Gold Psychology, Collapsing Bubble or Short-Term Hiccup?

Howard: "That's gold, that's what it makes of us. Never knew a prospector yet that died rich. Make one fortune, you're sure to blow it in trying to find another. I'm no exception to the rule..."

~Treasure of the Sierra Madre (1948)

Treasure of the Sierra Madre ranks among the best movies on speculation and its damaging effect on the psychology of men. And there-in lie lessons for gold investors.

In 2009 and 2010 virtually every investment conference I attended included a speaker extolling the virtues of diversifying a portfolio into gold. That advice went over well as the price of gold rose. But gold has declined 25% from its 2011 peak, especially as the market experienced a rush to the exits with a 10% drop over the past 2 weeks.

Events of the past 2 weeks, including an emerging consensus that gold is over-valued, triggered a panic in the gold market. First, two weeks ago Goldman Sachs formally reversed a bullish forecast for gold. Then a rumor spread that Cyprus was dumping its 14 tons of gold reserves onto the market. Paul Krugman wrote an article summarizing the evidence that there has been unsustainable investment in gold (Lust for Gold). Krugman cites a 2011 Gallup poll in which one-third of Americans called gold the best long-term investment. Barry Ritholtz debunks some of the cult-like rationalizations of gold hoarders in this interview. The gold consensus has rapidly turned bearish.

Back to Treasure of the Sierra Madre (1948):

Howard: Gold itself ain't good for nothin' except makin' jewelry with and gold teeth. Aw, gold's a devilish sort of a thing anyway. You start out to tell yourself you'll be satisfied with twenty-five thousand handsome smackers worth of it, 'so help me Lord and cross my heart.' Fine resolution. ... Ten you want to get twenty-five. Twenty-five you want to get fifty. Fifty, a hundred. Like roulette. One more turn, you know, always one more.

The historical lust for gold has affected all of us, in ways obvious and subtle. To give one example, Latin America was permanently shaped by the Spanish search for gold. Conquistadors such as Coronado spent their family fortunes searching for Cibola - the lost city of gold - from Patagonia to as far north as the plains of present-day Kansas. In fact, a high school in my home town was named after Coronado. Gold has an allure that drives people to fantasy and wild speculation - often to the point of ruin. And the psychology that drives its pursuit is common across the human treatment of all similar assets.

In this week's newsletter we take a look at gold, the psychology driving its prices, make a few forecasts, and revisit crypto-currencies.

What Goes Up...

"Then leaf subsides to leaf.

So Eden sank to grief,

So dawn goes down to day.

Nothing gold can stay."

~ Robert Frost

In this prior newsletter, we showed how consensus price forecasts for commodities are contrarian in nature. That is, when the media collectively states the price is likely to rise, they tend to be wrong over the next week to month.

Below is the consensus price forecast for Gold as a 200-day moving average. As you can see, it is hitting a dramatic low (the lowest point since early 2009).

So in the short term - week to a month - it looks like the pessimism about gold is overdone.

When we run studies to identify the most predictive sentiment and macroeconomic variables on commodity prices, we find that Production Volume has the largest year-over-year predictive value for commodities. That is, higher production volumes in one year lead to lower prices the next year.

While investigating the factors that move commodity prices, the below equity curve for a basket of commodities was created by our Chief of Analytics, Changjie Liu. The curve represents the profits generated, excluding transaction costs, using a long-short arbitrage strategy on the six commodities with the most news Buzz over the past one year. The two commodities with the highest production volume are shorted and the two with the lowest Production Volume are bought. The equity curve represents the differential return between the long and the short positions. This strategy is run since 1999, updating monthly. You can see an 8x return excluding transaction costs:

Given the impact of Production Volume, we investigated Gold's Production Volume. Gold is near decade highs of Production Volume buzz as you can see in the following chart.

Our conclusion? Based on our data, the recent sell-off in Gold is overdone in the short-term, but will continue in the longer term.

What About Gold Miners?

Miners of gold, like those in Treasure of the Sierra Madre, often risk everything in pursuit of a huge one-time jackpot. In modern times, because of the huge potential return, gold miners employ leverage - lots of it. As a result, when credit dried up during the financial crisis, many of them were forced into bankruptcy. Small gold mining operations often don't tap the credit markets, they rely on the risk-taking penchant of wealthy armchair speculators and former prospectors who struck it rich.

In current conditions many gold miners, with the P/E ratio of the gold miners ETF (GDX) at 11, seem like value buys. But we see the psychology of speculators lined up in exactly the wrong direction for a sustainable rally. Those who remain holding onto gold stocks are tremendously bullish about them - a negative psychological indicator.

Above I showed the chart of Gold's consensus price forecast. The gold miner stock price forecast - based on the constituents of Thomson Reuters Precious Metals Industry - is surprisingly middle-range, The selloff of the past few weeks has not yet dampened the optimism of gold stock investors:

This complacency is a fairly negative long-term sign for gold stocks. We also see that a long-term average of our MarketRisk index (a.k.a. the Bubbleometer) remains high for gold miners:

As a result of these sentiments, we're under the impression that even at these low prices, and the likelihood of a short-term bounce, gold miners are in longer-term trouble. But trading occurs at multiple time horizons.

That said, we have short term (one week only) buy recommendations for several gold miners because the fundamental short-term driver of such stocks is FEAR. And fear is high. See the Trading Recap section below for specific Gold Miner stock recommendations.

Revisiting Cryptocurrencies

Our last newsletter discussed the emerging bubble in cryptocurrencies and the benefits of buying into a bubble early. As you can see in the below chart, the bubble has come and gone and is coming again:

The story continues to evolve. We believe that a future cryptocurrency will become established as a reliable means of value transfer (if not storage). I say "future" because there are a number of constraints of current cryptocurrencies that are impeding their wider adoption. A laundry list of the flaws in cryptocurrencies include weak exchange infrastructure, price manipulation, volatility, slow transaction clearing times, high energy consumption needed to produce/mine the currencies, hoarding by investors (only 63% of mined bitcoin has ever been transacted), and lack of spend-ability.

Of course, most of the above considerations apply to physical gold as well. And as with the emergence of gold, cryptocurrencies could widely penetrate society over the next decade as a store of value and frequent means of transaction. The truth is that cryptocurrencies have several significant advantages including anonymity and portability. In the case of cryptocurrency, they are likely to follow the Gartner Hype Cycle for a new technology. Time will tell which emerge as the leaders in the field.

Trading Corner

We've been developing equity predictive models using our TRMI data. Based on the latest models, we're seeing some interesting Buy signals.

On non-gold-related signals we're seeing a one-year buy on Carnival cruise lines (CCL). Carnival has had a series of vivid accidents (customers trapped on a ship with spoiling food and overflowing toilets, for one). As a result, anger at the company is high, and the stock has fallen considerably. It is likely to rebound over the next year, as the bad news is already priced in.

As far as gold is concerned, we have a one week buy on: gold (GLD) and gold miners including Silver Wheaton (SLW) and Barrick Gold (ABX) and the Gold Miners ETF (GDX).

Our trading models are being migrated to a public website: www.marketpsychinvest.com. This site showcases up-to-date asset price forecasts for currencies, country equities, and U.S. ETFs and Equities using our Thomson Reuters MarketPsych Indices. Our data does very well with global macro strategies, and this site showcases how sentiment data can be used as a standalone source of uncorrelated alpha. Please contact me (reply to this newsletter) if you'd like a trial to the website.

Housekeeping and Closing

Let's revisit the characters of Treasure of the Sierra Madre. (Spoiler-Alert) Humphrey Bogart's character (Dobbs) and two companions set out together from their flop house in Tampico, Mexico to search for gold. Amazingly, they find gold. After secretly mining gold in the Sierra Madre from their stake for several weeks, Dobbs begins to suspect his partners will kill him to steal his share of the gold. He becomes increasingly paranoid about their intentions and he tries to pre-emptively kill one of his partners while the other is away. His partner survives, but Dobbs is himself killed by bandits. The bandits steal the partners' gold but then dump the dust out into the wind, thinking it is sand. The gold blows away. The other two partners - the least greedy and most circumspect - live on but without any gold.

The excitement that accompanied striking it rich morphed into desperation and paranoia for Dobbs. He couldn't stay grounded in his humanity.

As you go forward in investing, remember to keep your money and investments in perspective. If it consumes your thoughts and no longer feels like a business venture, then it's not going to end well.

Are we witnessing the end of a long bull market in gold and precious metals? Yes, it appears that way. That said, short-term (one week) we have a buy on gold and gold miners. Longer term (months to years) we see dark clouds on the horizon.

We love to chat with our readers about their experience with psychology in the markets and with alternative economics - we look forward to hearing from you! We especially love interesting stories or your or others experiences.

We have upcoming 2013 speaking engagements in New York, Orlando, Dallas, and San Francisco - we look forward to seeing our friends in those cities! Please contact Derek Sweeney at the Sweeney Agency to book us: [email protected], +1-866-727-7555.

In 2012 we launched the Thomson Reuters MarketPsych Indices for monitoring market psychology for 30 currencies, 50 commodities, 120 countries, and 40 equity sectors and industries in social and news media. This data is used by top global hedge funds to improve their investment returns. Please let us know if you'd like to learn more.

Happy Investing!

Richard L. Peterson, M.D. and The MarketPsych Team

Books
Both books named "Top Financial Books of the Year" by Kiplingers.

MarketPsych: How to Manage
Fear and Build Your Investor Identity

Inside the Investor's Brain:
The Power of Mind Over Money (Wiley Trading)

Who We Are

MARKETPSYCH DATA

179 POST RD W, WESTPORT, CT 06880

www.marketpsychdata.com

Linguistic analysis paired with behavioral economics opens a new dimension for financial products and trainings.
MarketPsych Data provides granular quantitative sentiment data from streaming social and news media through Thomson Reuters. Please contact us for more information.

Optimized to identify value over two+ years of real-time trading.
The Thomson Reuters MarketPsych Data feed includes minutely macro indices tracking reported price action, supply and demand dynamics, media expectations, and other concepts and sentiments from 2 million articles daily for major countries, commodities, currencies, ETFs, and equities (over 20,000).
Contact:
Richard Peterson
+1 (323) 389-1813

[email protected]

DISCLAIMER

This material is not intended as and does not constitute an offer to sell any securities or a solicitation of any offer to purchase any securities.

The information of the MarketPsych Report is presented free of charge. It is no substitute for the services of a professional investment advisor. Investments recommended may not be appropriate for all investors. Recommendations are made without consideration of your financial sophistication, financial situation, investing time horizon, or risk tolerance. Readers are urged to consult with their own independent financial advisers with respect to any investment.

Past performance is no guarantee of future results. Screen and model signals and related analysis are for informational purposes only and should not be construed as an offer to sell or the solicitation of an offer to buy securities. Most financial instruments (stocks, bonds, funds) carry risk to principal and are not insured by the government. Anyone using this newsletter for investment purposes does so at his or her own risk.

Data accuracy cannot be guaranteed. Opinions and analyses included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty, expressed or implied, is made as to their accuracy, completeness, timeliness, or correctness. We are not liable for any errors or inaccuracies, regardless of cause, or for the lack of timeliness of, or for any delay or interruptions in, the transmission thereof to the users.

As a matter of policy, we may act upon the investment information that this newsletter provides prior to making it available to the public. We do not accept compensation of any kind from any companies mentioned herein.

MarketPsych is not responsible for any special, indirect, incidental, or consequential damages that may result from the use of, or the inability to use, the Information contained on this newsletter whether the Information is provided or otherwise supplied by MarketPsych or anyone else. Notwithstanding the foregoing, in no event shall MarketPsych total liability to you for any and all claims, damages, losses, and causes of action (whether in contract or tort or otherwise) exceed the amount paid by you, if any, for accessing this newsletter.

MarketPsych expressly disclaims all warranties and conditions with regard to the Web sites, their Content, and the Information, including, without limitation, all implied warranties and conditions of merchantability, fitness for a particular purpose, title, and non-infringement. By using the Web site, Content, and Information, I assume all of the risks associated with their use, and I release and agree to indemnify and hold harmless MarketPsych from any and all liability, claims for damages, and losses arising from or connected with such risks.

IF YOU DO NOT AGREE WITH ANY OF THESE TERMS AND CONDITIONS OR FIND ANY OF THEM TO BE UNACCEPTABLE, SIMPLY UNSUBSCRIBE FROM THE EMAIL LIST. If you understand and accept these caveats, feel free to read the newsletter.

LinkedIn Twitter