Gold & Silver Update: Paring Gains Into Meltup

Since we’ve had some changes in the gold and silver markets, especially with regards to sentiment, I thought I’d update my thoughts on the two precious metals that have so many traders captivated right now. Today gold reached the round number and new record of $1,500 per oz. and silver has blown past $40 on its way to who-knows-where.

If you’ve been reading my recent comments you know that I’ve been rather bullish on gold for some time now. Up until recently gold’s rise was met with lukewarm sentiment.

Looking at the futures market for the precious metal, both commercials and large speculators have a neutral position. But the small speculators have upped their net long exposure to a multi-year high. But even more alarming than that, several sentiment measures for gold are now approaching bullish extreme.

Among them the Daily Sentiment Index (from trade-futures.com) which hit 95% this week. This means that the retail trader is almost entirely leaning into the rally now and with almost certainty expecting more price appreciation.

Rydex traders provided us with some reassurance of the rally’s staying power (in a contrarian way). As gold was climbing higher, Rydex traders who are usually very fast to jump on hot and trending markets were not adding to the sector’s fund. On further reflection, I’ve come to realize that a large part of the lethargy can be explained by the relative weakness of gold stocks compared to the commodity itself.

That is , if we use the Rydex Precious Metals fund unit value as a proxy for the gold equity market we see that while gold is significantly above its November 2010 levels, this Rydex sector fund is back to its November levels (or even slightly below them). So investors in gold are doing much better than investors in the Rydex Precious Metals fund (or for that matter almost any gold sector equity fund).

Considering this, can you blame the Rydex investors for not being too enthusiastic about the Precious Metals fund?

Of course, if in spite of this we saw them piling in with the hopes of equities catching up or overtaking the commodity, then it would be a huge red flag signaling an extreme and unfounded bullish bias. But at this point, what I see is a fairly persuasive argument why the apathy we are seeing from the Rydex traders may not be all that supportive of gold’s continuing rise.

If instead we look at the rate of change in the asset of the iShares Gold Trust NAV History (IAU) we see something different. As opposed to the Rydex Precious Metals Fund, this ETF tracking gold has both outperformed gold equities and it has garnered a significant following once again. Today it holds appx. 134 tonnes of gold whereas at the low in January it had 116 tonnes. The 40 day rate of change is suggesting a market top in sight:

Hi-Yo Silver Away!
Right now the silver market is probably the strongest bull market out there. Every single day it slices through resistance like a hot knife through butter. I’ve already written about the parabolic characteristics of this market and why I’m staying away from it. There is no doubt that it is exhibiting a classic blow-off bubble mania pattern.

Right now sentiment for silver is at an astonishingly bullish level. We are seeing excitement that meets and exceeds previous silver tops in April 2006 and February 2008. Similar to gold, the Daily Sentiment Index for silver reached 95% this week. As well, the Silver Market Vane Concensus sentiment indicator breached 93% level in its short term (10 day) trend line.

The rocket ride higher has stretched price above its long term trend to the breaking point – again similar to those previously mentioned important tops. Here’s the updated chart of silver showing its relative distance from its trend:

The trick is that with such patterns it is extremely difficult to pick the exact time that the pattern will implode and unwind. Entering into such a market brings with it extreme risk either way. If you go long you risk seeing a massive reversal blow off any semblance of hope you had for a stop-loss. If you go short, the market volatility can easily go past (way past) your uncle point because the final segment of a parabolic top is the most volatile by its very nature.

Point in case is my expectation that $40 would both act as a round number magnet and as resistance. Silver blew the lid off $40 – so much for that idea. Anecdotally, the extremely negative reaction I get from readers towards my reticence is also quite telling.

Those that bring up fundamental reasons for the continuous rise in silver have to believe the most dangerous words in trading “this time it is different”. They have to believe that price can not go up an incline approaching 90 degrees and sustain itself. Of course it can’t. We’ve seen this in all sorts of markets from commodities, to forex to equities and in the brilliant fractal nature of markets, it is visible in all time frames.

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2 Responses to Gold & Silver Update: Paring Gains Into Meltup

  1. Wes says:

    Babak,

    It looks like the driver of the PM market is the US dollar. Until the dollar can put in a meaningful low, I think the PMs continue higher. There is no question that a correction (in both PMs and the dollar) is due at almost any time, and while I think it will be deep, I also think it may be brief.

    What do you see that may turn the dollar ? Anything before the end of QE2 ?

  2. Jim says:

    Wes, it seems to me like the bottom for the dollar could start any day. If this 74 area doesn’t hold, I think the 72 area should offer a good deal of support.

    Typically, the dollar forms a bottom over 1-3 months, so I wouldn’t be in a rush to pick the bottom. Take a look at how the bottoms form over the past 3 years, for example:

    http://stockcharts.com/h-sc/ui?s=$USD&p=D&yr=3&mn=0&dy=0&id=p53446022871

    However, I think commodities like silver will peak when the dollar *starts* its bottoming process, so if you’re leveraged to commodities I think anticipating the dollar bottom becomes more important. JMHO

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