Trader’s Narrative

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.

The US dollar has fallen to its long term support. And I do mean long term (see chart below).

Since the early 1990’s it has approached this level 5 other times. In all but one case, it has reacted by bouncing off support.

The exception was in 1992 when for a short time the index breached the 80 “line in the sand”. But it then bounced above and went on to rise much higher. A classic bear trap.

Right now we are still above 80. History is our guide but anything can happen in the markets. We could bounce higher, we could go lower or we could just sit here at these levels for a while.

What I’m going to be watching is sentiment. Keep a watchful eye for negative articles or even better headlines and cover stories about the dollar. Or about the debt held by China.

The best contrarian signal the longs could hope for would be a very negative cover story in a general interest magazine like Time or Newsweek. Maybe Business Week will pull through as it has so many times.

Since the dollar and gold are intricately linked, any bounce for the dollar here will be the final nail in the coffin for the gold sector. But then again, that massive consolidation in the Phili Gold index (HUI) could turn out to be a bull flag. I doubt it. But who knows.

Click to Enlarge Graph:

Before I delve into this, let me go back to my previous call in this sector (blog accountability and all that jazz). Last year, at the beginning of July, I wrote that the gold sector was in for a rough patch. At that time, the AMEX Gold Bugs Index was trading at around ~340. I drew a neat little head and shoulders pattern, implying that it would head down to form the right shoulder.

The HUI did carve that right-hand shoulder but it didn’t complete the measured move, instead it bounced off the neckline. All in all a pretty good call. I’d say it deserves atleast an A- — but I’m biased

Today, the picture isn’t any brigher. If you’re a gold bug, I’m afraid you’re in for some (more) disappointment.

Although gold futures have bounced a bit, they’ve bumped their heads on serious resistance in the $700-$725 level. If you look at the relative performance to the equities market, you notice that things have been very lukewarm for gold bugs. As well, there is the recent matter of a massive short position by the commercials . According to the latest commitment of trader’s report, they’re as short as they have been at previous intermediate highs: late February 2007 and May 2006. One thing you do not want to do, is to bet against the commercials in any commodity. Unless you actually want to lose money.

The gold equities (as shown by the AMEX Gold Bugs Index) have been pretty much mirroring the commodity. Unless we see a decisive breakout from this range, money in this sector is wasted. Again, notice the relative performance compared to the S&P 500 Index.

If we combine the two graphs we get the k-ratio (not shown). And it is telling us the same story. Not a good time to be in the gold market. The breadth of the sector also confirms this with 60% of gold stocks being above their 200 day moving average. The best thing we can look forward to is more meandering.

But gold bugs are nothing if not tenacious. So while the equities are partying like its 1999 — with the Dow blasting through 13,000 today — a select few will choose to be “smart” and sit on their long positions in gold or gold shares, sneering at the equity bulls. Oh well, I guess that’s what makes a market.