Disclosure: I am long AGQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
Big movements take time to develop... Men who can both be right and sit tight are uncommon. - Jesse Livermore
The bearish sentiment and analysis of the gold market continues to relentlessly pour forth from the media and Wall Street. Just this week Goldman issued a report suggesting at $1200 price target. Fortunately, if you study Goldman's track record with regard to issuing "buys" and "sells" on gold (and other commodities) you'll find that taking the other side of Goldman's calls has been pretty close to 100%.
Over time, using contrarian analysis has been a successful tactic in the markets. The idea is to buy an asset class or stock when everyone else is running away from it and sell when everyone is chasing the price higher.
The key is knowing what to look for in terms of measuring investor sentiment. I would argue that currently the investor sentiment with regard to the precious metals sector is not only at an extreme, but is hitting rock bottom - indicating that right now is the best time to enter or add to positions. Why do I say this?
In my last article I showed the high correlation between large hedge fund Comex gold short positions and market bottoms for the price of gold. I thought I would show a few other indicators that can be helpful in determining whether or not this sell-off is at or near the end based on investor sentiment/behavior.
The first chart shows what is known as "rGold." rGold takes the 200-day moving average of the price of gold and divides it by the current price. When this ratio is evaluated in a time series chart over long periods of time, market tops occur when the ratio is over 1.20 and market bottoms occur when the ratio goes below 1.00. The .94 area is an extreme reading. The idea is that, if the 200-day moving average is useful to statistically measure, on average, the general daily price variance of an asset over time - the price variance of that asset will generally fluctuate within a certain range around that average price variance. When the price moves in an extreme variance above or below that 200-day mean price, there's a high probability that the current price is an "outlier" occurrence and it will "regress back to mean range" and possibly move to an extreme in the other direction.
This first chart shows rGold with the price of gold from March 2004 to March 2008. It was produced by a previously well-regarded gold market analyst, Eric Hommelberg. For some reason he stopped publishing his work about five years ago, which is why this chart only goes to March 2008:
(click to enlarge)
I've highlighted the areas in red where readings below 1.0 signal an impending move higher for the price of gold. The .95 reading in September 2006 preceded a move in gold from $575 to over $1000.
The current rGold ratio as of Thursday (2/28/2013) is .948. I believe in 2008, the ratio briefly spiked down close to .90, but the sell-off back then happened within a 6-month period, as opposed to the current one, which has lasted nearly 18 months (from September 2011). My point is that if a .94 reading is a "2-sigma" event, then a .90 reading would be a black swan.
My next chart is really based more in fundamental analysis, but the current price of gold vs. an expected fundamental price has diverged by enough of an extreme that it reflects extreme bearish investor sentiment. This chart shows the correlation between the Federal Reserve's monetary base for the last three years and the price of gold:
(click to enlarge)
The monetary base is - simplistically - the size of the Fed's balance sheet less some adjustments. Up until the point indicated by the red line, there has been high correlation between the Fed's monetary base and price of gold. But in the time since late September, the monetary base has increase by approximately 18.5%, while the price of gold has dropped approximately 12.5%.
The next chart shows a long-term correlation between the monetary base and the price of gold:
(click to enlarge)
As you can see, going back to 1990, there is a tight correlation between the monetary base and the price of gold. Given this fact, the large current divergence between the monetary base and the price of gold can be considered a reflection of extremely high negative investor sentiment - for whatever reason - toward the price of gold.
Essentially the market is saying that either the Fed is going to take action in the near future to substantially reduce its monetary base - i.e. start unloading a lot of Treasury bonds and thereby significantly reduce the money supply - or the price of gold is going to "catch up" to its long-term correlation ratio vs. the monetary base. This would mean that we should see a big rally soon in the price gold.
In terms of whether or not the Fed can possibly start reducing the amount of QE it is throwing into the system, unless the Fed is going to force to the Government to cut back significantly on its spending, it would be mathematically impossible for the Fed to end QE without throwing our system into a depression of unprecedented magnitude. Does anyone think that Ben Bernanke wants to go down in history as the Fed Chairman who did something like that willingly?
If you think my analysis is correct, based on the current rGold statistic, among many other sentiment indicators I've discussed previously, my recommendation to take advantage of this market "dislocation" is to allocate a meaningful portion of your investible cash to buying physical gold and silver for your core long-term holdings (not any of the paper ETFs). You can take an aggressive trading stance by buying near-money and out-of-the-money calls on GLD and AGQ. I would recommend going out to May for that.
I have been adding aggressive trading positions in NUGT and AGQ for my fund. In fact, one "hedge" trade I put on today was to buy NUGT at 5.64 and short March expiry 6 strike calls against the position for .25. If I'm right about the market, I've locked-in a 10.5% rate of return, outright and not annualized, on that capital. If my view takes longer than March 15th (option expiry) to play out, I can decide to keep the NUGT at a reduced price basis from keeping the call premium or just sell NUGT outright while using the premium to offset the loss or small gain. I can say with complete conviction that right now is probably the best time to invest in the precious metals sector since 2001.
Additional disclosure: The fund I manage is long physical gold and silver, AGQ and NUGT