A golden wall of worry

CHAPEL HILL, N.C. (MarketWatch) — Gold market sentiment over the last couple of months has provided a textbook illustration of what typically happens during bull-market corrections.

In early December, for example, when gold hit what so far has been its all-time high, bullish sentiment was nevertheless much lower than it had been on several other occasions over the previous several years. And over the subsequent six weeks, during bullion’s $100 correction, what bullish sentiment that had existed rapidly evaporated.

On both counts, contrarians could detect little of the enthusiasm and outright exuberance that signals an imminent major decline.

And, sure enough, gold’s correction turned out to be quite modest, and bullion is now back to within shouting distance of its early December high.

Consider what happened over the last couple of months to the average recommended gold-market exposure among a subset of the shortest-term gold-market timers tracked by the Hulbert Financial Digest (as measured by the Hulbert Gold Newsletter Sentiment Index, or HGNSI):

• In the week leading up to gold’s early December high, this average remained quite subdued. As I reported then: “The HGNSI is not at overheated levels right now. It currently stands at just 40.3%, which means that the average gold timer is allocating 60% of his gold portfolio to cash. That’s amazing, given that gold bullion is back to within shouting distance of its all-time high.” ( Read my Nov. 24 column.)

• In late January, a point that we now know to have been close to the correction low, I reported that “this quick run for the exits [that had been exhibited by the average gold-market timer] is not typical of the stubbornly held bullishness that, according to contrarian analysis, is a hallmark of major market tops. “ ( Read Jan. 20 commentary.)

The $64,000 question now, of course, is whether gold’s rally will soon take the yellow metal into new high territory. Contrarians are betting that it will.

That’s because the mood among gold timers remains quite restrained. The HGNSI currently stands at 45.3%, just half of its all-time high of 89.6%. In other words, despite gold being only a few dollars shy of its all-time high, the average gold timer is still allocating more than half of his gold portfolio to cash.

That doesn’t guarantee that gold will go up, of course. But it does mean that there is a lot of sideline cash ready at a moment’s notice to be shifted into the gold market to propel gold higher.

Nay-sayers will object that gold’s big rally over the Presidents Day weekend had nothing to do with sentiment, arguing that it instead was caused by a flight to safety among investors worried about rising geopolitical tensions in the Middle East. And no doubt they are partially right.

But not completely so. My econometric tests of the HGNSI over the last 25 years shows that, at the 95% confidence level that statisticians often use to conclude that a pattern is genuine, higher HGNSI levels are more often than not followed by below-average subsequent returns, and vice versa.

(Source: http://www.marketwatch.com/story/a-contrarian-analysis-of-the-gold-market-2011-02-22?siteid=rss)