Smart money signalling a bottom in gold: Larry MacDonald

But go paper, not physical.

CB_gold ingots

Some usually reliable indicators are signalling that a bottom may be forming in the gold sector. The indicators mostly involve tracking what the smart money is doing.

Back in March, faithful readers may recall that I wrote “Don’t buy gold stocks just yet.” I’m now feeling more favourably disposed as a result of these and other indicators. In fact, in April I began buying the BMO Junior Gold Index ETF (ZJG), using subsequent dips to average down my entry price.

The first indicator comes from the gold futures market and uses data from the Commodity Futures Trading Commission. As a signal, it’s showing a degree of bullishness not seen in five years.

The smart money in this market is the commercial buyers (involved in the production and merchandising of gold). Since October, they have dramatically ramped up their long positions in gold futures contracts. By contrast, traders (hedge funds) and small investors are expressing historically high levels of bearish sentiment (both groups are known for following trends and being wrong at turning points).

Another key signal is coming from insiders at gold companies. While insider trading has become negative in U.S. stocks and positive on Canadian stocks, it’s become extremely positive in Canadian gold stocks.

According to INK Research, more than eight gold stocks have net insider buying for every one with net insider selling. This is a doubling of the ratio since January, to a level usually only seen at major bottoms.

Some investors are known as savvy operators; what they do often foreshadows trends. In the fourth quarter of 2012, billionaire investor George Soros dumped half his stake in the SPDR Gold Trust exchange-traded note. Afterward, a sharp downturn occurred in the price of gold.

However, in the first quarter of 2013, 13F filings reveal that Soros’ hedge funds doubled their stake in the Market Vectors Gold Miners ETF (GDX). They also bought $25-million (U.S.) worth of call options on the Market Vectors Junior Gold Miners ETF (GDXJ), leveraging their position beyond the two million shares they already held in the ETF.

An unknown is the timing of the reversal in gold’s downtrend. It could be upon us now or it may take several more months and require some patience to wait out the interim fluctuations.

Why own gold stocks instead of gold? While gold is taking a beating, gold stocks are down even more and considerably underperforming gold. This makes them an even better value to contrarian investors.

It could also be argued that stocks possess intrinsic value thanks to the cash flows to be derived from a business endeavour. Along with these cash flows come the potential for growth, capital appreciation, dividends and other opportunities to deliver shareholder value.

In recent years, gold miners have done a poor job delivering shareholder value due to the cost overruns and excessive share dilution that accompanied the rush to put production on stream. But a recent round of management changes within the industry portends more concern for shareholder value.

“The final catalyst for gold shares may well be intense investor pressure to contain cost overruns and focus on efficiency,” observes BCA Research. In addition to such operating improvements, another source of value improvement could be consolidation of the junior gold miners via mergers or acquisitions, particularly by senior producers seeking to replenish their reserves.

Larry MacDonald is a former economist who manages his own portfolio and writes on investment topics. He is the author of several business books and tweets at @Larry_MacDonald