Trader’s Narrative

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:

The new Market Vector Gold Miners ETF is the first ETF to track the gold mining sector. It replicates the AMEX Gold Miners Index (GDM) which is composed of 43 individual precious metal stocks. The ETF’s creator, Van Eck Global, is well known in the gold community since they were also the first to introduce a gold mutual fund, way back in 1968.

One of the advantages of this ETF is that it is more skewed towards the smaller capitalization gold stocks (compared to say the XAU). and should therefore provide more beta. It is also a good way to play the coming gold stocks bounce, if you don’t want to bother with individual gold stocks.

As I expected, today gold stocks rebounded sharply from their oversold levels. The intraday price action in Glamis Gold is a good example of how one can key off longer term technical indicators but trade in a very short time frame intraday. This provides a context above and beyond the usual short term entry signal. Such layering of signals increases the probability of a profitable trade. As well, by trading in a smaller timeframe risk can be defined more narrowly - which in turn allows for potentially higher +R trades.

This morning, Glamis gapped up with a wide range and positive candle. The second candle provided an opportunity for an entry (buy above green line) with limited risk (stop loss below red line). If you look closely you might notice that the low of the third candle actually was below that of the second candle. However, since this low was made before the entry, the stop loss would not have been triggered.

Gold stocks (as measured by the Gold Bugs Index) have now closed down for eight consecutive trading days. This has taken the HUI from a high of 400 to striking distance of 300.

The good news is that the bullish sentiment that accompanied the recent highs in the gold index, has for the most part evaporated and been replaced with reticence. As measured by the Hulbert Gold Newsletter Sentiment Index, bullish gold sentiment has fallen from a high of 73.2% to 8.93%. Likewise, gold sentiment, as measured by Market Vane, shows a significant and sharp drop in bullishness. This is what you’d want to see if you’re looking for a bottom.

The technical picture also looks promising. Taking a look at the % above their moving averages, we find that there are zero above their 10 day moving average, 15% above their 50 day moving average (but appx. 90% remain above their long term 200 day moving average). This is supportive of an intermediate to short term bounce.

Turning to the k-ratio (approximated using HUI and price of gold), we see that it has fallen significantly. This tells us that gold stocks have fallen more than the commodity itself and are therefore more attractive than gold (relative to just a few weeks ago). The k-ratio is not as low as last April and May, but it is in an area of support.

Finally, to round out the positive outlook for a coming bounce in gold stocks, as I look at the individual charts, I see hammers everywhere. Most obvious, the HUI itself has put in two daily hammers back to back. If the high of the hammer is exceeded and the close is positive or if there is a positive engulfing pattern this week, that would be a very good confirmation signal.

The only negative I can find is that May and June in the seasonal chart for gold are not very favourable. The best time for gold, historically, has been September to October. But all this may mean is that if/when gold stocks do rise, they may not have the added boost of a rising gold price.

Ticker Sense mentioned that according to the Merril Lynch’s monthly survey, investors’ optimistic sentiment is now down to six month lows. As well, 70% of those polled said that they expect inflation to rise this year. “This is the highest level since March 2005 which coincided with another short-term spike in interest rates.”

I’m not surprised at all to hear that since I mentioned previously that according to the COT and other techincals, the yield of the 30 year Treasury bond is headed for a tumble.

The sentiment on inflation also dovetails nicely with something else which has already started to play out: the weakness in gold stocks. According to the k-ratio, gold stocks were rather stretched and were headed for a tumble. Since I wrote about it, the Amex Gold Bugs Index has fallen from 387 to less than 340.

As you have probably surmised, these two seemingly separate markets are actually very much related because they both key off inflation.

In fact, if we compare the the Amex Gold Bugs Index and the 30 year Treasury bond yield, we see that around March 2005 (when inflation fears were as prevalent as now) they both made an intermediate top.

For many, this intermarket relationship is a fact and therefore assumed to be a give. Yet, for me it is fascinating that different technical tools can, in the end, guide us to the same conclusion and in essence, reiterate the relationship.