Investing to Wealth

I was going to talk about the sentiment surrounding gold in the weekly sentiment overview but eventually the topic grew so much that it deserved its own space.

First, I’ll present various sentiment surveys measuring the mood surrounding gold. Then some not so traditional gauges of sentiment such as price targets and specialized investment funds.

Then I’ll go over a simple technical indicator which has reliably found significant tops in gold and see what it is saying now. And finally, we’ll look at the correlation of asset classes and what that means for gold.

Bloomberg Gold Sentiment
The recent survey of Bloomberg terminal users found an overwhelming 94% of them to be bullish on gold. This is a new record high since Bloomberg started this survey in 2004.

However, before we rush to use this as a contrarian signal, it merits to consider that it hasn’t been a not very good as a contrarian indicator in the past. The closest it has been to the current high was at the start of the year in January 2009 when it reached 91%. Then, gold was trading at approximately $900. And yet the consensus is so bullish, that while there is no clear cut contrarian pattern this is definitely noteworthy.

Daily Sentiment Index
Moving on, the next sentiment gauge is the Daily Sentiment Index for gold. According to Elliott Wave International (who by the way, are offering a limited time, free report on the 100 safest US banks):

Gold’s rise has now engendered back-to-back days of 97 percent bulls, the first time this has occurred in the 22 years of Daily Sentiment Index data that we have from MBH Commodity Advisors. Today’s $1153.50 high is within the $1151.90-$1167.56 range we discussed Monday night. The lower end of the range is where waves 5 and 1 are equal, while the upper end is where wave B (circle) would be 1.382 times wave A (circle), the most common wave relationship in an expanded flat (see EWP, p.46), as noted in the previous Update.

So, gold prices are right there. Whether or not there is one final spike that results in the price peak and the trend reversal, we are uncertain. But we’ve seen the grip of this manic fever many times before, most recently with respect to oil into its July 2008 peak and subsequent crash, so we know the progression of the psychology. By the time wave C (circle) down is complete, pessimism toward gold’s prospects will be as deep as current optimism is high.

Hulbert Gold Newsletter Sentiment Index
The HGNSI, which measures the position of newsletters which try to time the gold market in the short term, is now more bullish than it has been the past four times that gold hit resistance.

The current HGNSI stands at 68% which is slightly higher than in March 2008, when gold corrected about 16%. To put this into perspective, consider that the HGNSI spent most of February 2002 at 89.58% bullishness - the highest this indicator has ever reached. Gold started that month at $379 and fell to $323 by April. It wasn’t until September of 2002 when gold overtook the previous high of $380.

While the Hulbert Gold Newsletter Sentiment is not the highest it has ever been, it is elevated enough, relative to previous recent highs to be a cause for concern. Especially if we see it continue to be stubbornly high as gold prices correct.

Dylan Grice’s “Price Target”
Recently the Societe Generale analyst wrote a throw away comment about gold which has been latched on to and repeated ad nauseum to deafening tone thanks to the internet and blogger echo chamber:

The US owns nearly 263 million troy ounces of gold (the world’s biggest holder) while the Fed’s monetary base is $1.7 trillion. So the price of gold at which the US dollar would be fully gold-backed is currently around $6,300. Gold is very cheap — at current prices, the USD is only 15 percent gold-backed

While everyone has mistakenly interpreted this to mean that Grice is putting a price target of $6,300 on gold, it is far from what he’s actually saying. If you read his full analysis, he says this in the context of the role that central bankers have played in the gold market:

Central bank hoarding of gold in 1970 ushered in the famous gold bull market. With central banks likely to be net gold purchasers in H2 2009 for the first time since 1988 the same starting gun is ringing out today. The price at which the USD would be fully backed by gold (as it was during the peak of the 70s mania) is $6,300. So there is a case for gold being “cheap.” Moreover, the 70s bull market was facilitated by tight energy markets, overly accommodative central banks and nervousness that policymakers had lost their way. Sound familiar?

In 1965, concerned at the inflationary policies of the US and the attendant threat to their dollar reserves, the French central bank started converting their dollars into gold. This set in motion events which saw the central banks of Belgium, the Netherlands, Germany, and eventually Britain doing the same in 1970. By 1971, the Bretton-Woods system, by which all currencies were pegged to the dollar and the dollar effectively pegged to gold, had broken. The French had fired the starting gun for the great 1970s bull market in gold and silver.

Here’s a chart to illustrate the above argument:

You can read the full report entitled “Worst-case debt scenario” from Societe Generale (SocGen) by downloading it for free from the Trading Resource Section (Reports & Articles folder).

In any case, the point I’d like to draw your attention to is the type of sentiment that has to be so pervasive for such a comment to be given such lavishing attention. Those that have been around the block a few times will recall the astronomical targets that were placed on tech stocks in 1999-2000. Back then, analysts would outdo each other in an attempt to gain notoriety and attention for themselves and their firms. The most famous of them is Henry Blodget who after being charged with fraud and settling out of court, was barred from the securities industry.

Although Grice admits that the rationale that brings him to the rarefied $6,300 “target” is specious and that it is simply an intellectual exercise, it is fascinating that everyone turns around and trumpets Grice’s words as a prophecy. The twisting of meaning and the unblinking acceptance of such a target on the flimsiest of reasoning, is telling of the very bullish undertones in the gold market.

Paulson’s Specialized Fund for Gold
John Paulson has recently announced plans to seed a new fund specializing in gold and gold stocks with $200-250 million. He already owns a chunk of gold and gold shares but this will be standalone fund with a cadre of top notch analysts head hunted from Credit Suisse and HSBC.

When Wall Street starts to create specialized funds for specific investment purposes, we have a tell tale signs of a top. This has happened over and over again so much so that there is a Wall St. maxim: when the ducks quack, feed them. For more examples, see Don’t Buy What Wall Street Sells. While Paulson is no average investor and this is not a run of the mill, retail ETF investment vehicle, the concept stands. Ask yourself this, would Paulson have been able to attract investors for his fund when gold was trading at $250?

Technical Analysis of Gold
Having exhausted the sentiment side of the analysis, let’s turn to the tape itself. With gold rocketing higher, climbing the price chart almost vertically, it has created a rare situation for itself: the relative distance of price from its 200 day moving average is now 18% and approaching 20%.

This is significant because prices usually can not deviate much more without either correcting, or meandering sideways until the long term trend catches up. Persevering readers will remember a similar indicator which I’ve been pointing out lately for the equity market: Stocks Have Little Room to the Upside.

The Maginot line for equity markets seems to be 20% and surprisingly, this is also true in the gold market:

Note that in the above chart I’m using the exponential 200 day moving average while previously for the equity market I used a simple moving average. Since the exponential average adapts faster, it is slightly higher than the simple (965.22 SMA, 974.55 EMA). As long as we consistently apply one across time, there is no problem.

There is nothing magical about a 20% incursion from the long term trend line. However, in the past, gold has had trouble being able to push higher after reaching such a height. It has been able to a few times, as you can see from the chart above.

On January 15th 2006 when gold closed at $557.24 it stood 19.52% above its 200 day EMA. In early February 2006 gold was able to push slightly higher to $572.15 where it topped for the next 60 days.

On May 12th 2006 when gold closed at $715.73, it reached a 32.86% above its 200 day EMA. While this was a rare instance above the 20% level, it was an empty victory to all but short term traders on the long side as gold promptly lost 68%.

The last time the relative distance of gold was this high was earlier in the year: on February 20th 2009 when gold at $1000 it was 17.79% above its 200 EMA. That was followed by a 15.5% correction and it took 6 months for gold to regain the $1000 level.

Even though gold could continue to go up and up and up from here, it would be improbable based on its historical pattern of trading. More than likely, this technical position hints that we have either already arrived at a significant top or are just about to.

Set All Correlations to 1
It would be naive to ignore the troubling effect of the US dollar carry trade in forcing almost all assets into a unity of correlation. This is especially important because of the myth that surrounds gold as a safe haven. Those that expect gold to act as a hedge are in for a rude awakening.

Even during past market environments where world financial markets weren’t as correlated as they are now thanks to the single reliquification trade, gold offered no protection in times of crisis.

Now, gold is even more susceptible to the same vicissitudes that buffet other financial markets. When all assets: commodities, equity markets, high yield bonds, gold etc. walk in lock-step up a steep bull market, the reversal promises to be as homogeneous. And therefore, even more shocking since there is no port of safety to flee to.

Remember that tops are formed during the brightest and most optimistic periods of time. They are formed when the majority are expecting higher prices, when the news is shiny, when everyone can rattle off a laundry list of why prices will continue to go higher but almost no reasons for the opposite and when those who don’t agree with the prevailing consensus are ridiculed and marginalized. While I don’t think that this is the top for gold, it certainly looks to be a top.

Grice FT Interview
Dylan Grice is fast becoming one of my favourite analysts. Here is a recent interview podcast he did with the Financial Times on geopolitics, stock market bubbles, and China’s future:

It is rather long (44 minutes) but very enjoyable. Save it to listen to when you have time or download it to your iPod.