In this article, I examine whether bullish gold investors are too early in their timing. Since the beginning of the year, some market participants have turned bullish on gold by using a contrarian approach to investing, suggesting that it is now a good time to buy as most investment banks do not expect gold prices to rally this year after the 28% plunge last year.
One of the most famous gold contrarians this year is Dennis Gartman who recently made a few comments in his Gartman Letter: 'The analyst landscape is uncommonly bearish. […]Even the 'gold bugs' are neutral of gold and that is stunning, really. […] It is time to be quietly bullish.'
First, it is true that investment banks have turned bearish on gold this year as gold prices plunged by 28% for the first year after 12 years of gains, recording the worst year since 1981 when gold prices fell by 31%. Here is a recap of 2014 average gold price forecasts.
Exhibit 1: 2014 Gold Forecasts
Source: Mikz Economics
However, this does not necessarily suggest that gold will rise this year just because sell-side analysts are, on average, generally wrong in their predictions.
Second, are the "gold bugs" neutral on gold now as Gartman seems to believe? No, that is not correct.
Of course, some of them have turned neutral, such as legendary hedge Fund Manager John Paulson who told clients at his firm's annual meeting on November 20, 2013 that he wouldn't personally invest more money in his gold fund because it is not clear when inflation will accelerate, according to a person familiar with the matter quoted in the article linked above.
However, most "gold bugs" are still convinced that the reason behind the plunge in gold prices in 2013 is manipulation and the yellow metal will inevitably rise in 2014. One of the world's biggest and famous gold bugs, Eric Sprott, recently said in an interview that: "he is absolutely convinced we are going to go to new highs this year. In fact, it might be a very stunning recovery, i.e., in a very short (period of) time when the truth comes out. And believe me the truth is going to be coming out here."
I believe that this kind of misleading information in the gold market caused confusion among market participants, resulting in a peak at $1,920/toz in September 2011, a "weak" performance in 2012 (a single digit rise) that has been the "smoke" signal that 2013 would be difficult as I wrote here, and finally a sharp sell-off in 2013.
Indeed, if we have a look at the gold bull market since 2001, an increasing number of short term/opportunistic market participants went long due to bullish momentum from 2007 to 2011. A lot of market participants wanted to "play" the gold market. When a peak was reached, momentum began to weaken and this category of short-term investors reacted accordingly and moved on. Long-term investors then came to realize that over-bullish arguments for owning gold made by "gold bugs" were not founded and decided to reduce their exposure to gold. This is mainly why gold ETFs fell by a record in 2013 and resulted in a gold plunge of 28%.
Exhibit 2: Gold ETF Holdings
The question now becomes whether these long-term investors will get back in the gold market? If so, when?
First of all, I believe that they exited the gold market just on a temporary basis because first, over-bullish reasons for owning gold such as "hyperinflation" did not occur and second, as gold prices were falling, these long-term investors were sufficiently convinced to reduce their exposure, at least in the short term. However, this category of investors still has a positive long-term outlook on gold as macroeconomic problems are still present. That is why we have seen solid support at $1,180/toz because this category of investors sees a good long-term buy at this level. Nevertheless, it does not invalidate the fact that gold prices could decline further below $1,180/toz this year, as I wrote here.
Second of all, as I discussed in a previous article, in the long run the primary driver of gold prices is fundamentals, while it is sentiment in the short term. It is clear that the sentiment in gold is pretty bearish and that is why gold prices declined on such a magnitude in 2013. However, in order to see a bottoming process in the gold market, sentiment needs to be extremely bearish.
As it is always hard to measure metals sentiment quantitatively, let's use the Hulbert Gold Sentiment Index to gauge the gold market sentiment.
Exhibit 3: The Hulbert Gold Sentiment Index
Source: Sentiment Trader
This chart suggests that sentiment in early 2014 is not extremely bearish as it was during the summer of 2013. In fact, the average gold timer was more than 3 times more bearish in the summer of 2013 than today. Thus, I believe that sentiment can become potentially more bearish before reaching extremes. This suggests that gold prices could decline further in the beginning of the year and long-term buyers will not likely re-enter immediately as they will need to see more evidence that a bottom has been reached.
In sum, while some contrarians consider that it is a good time to buy gold as most investment banks have turned bearish, I believe that even though the gold outlook is very positive in the long term, there is still a potential downside risk before reaching a bottoming process.