Are Investors Too Bullish On Gold?

by: Clif Droke

Investor sentiment should be bearish at a major bottom.

Instead, anecdotal evidence suggests investors are bullish on gold.

Gold stock weakness also warns that gold hasn't bottomed yet.

In most cases when an asset such as gold experiences a corrective decline over a period of several weeks, investor sentiment tends to become bleak as the decline nears its nadir. This is in keeping with the tendency for short interest to increase on the way down, which in turn serves as fuel for a short-covering rally once investors realize the decline is no longer justified by current fundamentals.

If the latest batch of gold commentaries and articles appearing on many financial portals is any indication, however, investors are as bullish on gold’s prospects now as they were back in February when the price was still rallying. In today’s report, we’ll look at evidence that gold could use more time to gather strength before commencing its next rally and that the bulls’ hopes will likely be frustrated in the immediate term.

When discussing gold’s fundamentals, there is no bigger fundamental than its currency component. That is, the relationship of gold to the U.S. dollar is of prime importance in determining gold’s intermediate-term (3-6 month), as well as its short-term, trend. That fundamental remains in opposition to a strong gold price right now. The U.S. dollar index is still in the ascendant and is creating a major headwind for gold. The following chart exhibit states this case better than I could in a thousand words. It shows the Invesco DB U.S. Dollar Index Bullish Fund (UUP) in relation to two of its most important trend lines, namely the 15-day and 50-day moving averages.

Invesco DB U.S. Dollar Index Bullish Fund

Source: BigCharts

As you can see, the dollar ETF is near a 52-week high and has so far refused to close under its 15-day MA on a weekly basis. This confirms that its immediate-term (1-4 week) trend remains up, along with its intermediate trend. Until the dollar index ETF closes under both trend lines discussed here, the gold bulls aren’t justified in expecting an imminent reversal of gold’s 10-week decline. Until the dollar reverses, gold will likely require more time to rest and consolidate before attempting its next sustained upside move.

What’s more, the latest policy statement from the U.S. Federal Reserve gave dollar bulls a reason to remain bullish on the currency. The Fed highlighted the recent improvements to the U.S. economy, as well as the low inflation rate. Early weakness in the dollar index on May 1, the day of the latest Fed meeting, gave way to a sharp recovery in the dollar later in the day after the Fed released its interest rate decision. This reversal serves as a reminder that the dollar’s forward momentum remains strong and will likely prevent a sharp reversal of the dollar’s uptrend in the immediate term. Low inflation and a stronger economy are also reasons why gold’s safe-haven bid is diminished.

Another somewhat troubling sign for gold’s near-term prospects was manifested on May 1. I’m referring to the breakdown to multi-week lows in the PHLX Gold/Silver Index (XAU). As you can see in the following graph, the XAU fell 2.20% on May 1 and sliced under a psychological benchmark at the 70.00 level. This was the XAU’s nearest round number “support’ level, one that many technical traders had marked as a “line in the sand.” To many gold stock traders, a violation of the 70.00 level suggests that bears now control the market for gold mining shares - especially now that the XAU has surrendered more than half its gains since November.

PHLX Gold/Silver Index

Source: BigCharts

More importantly, from a gold investor’s perspective, the recent extreme weakness in the XAU index serves as a warning of further potential weakness in the gold price. While gold prices don’t always follow the XAU, gold stocks have often served as a leading indicator for the near-term direction of the physical metal.

While the evidence is admittedly anecdotal in nature, I would note that many of the articles I’ve seen on various financial sites in recent days have tended to be bullish. Normally, after a pullback of the magnitude gold experienced in the last 10 weeks, there would be more negative sentiment on the metal. Instead, there appears to be quite the opposite. In my estimation, this is a sign that investor psychology isn’t yet ripe enough for a confirmed gold price low.

Investor sentiment is admittedly volatile and difficult to use for forecasting purposes, and it’s also one of my least important pieces of evidence in most cases. However, it still troubles me that there seems to be so much complacency on the gold market among investors given gold’s weak showing since the February high. For this reason, continued caution is recommended as I suggest investors remain in a cash position.

Turning our attention to the gold ETF used in this report, the iShares Gold Trust (IAU) remains below its two key trend lines, the 15-day and 50-day moving averages. Both trend lines are also currently downward sloping, which suggests IAU still faces some short-term downside momentum. What’s more, the overhead supply between last week’s low of $12.15 and the $12.50 level (which encompasses April’s trading range for the ETF) needs to be fully absorbed before IAU is fit to rally again on a sustained basis. For now, I recommend that ETF traders remain in a cash position until the next immediate-term buy signal is confirmed in IAU.

iShares Gold Trust

Source: BigCharts

As discussed here, the primary fundamental obstacle to gold’s next rally is the strong dollar. This remains my main focus due to the importance of gold’s currency component. Until we see significant weakness in the dollar, gold is likely to encounter strong headwinds and buying gold in this climate isn’t advised. Moreover, a strong dollar will only increase gold price volatility. For now, a defensive position is still warranted with no new long positions in either bullion or gold ETFs recommended.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.