Renting Gold For An Opportunistic Trade Higher

I’ve been stalking gold during its most recent correction. In early December I cautioned saying that it seemed gold was making a top. That proved to be a very good call as gold did top out at $1424. I followed up with the suggestion that since gold sentiment was quickly retreating in the face of a limited retracement in gold price, the correction would probably be shallow.

There are indications now that this newest correction in the secular gold bull market is very close to ending. I’ll outline the reasons starting with the technical overview of gold prices.

Technical Support
For the past two years, a clear uptrend (blue line) has provided support in previous corrections. As well, gold has fallen to within touching distance of the Fibonacci 38.3% retracement level (if we take its recent high and the July 2010 low.

Zooming out a few more years we see that the previous trendline is approximated very well by the 200 day moving average and gold has been able to stay above this important long term trend for most of its bull market:

The lower pane shows the relative distance of gold from this 200 day moving average and how most of the time, it is able to stay above it. The one big exception was the correction that came in late 2008 (red circle). By the way, this holds true for gold stock indexes like GDX, HUI and GDXJ as well.

Apart from technical reasons to expect the correction to have run its course, we have a confluence of several sentiment indicators. Most of these we’ve already discussed previously.

CEF Discount
The Central Gold Trust (GTU) has once again fallen to a discount on the NYSE. Unlike the SPDR Gold Trust fund (GLD) this is a closed-end fund and it can trade at a premium or discount. Obviously, when traders feel pessimistic, they sell even when the assets of the fund are higher than the market price. The discount is small (2.5% for today) but we haven’t seen this since much of a discount since August 2007 when gold was trading hands at around $660 per ounce.

Tonne of Pessimists
According to Reuters, the SPDR Gold Fund (GLD) had its largest one day decline on January 25th, 2011 with a loss of 31.3 tons to fall to an 8 month low (1229.6 tons). Here is a chart showing that the tonnage held by the fund has fallen much more than the fund’s total value:

Another way to look at the same data is by looking at the 2 week percentage change in tonnage held by the fund. As this chart from McClellan Financial shows, this has been a remarkably accurate indicator of major corrective lows in gold for the past two years:


Source: McClellan Financial

Committed
The latest Commitment of Trader’s report from the CFTC shows that commercials (considered the ‘smart money’) have reduced their net short positions to its lowest levels in more than a year. Since they usually hold net short positions, what is important is how net short they are. Large speculators in contrast have reduced their net long positions to its lowest levels since the summer of 2009.

Rydex Traders Bail
The excitement from Rydex traders was one of the main reasons why I became suspicious of a top back in early December 2010. Just two months later, these same group of investors have now drastically reduced their holdings in precious metal stocks. While gold has fallen 8% from its recent top, the assets of the Rydex Precious Metals sector mutual fund have fallen 45% over the same period.

According to Jason Goepfert of SentimenTrader.com, Rydex traders have bailed on this sector at such a rate that it accounts for just 13% of total sector assets within the Rydex family of mutual funds. Two months ago, when gold topped out, the Rydex Precious Metals sector mutual fund accounted for 25% of total sector assets.

Gold Sentiment
As you would expect, considering the way that the preliminary surveys showed a few weeks ago, the public’s reaction to the latest weakness in gold has been to walk away. Even though gold is still in a clear secular bull market and trading close to all time highs, the decline in price has been protracted and lengthy enough to push most of the retail investors into the pessimist camp.

What Could Go Wrong
To play Devil’s Advocate, there are a few caveats. First, I’m not suggesting that you go out and rush back into the gold market or scoop up gold stocks. I’d prefer to see some firmer trading and a confirmation. I do think we are close to that.

But here are a few things to watch out for. First, we are in a really bad time period when it comes to gold seasonality. The best time period was a few months ago but now gold bugs have the wind in their face as opposed to at their backs.

Marc Faber thinks that the gold correction isn’t over and gold will correct, top to bottom, 20%. That would mean falling back down to $1140, below previous low. This would be similar to the deep correction we saw in late 2008.

Usually gold stocks follow the general stock market. And if the general stock market is extremely overbought – as I and many others believe – then owning gold stocks may not prove to be much of a defensive posture.

Finally, if the 200 day moving average doesn’t provide enough support to halt gold’s correction, then we may need to go much lower. That is what happened in late 2008. See the ominous red circle in the top chart.

The scenario is supportive of an upcoming opportunity for gold bugs to ride another wave higher. But for that to happen, we’d have to see a confirmation that long term support is once again taking effect.

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3 Responses to Renting Gold For An Opportunistic Trade Higher

  1. DoctoRx says:

    Thanks for the updates, Babak. Good work!
    True “gold bugs” hardly care about the price relative to USD. Probably more relevant to them is price vs silver, oil, farmland, etc.
    To speak like a goldbug if I can, gold is real money/store of value and paper money is worthless. Interest on paper money is paid in more paper money, they say, simply perpetuates the Ponzi of unbacked fiat money. It’s kind of a church (gold) and state thing.
    I am curious as to whether you are able to track the HGNSI more often than is publicly released via MarketWatch etc. I would guess that almost all newsletters are cautious to short-term bearish.

  2. Trendsman says:

    Great blog…

    But gold stocks do not always follow the stock market. They went up from 01-02, early 08 and at the end of 08 and early 09.

    Gold stocks are down 20-25% but the stock market hit new highs. This is a clear divergence to the theory. Today, stocks are getting killed while precious metals are enjoying a nice rally.

  3. Pingback: Sentiment Overview: Week Of February 11th, 2011 | tradersnarrative

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