Below is an extract from a commentary originally posted at www.speculative-investor.com on 12th January 2006.
Some people are bullish regarding the short-term prospects for gold and gold stocks because they think the majority (the public) is too bearish, whilst other people are anticipating a sharp sell-off because they think the majority is too bullish.
Supporting the view that sentiment is a long way from reaching a bullish extreme is the cumulative cash flow of the Rydex Precious Metals Fund (Rydex PM), a fund that holds the shares of companies that mine precious metals. Specifically, the below chart shows that the 40% gain in the price of Rydex PM since the beginning of July-2005 has been accompanied by a 15% FALL -- from US$250M to US$211M -- in the net amount of cash invested in the Fund. In other words, the Fund has suffered net REDEMPTIONS totaling $43M in parallel with a 40% increase in its price.
This type of divergence borders on the ridiculous and we wonder if there's something totally unrelated to sentiment that has caused it. One of our readers suggested that people who might otherwise have been putting money into Rydex PM have, instead, been investing in Streettracks Gold Trust, a gold bullion ETF that trades on the NYSE under the symbol GLD. This might be part of the reason, although GLD didn't suddenly come into existence during the second half of last year (it was introduced during the final quarter of 2004). And Rydex PM has outperformed GLD by a wide margin over the past six months so anyone being drawn into the market by price action would have had no reason to favour GLD over Rydex PM. Unfortunately, we don't have cash flow figures for other PM-related funds and therefore can't check if the curious Rydex PM situation is fund-specific or indicative of a broader trend.
The relatively low level of the small traders' net-long position in COMEX gold futures also supports the view that the public is yet to become very bullish on gold.
There is, however, plenty of evidence in support of the opposing view (the view that sentiment is approaching a bullish extreme). For example, the premium over net asset value (NAV) at which the Central Fund of Canada (AMEX: CEF) trades has risen from zero to around 7.5% over the past month (see chart below). Now, a premium of 7.5% is obviously a lot lower than the 25% premium at which CEF traded in early 2003 and the 15% premium at which it traded during much of 2004; however, the 2003 and 2004 premiums are not comparable to the current premium because the Streettracks gold ETF (NYSE: GLD) -- a fund that invests in gold bullion and trades with no premium -- was introduced in late 2004. Since that time (late 2004) there has been no good reason for CEF to have any premium whatsoever except for the fact that 50% of its assets are held in the form of silver bullion and there is presently no silver ETF (there is no way for people to buy exposure to silver bullion in the stock market other than to buy the shares of CEF). Therefore, the current 7.5% premium for CEF is probably best understood as a 0% premium for the Fund's gold holding combined with a 15% premium for the Fund's silver holding. In other words, although silver is currently trading at US$9.00/oz today's buyers of CEF are, in effect, paying $10.35/oz. This suggests a high level of optimism.
On a side note, we suggested buying CEF at around US$5.50 in September when it was trading at a small discount to NAV and again at around $6.20 in December when it was trading at a small premium to NAV, but we would not be buyers at the current high premium. If a silver ETF is introduced then the CEF premium will drop to around zero.
Another indication that the public has embraced the gold rally is the goings-on at the speculative end of the gold share universe. Specifically, most exploration-stage stocks did very little for many months as the gold price and the prices of the major gold shares drove upward, but these small-cap stocks have now come to life in spectacular fashion in response to a surge in the public's enthusiasm. On a related matter, a few months ago the stock market was generally ignoring good news announced by 'the explorers', and newsletter/brokerage buy recommendations were having almost no effect on stock prices. Recently, however, small stocks have been rocketing higher in response to positive publicity. For example, over the past week we've seen our Desert Sun Mining shares gain 30% in two days in response to a buy recommendation from Canaccord and our Exeter Resources shares gain 24% in one day in response to a buy recommendation from Casey Research.
Weighing all the evidence, we don't think there's much doubt that sentiment towards the gold sector is bullish. However, the current optimism about the future prospects of gold and gold shares goes hand-in-hand with the current optimism towards commodities in general and shares in general. Most prices continue to be pushed higher by a rising sea of liquidity and when liquidity is abundant the future almost always looks bright.