Gold’s Consolidation Setting Up Short Term Opportunity

Gold started the year off on the wrong foot. On January 4th the precious metal had the largest single day’s decline since July 2010. That shouldn’t have been surprising since there were several signs that gold was on thin ice.

In early December I wrote a negative piece on gold: Gold Looks Toppy. At the time, gold was trading around $1425.

So far gold hasn’t fallen dramatically but entered into a sideways correction phase. This is in line with my thinking. As I wrote back on December 8th, there was little conviction, from a contrarian viewpoint, of an impending dramatic decline:

…at the moment, there isn’t a very clear picture of gold from the various indicators we surveyed. Usually when faced with such a frustrating lack of edge, I stand aside but if I had to insist on taking a position it would be short term bearish.

But at the same time there were certainly signs that the bulls had overdone things. Among these was the Bloomberg gold sentiment survey which reached a peak of 90% bull ratio on December 31st 2010. As well as the enthusiasm of Rydex traders.

I wasn’t the only one who thought gold was on perilous footing. Just one day before the big fall, Mike Drakulich of EWI’s Metals Specialty Service wrote:

“I think we either have to top and reverse lower very soon… I will use a topping arrow for today. We are a critical short-term juncture. I suggest watching very closely to see if a sharp reversal might occur here at any time.”

That was of course, spot on. So where does gold stand now, after a month?

The small correction (or more accurately, sideways consolidation) has actually provided wrung out a surprising amount of bullish sentiment. If we check in with the Rydex traders, we see that they have dramatically reduced their dedication to the precious metals sector:

The chart above compares the total assets of the sector fund (in millions) with the SPDR Gold ETF (GLD). The most recent correction is just the start of what is usually a much more protracted decline in assets. So far, we haven’t seen a real abandonment of the sector from Rydex traders.

On the plus side, the SPDR Gold ETF (GLD) is down about 4% from its recent high. In contrast, the total assets of the Rydex Precious Metals fund is down about 15% from its recent high. So we are seeing an asymmetrical reaction. But from a contrarian viewpoint that’s just a good start.

As well, the Bloomberg sentiment poll has also reacted to the fall in gold price. The bull ratio adjusted this week to 42% from more than double that the previous week. The last time it was lower was on December 17th 2010.

Stealth Correction
The composite sentiment indicator from SentimenTrader is relatively low at 69.63%. Frankly, I’m surprised that it isn’t higher since gold is trading very close to highs – or at least it was. So here the gold bugs have some vindication that bullish sentiment isn’t as high as it merits, considering the strength of gold.

Most importantly, breadth in the sector is suddenly extremely poor. As of yesterday, only 8% are trading above their short term moving average (10 day). And just 23% are trading above their 50 day moving average.

From a longer term perspective, we still see breadth quite healthy with 62% of components trading above their 200 day moving average. Considering that gold is still assumed to be in a bull market, whenever the shorter term breadth indicators have been this oversold, we have seen a rebound in price.

In recent history, the last time this confluence of events took place was in late January 2010 and late July 2010. Both of those were the end of a corrective phase and a good time to go long.

Overall, it is surprising that a stealth correction has arrived via a sideways consolidation spanning October 2010 to January 2011. Short term sentiment has already reacted sharply while long term sentiment is not overly bullish. Breadth meanwhile continues to be supportive of higher prices.

The only caveat I’ll add is that gold equities move surprisingly in line with the general equity market. So if we expect the market to fall, then hiding out in gold stocks is not a good idea. I’m still not completely won over by the aggregate data but with just a few more down ticks from breadth and a give up from the Rydex traders, I’ll be happy to clamor on board once again and even call myself a “gold bug” again for a while.

Chuckles and Grins
Finally, if you haven’t yet, check out Colbert’s YellowLine commercial about the banana shortage and how you can cash in.