Trader’s Narrative

A little while ago I tried to separate the effect of the weakness in the US dollar on the price of gold to determine whether gold’s bull market could actually stand on its own: US Dollar’s Weakness or Gold’s Strength?

There is a better index out there to determine this very question. The Kitco Gold Index is the price of gold measured not in terms of US dollars, but rather in terms of the same weighted basket of currencies that determine the US dollar index: Euro (57.6%), Japanese Yen (13.6%), UK Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and Swiss Franc (3.6%).

So instead of pricing gold in the unit of a US dollar, the chart below charts it in the the same unit that we use to measure the US dollar index:

Source: Kitco Gold Index

This is the one year comparison but you can also see a 5 and 10 year chart (follow above link). These both tell the same tale. There is definitely a bull market in gold. But, it has been aided and abetted to a large degree by the weakness in the US dollar. Seen through the lense of other currencies, the gold bull is much more tame.

If you look at a very long term chart of the comparison, it becomes obvious that there are periods where the price of gold in US dollars shoots up only to come back in line with the currency basket. Right now is one of those times.

As you can see, the price of gold in the currency basket has yet to breach the high it set earlier this year. This was something I pointed out when others were focusing on the breaking of the nagging $1000 resistance: Major Non-Confirmation in Gold.

Also, the purest equity proxy for gold, the Philadelphia Gold Bugs Index (HUI), has yet to surpass its highs from last spring (March 13th 2008 - 515). According to the k-ratio analysis of the gold sector, this suggests that gold is ‘overvalued’ relative to gold stocks.

Last week we looked at the breadth of the gold stocks which showed about 80% of them closing above their short term moving average. Here’s an updated chart:

While gold stocks managed to eke out another positive day, breadth slipped from almost 90% to below 80%. Usually, in the past, when breadth has been this stretched, and heading down, there is a good chance that a short term top has been already made.

Gold has the wind at its back right now. Not only has it cleared the challenging $1000 resistance level, it has support from lax monetary policy as central banks around the world clearly hold the health of their economy in higher priority than the health of their budgets or their currencies.

The recent purchase by the central bank of India is being interpreted widely as a vote of strong support for the precious metal. Although I don’t argue against a secular bull market, it is amusing to me that a decision to buy gold at above $1000 is deemed to be a ’smart’ move when just a year ago they could have made the same purchase for 30% less. The fact that almost any news is interpreted as positive for gold has more to do with the prevalent sentiment than with facts.

In any case, before we get to the short term sentiment for gold, here is the recent commentary from David Rosenberg of Gluskin Sheff on the monetary backdrop for a secular bull market in gold:

All India did was bring gold to a 6% share of its total FX reserves from 4%. Fifteen years ago, that representation was closer to 20%. China has increased its gold holdings by 76% over the past six years but they are a mere 1.9% of the aggregate 2.2 trillion of reserves and Russia’s gold holdings is just under 5%. This is not the 1990s when Bob Rubin was running a hard U.S. dollar policy, U.S. fiscal deficits were vanishing and gold production was on the rise. Today’s world is exactly the opposite. Policymakers beginning in the 1990s wanted disinflation and got it. Now they want inflation — it will take years, maybe a decade, but it will come. For the near-term, we are still optimistic on Treasury securities but be forewarned that this view has an expiry date that is earlier than the peak we are likely to see in gold.

It is very clear that central banks are behaving in a way that would suggest that gold is now again being considered a currency within the global monetary system. As we said before, it is all about relative scarcity and a well-defined supply curve — fiat currency at this juncture does not share that quality.

Turning to the breadth in the gold stock sector, you can see that we’ve seen a sudden and dramatic jump from a week ago. The chart below compares the percentage of gold stocks trading above their 10 day moving average with the Philadelphia Gold Bugs index (HUI):

If you’re interested in timing the gold market, then you would be concerned that 82% of gold stocks are trading above their short term moving average. But you would also be alarmed that just a few days ago, that number was below 10%. Historically, gold shares have a very tough time continuing to climb when faced with such short term headwinds.

Turning to sentiment in the gold sector, on Monday when we looked at the arguments that Paul Tudor Jones II presented for his case of a secular bull market in gold, we also digressed a little to check the Hulbert Gold Sentiment index. That sentiment measure was showing a majority in the bullish camp; which from a contrarian point of view means that gold probably will have difficulty in advancing in the short term.

In a similar vein, here is a chart, courtesy of Elliott Wave, which shows the price of gold with the Daily Sentiment Index (DSI). The most recent DSI is 91% which is just about where previous short term tops have been formed:

Similar to the breadth measure (shown earlier) the DSI increased to 91% in a sudden jump (an 8% point jump over a day). Accoding to Elliott Wave, which tracks the DSI, this was the single largest increase since March 19th 2009 (11% point jump from 75% to 86%) when gold made a two month high at $960. With Elliott Wave, not only do you get their analysis of various markets but they do a good job of monitoring DSI, which is a proprietary sentiment metric from trade-futures.com and by itself would costs about $2000/year.

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While we’re on the subject of seasonality and how September is the albatross around the stock market’s neck these days, I’d be remiss to not point out that what has been historically negative for equities has been a boon for gold and gold stocks.

Last year, I also pointed out the positive seasonality of gold in September (and the remaining months left in the year). But, as measured by the Philadelphia Gold Bugs Index (HUI) gold stocks didn’t follow their historical path and finished the month pretty much unchanged. However, in mid-September there was a rally that took the Gold Bugs index 35% higher within the month.

In any case, here is a chart of the monthly performance of gold for the past 5 and 15 years:

If you compare this chart with a longer duration seasonality chart you’ll notice that during this current super-bull market for gold (which started in 2000) seasonality has shifted slightly. For these most current years (red line) there are really two big waves of positive seasonality for gold and gold stocks. The first is about to start while the second comes after a correction in October and lasts from mid-October to February of the following year.

Here’s a chart of the Gold Bugs index with the past two September’s and this year’s marked by a green arrow:

I didn’t bother marking the obvious triangle pattern that has formed in the gold stocks index. Prices are getting coiled into a spring and will potentially break out. However, over-head resistance is just 100 points higher at 475-500 - where the Gold Bugs index hit a wall early last year.

Remember, seasonality, while having a powerful and undeniable influence, is a secondary driver of prices. It is more helpful to think of it as context for the actual analysis of trend.

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.

Here’s a chart of an index of stocks which recently rallied more than 65%. Can you guess which one it is?

For the answer keep reading…

Continue reading ‘Guess Which Index Rallied 65%’