A Sure Sign of a Gold Bubble

08/26/2011 9:00 am EST

Focus: COMMODITIES

Andy Waldock

Founder, Commodity & Derivative Advisors

The flood of assets into the gold market has now reached truly unprecedented levels, and both technical and fundamental indicators are showing oversold signals. A gold bubble may indeed be upon us.

We noted early this month that small traders were overpopulating the gold market and that commercial traders had begun viewing this market as significantly overvalued. Several factors this week have pushed this market well into bubble territory, and the risks can be seen both fundamentally and technically.

The gold market’s rally has been fueled by fears of a declining stock market and the devaluation of multiple global currencies. The perception of gold as a “safe-haven” investment can be seen in its valuation compared to the S&P 500.

The two markets are compared several different ways. One of the simplest is to divide the price of the S&P 500 index by the price of an ounce of gold. This ratio is currently at .62. This level has not been seen since December of 1988.

To put this in perspective, the all-time high is 5.57, which was made in July 1999, while the all-time low is .135, which was made in January 1980. Clearly, we are pushing the lower boundary as fears about the stock market pushes more people into gold.

This fear can also be measured by the flow of funds and net asset values of exchange traded funds (ETFs). This week, for the first time in history, the net asset value of the SPDR Gold Trust (GLD), the largest gold ETF, surpassed the net asset value of the Spyder Trust (SPY), the largest S&P 500 ETF.

In fact, due to the flood of money into gold-based ETFs, the combined bullion holdings of all gold ETFs now surpass the gold holdings of all but four central banks. This fills their warehouses with more than 2,600 tons of gold, or more than 83 million ounces with a face value of more than $149 billion.

Individual investors are expecting the value of gold to surpass the earnings plus stock appreciation of the entire S&P 500 index.

We also want to take a look at some key intermarket signals. The silver market peaked on April 25, and since then, the market has sold off and consolidated. Last week’s sympathy rally in silver still failed to push it past key retracement levels.

Similarly, platinum’s peak is still bound by the 2008 commodities rally, and copper hasn’t made new highs since February of this year. The divergence between gold and the other metal markets helps to illustrate the life of its own that gold is taking on.

Technically, we’ll touch on one simple trigger. Trends are frequently measured by an indicator developed by Welles Wilder called ADX (Average Directional Indicator). Typically, any reading higher than 40 is considered a strong trend. Gold is at 57. This is the highest ADX reading of any current commodity market.

See related: The Pure Technician’s Indicator: ADX

The importance here is that along with the high ADX reading, we are also experiencing increasing volatility. This is to be expected in a bubble market as it jumps and jumps. However, we have seen an increasing number of outside key reversal days as this trend has extended. This is an illustration of unsure market participants who are both afraid to stay in at these lofty levels while simultaneously being afraid to miss the next part of the move.

Finally, the same Commitment of Traders (COT) data that points to an overbought gold market also points to an oversold stock market. Commercial traders have bought the decline in the stock market at a feverish pace. They have nearly doubled their holdings of stock index futures in the last three weeks. Their view is that this is not a repeat of the 2008 financial crisis and that both of these markets are approaching near-term inflection points.

See video: Using the Commitment of Traders (COT) Report

By Andy Waldock of Commodity & Derivative Advisors

Andy Waldock is a trader, analyst, broker, and asset manager. He may have positions for himself, his family, or his clients in any market(s) discussed. This article is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

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