Trader’s Narrative

The poor besieged dollar gets a short reprieve as the gold bull market pauses. But the gold bugs suddenly have an unexpected and persuasive ally in their camp. As an interesting addendum to what’s next for gold? in the most recent quarterly client letter, Paul Tudor Jones II builds a fundamental case for a long term bull market.

He compares the relative historical value of the precious metal to the US monetary base, crude oil and the S&P 500 index. Their econometric model declares “gold is 20% undervalued over the next 24 months”. But the rationale is not restricted to the monetary forces which are at play.

Strengthening his case, he delves into the basic demand and supply of the commodity. On the supply side, mining production has been stagnant for the past 10 years. And central bank selling has slowed to a trickle with no new sales planned in the future.

On the demand side, the physical investment allure of gold continues strong. As well, to that we can add the penchant of modern investors for digital investment in gold. Relative to the gargantuan size of the equity market, the bond market and alternative investments (real estate, timber, etc.) gold’s share continues to be lilliputian. This means that even a sliver of asset flows diverted to gold will dramatically alter the equation.

Source: Tudor Investment 3rd Quarter Letter

Gold ETF holdings as a ratio of above ground stocks has increased incrementally 4 years. And the trend, does not look like it is about to reverse.

While Paul T. Jones presents a text book case for the long term bull based on fundamental analysis, I can’t help but think it is all an elaborate window dressing to rationalize a position he has arrived at through other, shall we say, more esoteric means. Clients obviously prefer logical, well thought out reasons for why a professional is allocating their money a certain way.

No one would be comfortable to be told that their trust fund is being gambled on nothing more than squiggles and trend lines or better yet, something called Elliott Wave (which we know, by the way, that Paul T. Jones II used to make a killing on Black Monday while practically everyone else on Wall Street was busy having an aneurysm). Interestingly enough right now Elliott Wave is bearish on gold.

This is just speculation on my part, of course. I have no way of knowing exactly why Tudor Investments is bullish on gold. Maybe I’m too cynical and we can take them at face value. In any case, even if the long term gold case is solid, you might want to fine tune the entry by looking at the gold sector sentiment.

Here is a chart comparing the price of gold and the Hulbert Gold Sentiment Index, which measures a subset of newsletters which time the gold stock sector:

Source: Risk Management and Convex Return Profiles

While the Hulbert gold sentiment metric isn’t as high as we’ve seen it historically, at these levels it does not bode well for another leg up. At least not without a pause first. As I mentioned before, to me it isn’t just the altitude of the bullish sentiment, it is also the attitude: as gold has corrected recently sentiment continues to reflect the same amount of optimism.

Not surprising after the extremely negative sentiment in the US dollar index, the greenback has staged a modest rally. In response, gold has wilted. Here are few perspectives on what may be next for the precious metal:

Elliott Wave International
Arguing for the bearish case, is Robert Prechter of Elliott Wave International. He writes that since 1913, as shown in the chart below, the purchasing power of the US dollar has eroded by 96% (great job Fed!). If gold had simply offset this loss in purchasing power, it would have to have increased 25 times. But instead gold has multiplied in value by 50 times. Therefore, Prechter argues, it is 50% ‘overvalued’.

This is a strange sort of argument because most gold bugs would say that gold’s strength, the very fact that it has gone up so much, reflects positively on the precious metal. Prechter has had a very hot hand lately in timing the stock market so I’m willing to listen to his argument even if it sounds a bit odd. It appears that he implies that gold’s only sensible ‘value’ is to be the anti-dollar. However, I’m not sure that’s a valid point because as far as I’m concerned, gold is just another commodity with all the inherent susceptibilities to manias and panics we ascribe to other more traditional markets like stocks.

While I’m reticent to embrace this line of thinking, I do agree with something else that Prechter wrote recently about gold:
Continue reading ‘What’s Next For The Gold Bull?’

Proving the old technical analysis adage true that the more a level is attacked, the higher the probability that it will break, gold recently broke through the $1000 ceiling and closed at a new, all time historically high price.

While this got a lot of attention in the media, gold sentiment remains relatively subdued in response. Since gold is the haven sought by dollar bears, the big question is whether this important technical move is a result of weakness on the part of the US dollar or whether it is secular strength from the gold market pure and simple.

The simple way we can look at this question is to strip away the effect of the US dollar by dividing the price of gold by the US Dollar Index, as the chart below shows:

With US dollar sentiment at historic lows, the dollar continues to be about as popular as a leper. In contrast, the yellow precious metal continues to be the belle of the ball. Today it closed at a new, all time high at the Comex. The December futures contract closed at $1045, decisively higher than even the intra-day high in March 2008 (when the fall of Bears Stearns lead to a panic).

Here is a short video covering the recent move and a look ahead at what’s coming up at the hard right edge of the chart (make sure to watch till the end for a bonus):

It wasn’t too difficult to anticipate a successful break above the hitherto challenging $1000 level. An analysis of the investor sentiment in gold revealed a mostly bland response to its advance this time around. Unlike previous rallies.

As well, gold’s seasonality was the wind at the back of its uptrend. However, as you’ll notice from the seasonality chart in the previous link, a pull back is to be expected for gold in October. At least, that’s what has been average historical pattern.

Checking in with the K-Ratio (the ratio of the price of gold to the Philadelphia Gold Bugs index), we see it in neutral territory:

This recent move helps to cement the long term uptrend for gold, however it isn’t smart to chase it higher. Once a decisive break through tough resistance like this is made, it is typical to see a pull back to that level again as it acts as support. With the seasonality weakness about to kick in, that’s what I’d expect to happen. So keep watching this market for a good opportunity.

Also keep in mind that there are many ways to play this. You don’t have to buy gold futures or the Gold ETF (GLD). There are many highly leveraged mining companies that provide a fantastic proxy for this precious metal. The K-ratio still has room to move higher, which means that relative to gold, gold equities are not expensive.

Finally, the bigger picture is the slow decline of the dollar. I expect a rally in the US dollar, especially as the sentiment is so extremely pessimistic. But the long term trend is clear. There are some rumblings in the background that oil producing Middle Eastern countries, along with China and Russia are working together to stop pricing crude in US dollars. As well, the Reserve Bank of Australia wins a gold star for being the first among industrialized nations to start on a tightening cycle.

Earlier in the week we looked at the situation the gold market finds itself in with the precious metal sitting at the important $1000 level. I offered various takes on the technical position as well as the sentiment for gold. Here I want to delve in a bit deeper into the sentiment to see if we can glean whether there is any excess optimism which would flag a contrarian sell signal.

Here is the Google Trends chart for the keywords “buy gold”:

Not surprisingly, the peak occurred in the week of October 5th 2008 (3.66). The keywords: “how to buy gold” also reached a peak a bit earlier on Sept 21st, 2008 (not shown in graph). That’s still around the same time. This was, of course, right around the time that the equity market was getting a shellacking.

The term “stock market crash” reached a peak in Google searches at the same time (October 5th 2008). But right now, while slightly elevated, this makeshift indicator isn’t really signaling an excessively speculative sentiment towards gold. Of course, this is noteworthy because gold is trading about 20% higher than it was in October 2008.

In my earlier analysis of the gold market, we looked at the Commitment of Traders report, MarketVane’s as well as the Hulbert Gold Newsletter sentiment indexes. Let’s take a quick look at several other measures of sentiment for gold:

Rydex Traders
Guy over at the Technical Take mentions the asset levels in the Rydex gold fund. While the Rydex investor is the trigger happy type to jump on a trend, either long or short, there is no evidence that they have piled on gold at this time. There is only about $200 million in the Rydex Precious Metals Fund. I agree with Guy, there is a distinctive lack of froth.

Put Call Ratio
The put/call ratio for gold is also in neutral territory. This is the options data on the futures contracts which is about as speculative as you can get considering the built in leverage. There was a slight uptick in call buying as gold made its latest move towards $1000 but even as that level has been pierced, the put/call ratio has backed off (traders are less optimistic).

Conclusion
The consensus from several different measures of gold sentiment is that there is mostly a shrug of the shoulders from traders and investors in reaction to the latest rally in gold. The only conflicting data point is the CoT report which shows small speculators in the futures market heavily long gold contracts.