way. Gold stocks and gold should have a more or less stable relationship. After all, a gold stock is more or less just a gold mine plus some digging and refining expenses.

By looking at the the ratio we can see when this relationship is out of sorts. For example, if buried gold (gold stock) is being priced less by the market than dug up and refined gold (commodity), then being the smart contrarians that we are, we should take the other side and buy stocks instead of gold.

Using this simple tool you would have gotten in on every single major gold stocks bottom. The last one was in 2000-2001, by the way, just as most market participants’ attention was focused on tech stocks. At that time, the k-ratio hit an unbelievable value of 0.80!

Which bring us to the question, where is the k-ratio now? And what is it telling us?

In a nutshell, it is saying that the time to ride the gold bull market is pretty much over. There is a time and a season for everything. And the time to buy gold stocks for a long term hold was when they were being thrown out by a market enamoured with routers, fibre optics and switches. Not now, when gold prices and gold action is splashed in the front pages of magazines, newspapers and blogs everywhere.

Here’s a chart of the k-ratio using the AMEX gold index:

Kaeppel’s original article outlining the k-ratio. (Reports & Articles)