The following article is an excerpt from one of our past updates “Gold Beaks Down, Tests $1600”, sent to our subscribers February 18th 2013, when gold was $1611 (now $1580) and the HUI miners index was 379 (now 349). We believe that this information is very relevant in the current market situation, as well as for future situations, and have therefore decided to publish this piece for the perusal of the general public.
Longer term subscribers will recall us writing about “trapped longs” on a number of occasions before. We would like to explain the concept again for the benefit of new subscribers and to demonstrate how this applies today gold market, particular to the mining stocks. The concept of “trapped longs” simply applies to market positioning where the market is long, wants to sell, but can’t (or won’t). Of course you can get trapped shorts as well and the same dynamics apply.
The first clue to identifying this kind of situation is to get a handle on the market positioning. Whilst we cannot know for sure how all investors are positioned, listening to people’s view on the market can be a good proxy for this. Everyone else it appears, is long gold stocks, thinks they are significantly undervalued and believes that we are going to see a huge rally in gold stocks as gold moves to new highs and the miners have to play catch up.
We know of only one fund manager who is short the miners (against a long physical gold position) but is appears everyone else is long. We got out of gold mining stocks in May 2008 and haven’t looked back. Even with gold prices nearly doubling since then, the mining stocks have performed abysmally. (For further reading see our archive on ww.skoptionstrading.com where articles such as Are Gold Stocks The Real Barbarous Relic? and The Gold Beta Of Mining Stocks and Why We Continue To Avoid Them? can be found.)
The same investors who have are long gold mining stocks have been long for some time now. They still come out with the same spiel about how there is going to be a massive rally in the sector as the public begins buying into the gold bull market mania. This simply isn’t happening and will not happen this year, just like it didn’t happen last year, or the year before.
So we have established what the market positioning is, the next key step is to gauge the market mentality. The street (ie investors in general) can be long and still buy more, pushing the market higher, but that is not the case in the gold mining sector. The street is tapped out. There are no more bullets to fire and no more fresh funds to invest in gold miners. Gold mining bulls have bought every dip in the last few years and not sold the rallies as they are still under the false perception that there is going to be some super rally that they do not want to miss out on.
The market mentality has now shifted. With the breakdown in gold prices technically, a lack of momentum in the last 18 months and an improving economy that makes more QE less likely by the day, the gold bull market story is losing credibility. This means that the holders of gold stocks are now getting concerned they may not get the super rally they were desperately holding out for. If gold doesn’t make new highs, how can gold stocks?
Another symptom of this situation is some of the more desperate bulls resorting to conspiracy theories as an excuse for why they are losing money. We are not going to waste too much time discussing whether or not there is manipulation in the market. Was it manipulation that drove gold from $1900 to $1600 in the last year or so? No. Likewise the whole paper versus derivative argument that is often put forward appears to us as nothing more than a poor attempt to distract attention from the poor performance of the gold mining stocks and those who consistently recommend them. Sure, the physical gold market may trade at a different level than the futures, but we are talking about a few dollars and it’s irrelevant in the grand scheme of things. Physical gold isn't still selling for $1900, it's selling closer to $1600, and gold stocks fall when gold futures fall, so we ignore such arguments.
So these trapped longs are feeling some pain and it will come down to individual tolerance levels as to when various parties throw in the towel. Most will be opting for a strategy along the lines of “I’ll sell if we get a small rally”, and although not all will stick to this strategy, some will and this will keep the rallies back in gold stocks muted – particular if gold prices remain range bound. There is a chance however that we could see a period of total capitulation where the long throw in the towel and hit whatever bid is there in the market just to get out. This could occur if gold breaks $1550 and should the scenario eventuate then in our view 300 is a realistic target on the HUI gold miners index (equivalent to roughly $35 on GDX). If we do not see a capitulation then the most likely scenario is one of a slow bleed out, gold stocks grinding lower as one by one the longs bail out of positions.
Recognising situations such as these have boosted our returns this year, and we have combined this with other our other models to boost profits for our subscribers. So far this year we have closed 5 profitable trades with returns of up to 212.50%, and our portfolio is up 17.27%.
Through the careful analysis and recognition of various market situations we have generated an annualized return of 63.72%, and on average closed trades returning 30.83% in 52.38 days. In the three and a half years since we began trading we have closed 118 trades, 86.44% of which have been winners. Our model portfolio is up a grand total of 489.13% in that time period.
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