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Yesterday, Kevin asked if I had an opinion on what the sentiment picture looked like for gold. I do, and it is moderately bearish, with the possibility of it becoming extremely bearish in a short amount of time.

The main reason is the interaction between small speculators and commercial hedgers in gold futures. Commercial hedgers are those holding (long or short) at least 200 contracts of gold futures, and are using the futures markets for the express purpose of hedging their daily operations. These are typically institutional firms, or those directly involved in some part of the gold process, and thus are usually those most in the know about what is going on with the metal. Small speculators, on the other hand, are typically just that - small traders speculating on the price of gold. Not surprisingly, these traders are most often wrong on market direction.

In early 2003, commercial hedgers became the most net short in their history (dating back to 1986), at the same time small specs were their net longest in history. Gold quickly plunged $60 over the next couple of months, rewarding commercial hedgers and punishing small specs, as usual. That scenario played out again, though to a lesser degree, in June, and it's now setting up again. Recently, commercial hedgers have been building up their short positions and are close to all-time highs. Small specs have not been as enthusiastic as they were before, but they are still very net long. The pattern that has been repeated for 17 years is that commercial hedgers aggressively short every substantial gold rally, while small specs buy into it. It is no different this time, and should gold continue to rally, I would expect the upside to be relatively limited long-term, as commercial hedgers do not at all seem intent on buying into any rally. The argument against this is that commercial hedgers are supposed to hedge, so of course they are going to sell into a rally. But just like most other commodities (and stock indices), when the hedgers become extreme in their short positions, or add to them quickly, the underlying most often goes nowhere or down.

Confirming the enthusiasm that small specs have towards gold, assets in the Rydex Precious Metals fund continue to hit new three-year highs. When adjusted for the NAV of the fund itself, assets are still close to setting a record, despite the fact that gold is off significantly from its 2003 high. This tells me that the traders who frequent the Rydex funds (and are usually incredibly wrong at the extremes) are jumping on the gold bandwagon. This is a minor negative for gold.

Lastly, a proprietary put/call ratio I construct based off several gold stocks and indices is on the lower end of its range. This tells us that traders in gold shares have been concentrating heavily on calls as opposed to puts. This is a sign that these traders may not only be betting on more upside in gold, but more importantly are not concerned about the possibility of significant downside. A VIX-type index created with these same issues confirms this. This is also a minor negative for gold.

Overall, we are seeing a large amount of optimism for gold from those usually the most wrong, while those most right over the long-term are heavily short. There is always a lot of anecdotal "evidence" that gold is unloved, or disrespected. That does not appear to be the case. There is a very clear technical triangle forming in gold futures, and a break of that pattern to the upside would likely bring in some temporary buying. But from a sentiment point of view, the risk/reward in gold seems as though it would be better once the metal is a little less obvious.
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