A Contrarian Analysis of Gold’s Big Drop

Even after the declines marking the start of this week, contrarians continue to look for lower prices in gold.
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Contrarians weren’t surprised by gold’s huge plunge on Monday of this week, when the yellow metal at one point was down more than $100 an ounce.

To be sure, it would be going too far to give contrarians credit for predicting the plunge. But it is true that contrarians have been largely bearish since July, when gold market optimism reached hardly-ever-before-seen levels. So to that extent contrarians have been suspecting that any big surprises in the gold arena would be on the downside.

Even after Monday’s big drop, contrarians continue to look for lower prices.

These are the conclusions I draw after analyzing the average recommended gold market exposure level among a set of short-term gold market timers who my firm has been monitoring on a daily basis since 2000. (This average is the Hulbert Gold Newsletter Sentiment Index, or HGNSI.) Currently, this average stands at 31.7%, which is higher than 55% of all daily readings since 2000.

This high of a reading is quite surprising from a contrarian point of view, given gold’s huge plunge to start this week. And the reading is quite bearish, since contrarians consider it a particularly bad sign when the bullish market timers stubbornly hold onto their bullishness in the face of significant market declines.

Contrarians won’t be interested in buying more gold or gold-mining stocks until there is extreme bearishness among the gold timers. Though there are no hard-and-fast rules for what constitutes extreme bearishness, many of my clients use the bottom 10% of the historical distribution. This decile is represented by the shaded area at the bottom of the accompanying chart.

Hulbert Chart 111020

Notice from the chart that March was the last time the HGNSI was in that bottom decile, and that gold mining stocks (as represented by the VanEck Vectors Gold Miners ETF  (GDX) - Get Report) more than doubled in the ensuing three months. Though the HGNSI in October almost fell into this lowest decile, it turned back up before doing so.

Just as the bottom 10% of the distribution is considered extreme bearishness, the top decile is considered extreme bullishness -- and a contrarian occasion for selling. At gold’s top in July, as you can also see from the chart, the HGNSI rose to near the top of that decile. Gold has struggled ever since -- even before Monday’s big drop.

The VanEck Vectors Gold Miners ETF ended down 3.45% on Tuesday.

The bottom line? Pay close attention in coming days and weeks to gold market sentiment. It would be bullish from a contrarian point of view if the gold timing community quickly throws in the towel on their current bullishness and jumps on the bearish bandwagon. If that happens, look for contrarian buy signals in fairly short order.

In contrast, it would be bearish from a contrarian point of view if the gold timers stubbornly cling to their bullishness and quickly increase their gold market exposure at any sign of market strength. That would suggest that the gold market must suffer even more declines to wring out the last vestiges of this past summer’s extreme bullishness.

Given how the gold timers behaved earlier this week, contrarians aren’t holding their breaths.