Trader’s Narrative

Isn’t gold supposed to be a haven in times of stress? you know, real money? What happened then? why didn’t gold skyrocket to $2000 oz.? if it isn’t going to go up when the world’s financial market is in meltdown, when is it going to go up? The answer deduced from market history is that gold’s role as a safe haven is simply a myth.

It speaks to gold’s weakness in this market that it bucked the seasonality trend that I pointed out for the month of September. The AMEX Gold Bugs Index (HUI) - the only index which is comprised of only gold stocks - started and ended September at pretty much the same level.

My favourite indicator to time the gold market is the k-ratio. To understand how, check out the previous link. Here is a long term chart:

The k-ratio held almost constant, treading sideways for five years as both the numerator, gold stocks, and the denominator, gold prices, kept pace with each other. Because I was using this indicator to time the gold market, I lost some money because I didn’t see a fundamentally attractive opportunity at those prices. While it was painful to watch this historically reliable indicator, it has once again proven its merit. This is probably what people went through when it continued going lower and lower in the late 1990’s and 2000.

So what accounts for the collapse of the k-ratio? While gold has fallen around 4% for the year so far, gold stocks have fallen almost 50%! Believe it or not, that’s actually more than the equity market (S&P 500 Index). A large part of this is probably due to the forced liquidation that we witnessed in the markets last week.

Ironically, now that gold equity prices have fallen this much, the k-ratio is at levels last seen in late 1998 to 2002 - when the gold price was ~$250! The current gold price is more than 3 times that.

The AMEX Gold Bugs Index (HUI) has strong support at 175, which would mean the k-ratio to the low 0.20’s and once again, it could set up as a buying opportunity. I really don’t think we’ll revisit the lows that the k-ratio set in 2000 because that was due to a huge asset dislocation (thanks to Greenspan’s bubble).

As gold was rocketing higher last year, I was unimpressed because I thought that it was not the sort of thing that could be sustained. Although I was wrong in predicting weakness for gold and gold stocks.

Equally wrong were the predictions of emboldened gold bugs. After hitting the magical four digit milestone in March, gold fell on hard times. If you’re like me, then you see the precious metal as just another trading vehicle, without the need to get into philosophical debates about its role in the world or economy.

According to historical seasonality, one of the best instances of such trading opportunities in gold is about to set up:

As you can see, for most of the year gold goes sideways, flopping around and making everybody dizzy. Then towards the end of August and the beginning of September, it rockets up almost vertically only pausing a bit to finally close the year strong.

That’s certainly what happened last year:

But remember, while this is a rhythm observed over time and smoothed out in an average, it does not mean that every year has to follow the same script. That beautiful chart showing long term seasonality hides a lot of cross-currents as well.

The AMEX Gold Bugs Index (HUI) is in a good technical position, right at support levels to launch another leg up to the 500’s:

After flagellating myself for too much bearishness, the last time I wrote about the yellow metal I mentioned that I would be returning to it when it presenting a buying opportunity:

The best combination of breadth is strong long term (200 day average) and weak short term (10 and 50 day moving average). A good example was in mid December 2007 when there were only 10% trading above their 50 day MA and 5% above their 10 day MA with a very high 60% above their 200 day MA.

I’m keeping a wary eye on this sector until it presents a similar setup and will post about it.

After its top in March, the Philadelphia Gold Bugs Index (HUI) fell almost 20% in the span of a few weeks. And since I was distracted, I missed the opportunity to write about arriving at the exact oversold condition that I described above.

But since things haven’t significantly changed in this sector, let’s have a look. The commodity itself fell from a high of almost $1034 to $876 and it pulled down gold equities with it:

Gold Sector Breadth
We now have almost 60% of gold stocks trading above their 200 day moving average. So as described above, the long term is still in good shape.

And the short term is weak: in early April, only 10% were trading above their 10 day moving average. Similarly, only 20% were trading above their 50 day moving average.

Since then of course, they have moved up slightly but neither is so far extended to remove the oversold opportunity.

Gold Bullish Percent
The recent decline in the Philli Gold Bugs Index (HUI) also caused the bullish percent index (BPI) for the sector to kiss the 30% line iin early April 2008.

Historically, when the bullish percent falls to this level or lower it is a good time to “rent” some gold stocks. The previous instance was in January 2008.

Since there is nothing magical about this 30% area, the BPI can crash through it to reach significantly lower levels. For example, in October 2007, the gold BPI fell to almost 15%.

Getting back to today’s conditions, since earlier this month the BPI has recovered along with gold and gold equities. But we are still at a low enough stage that catching and riding a rally are possible.

Gold Sentiment
According to Mark Hulbert, the newsletters that write about gold and time this sector are now quite bearish. The Hulbert Gold Newsletter Sentiment Index (HGNSI) is now at -17.2% - meaning that these newsletters are now actually recommending their clients short the market.

While the all time record for pessimism comes in at -31.3%, this measure of gold sentiment has been lower than the current reading only 2% of the time in the past 20 years.

Since gold is clearly in a secular bull market, such a quick retreat after a ~20% drop shows that there is a complete lack of stubbornness on the part of the gold bulls. Which from a contrarian measure is very promising for the continuation of the gold bull market.

So when you have breadth, bullish percent (an alternative measure of breadth) and sentiment all congruently pointing one way, you have a pretty good chance for a profitable trade.

Time to ‘fess up. I’ve been horribly, horribly wrong on gold. So much so that now I’m afraid of being labeled a contrarian indicator!

So let’s see, in December I thought I saw a tentative double top in gold… which didn’t materialize. Instead, gold paused by trading sideways for a month and then continued blazing higher and higher:

To be fair, a double top formation is only triggered when the neckline (the dotted line on the graph above) is pierced. Since that didn’t happen, we didn’t officially have a double top, at least according to the widely accepted definition within technical analysis.

That doesn’t absolve me as I’ve been skeptical of a continuing gold bull market. And I’ve been wrong, wrong, wrong. Gold’s climb has been unrelenting. Just today it closed at $949.20 on the Merc, taking it within a nugget’s throw of $1000.

But while the price of the commodity is 12% above the swing high in November 2007, gold stocks - as measured by the Gold Bugs Index - are barely peeking above those levels. So if you’ve owned any gold equity, instead of the metal itself, you’ve lost out on a lot of money.

The k-Ratio
The discrepancy can be seen in the k-Ratio which shows a slightly downtrending chart (in the short term):

Since the k-ratio has entered a channel, the easiest strategy is to buy gold stocks only when it approaches the “floor” and to sell them when it hits the “ceiling”. I’m hesitant to venture into any trades with a longer time frame since I’ve been clearly off my game on this sector.

I think my mistake was that I used the k-ratio’s valuation message to mean that gold’s trend couldn’t continue. Boy have I been schooled. The valuation is still high - historically - but that doesn’t mean that a trend can’t continue. The k-ratio is an amazing tool but it is really useful in giving you the really big picture. For anything more granular it falls apart.

Seasonal Pattern
Surprisingly, the rise we’ve seen in the price of gold has been against the headwinds of seasonal patterns. Historically, the period of time from the end a year to the end of March of the next year has been a very bad time to be long gold. It is exceptions to such seasonality “rules” that remind you that the market doesn’t have to follow any dictates, no matter how well founded.

In case you’re wondering, the best time in the calendar to go long gold is at the end of August and into October. Traditionally, this short time frame has provided the biggest boost to the price of gold. But right now the summer is way too far away for me to use it to place any bets.

Sector Breadth
Finally, as an attempt to peer into the fog of future prices, lets do a quick review of the current breadth in the gold sector.

Almost 86% of the gold stocks that comprise the sector are trading above their 200 moving average. Since this is a strong bull market, the percent of stocks above their long term moving averages has been consistently high with only a few short blips lower.

In January it even reached the rare maximum: 100% - around the time that the Gold Bugs Index (HUI) topped out at ~480. This statistic tells me that if I want to go long gold stocks for an intermediate time frame trade, this isn’t it. Not even close.

Thanks to today’s strong close, 100% of the gold stocks in the sector are trading above their 10 day moving average. At the beginning of the month, that number was less than 10% - so again, this is not a good time to go long, even for a short swing trade.

The best combination of breadth is strong long term (200 day average) and weak short term (10 and 50 day moving average). A good example was in mid December 2007 when there were only 10% trading above their 50 day MA and 5% above their 10 day MA with a very high 60% above their 200 day MA.

I’m keeping a wary eye on this sector until it presents a similar setup and will post about it.

Gold futures (December contract) closed higher at $709.70 an ounce today and dragged with it gold stocks. While many journalists claim it was today’s atrocious jobs data, I doubt it.

That explanation may be neat and tidy but it is useles since gold and gold stocks started this short term rally a while ago, before any attention was focused on economic data.

Most probably the real reason why the gold sector has been doing well lately is that it was extremely oversold. In mid-August when I wrote about gold and gold stocks getting clobbered, I ended by saying:

…right about here I think gold stocks are ripe for an oversold bounce. Nothing fancy, just a tradeable rally.

Within the Gold Bugs Index (HUI) zero gold stocks closed above their 10 day and 50 day moving average. And only 7% closed above their 200 day moving average. Wouldn’t it be hilarious if gold stocks rallied along with the stock market?

Maybe not as hilarious as profitable. Hope you got yours.

Now the gold bugs are getting excited but I find no reason to join them in believing that gold is going anywhere in the medium to long term. For one, it has worked off a very extreme oversold technical condition. Now we have 50% of gold stocks above their 200 moving average. When I told you about this upcoming bounce there was only around 10%.

The other reason is that both gold and gold stocks are still mired in a trading range. By the time they make it up to the upper resistance level the technical picture will be overbought and they will get slapped back down again. Had this mid-August technical oversold condition occurred when the AMEX Gold Bugs Index (HUI) was just below 400, things would be very different.

The final reason is that according to the k-ratio that I’ve mentioned many times, the gold bull market is over.