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Market composition determines market sentiment
In any bull market, the early adopters who bought in when the asset in question was cheap and unpopular comprise a very small percentage of the total population of investors as the top of a market approaches. This explains the volatility before major turning points in markets as the full range of investors, from early adopters to late comers, all get anxious at the same time.
As a secular market top approaches, the universal 80/20 rule applies because 80% of investors are "brand name" investors who go for the branded financial product sold by Wall Street, a representative few listed here after the tag line: the buy-and-hold mutual funds more numerous than the stocks they are comprised of, the hot "New Era" tech stock as rare as a weekend shopping flier, or the American Dream of Home Ownership as a bloated 5,000 square foot house made out of two-by-fours and wall board thrown up in a few week's time, to name three.
Meanwhile the ornery 20% of investors remaining are either non-brand or, like iTulip, anti-brand. We figure whatever Wall Street and its trade press are selling is probably crap. Not surprisingly we don't get a lot of play in the Wall Street trade media. Thank the Internet for giving readers a choice. Still, most of the anti-brand independent thinkers crumble long before the foundation of their thesis does.
Take gold, for instance. We decided gold was cheap and hated for bad reasons in 2001 and piled into it – and silver and platinum, too. They laughed at us then, those precious metals nay sayers – laughed! – for the first years as the Fed fretted about deflation as if money with no intrinsic value could suddenly become scarce. How to make dollar, junk mail or spam or bad screenplays in Hollywood, appear valuable, that is the trick. The answer is to offer less of them than is demanded. But you can bet that while demand is partly a market and partly a government phenomena, dollar supply is assured.
Who's laughing now! Hah! Well, they are, again, now that gold, silver, platinum, and oil have plunged like shares in toys.com after the dot com bust.
They have once a year since 2001. Some day we'll miss their heckling at the top, when the price finally plunges and they are eager buyers. Maybe we'll get the last laugh, but only if we are smart enough to figure out when that top is in.
Was $1011 gold price March 17, 2008 the top?
At this time with gold a bit less than half way to the peak gold price we forecast in 2001, the market composition is as we estimate below. The sentiment breakdown is a follows.
The charts below show a buy price paid by an investor, a quantity of 100 ounces for the sake of simplicity, the total buy cost for 100 ounces at the price shown, a real sell price not spot price, a total sale value, gain or loss from the sale, the spread that the investor is paying to sell then buy back in in the future, the standard awful 28% "collectibles" tax charged because, unlike 0% capital gains on a primary residence owned for two years that the government wants you to buy and sell, gold is "short government" so is taxed at 28%. Finally the chart shows the net gain or loss net of transactions costs – the spread and the taxes – and the percentage net gain or loss. The spread is estimated at 2.5% in each direction and we ignore de minimis costs such as shipping, often free, and storage, usually less than $100 a year.
Anyone still in the market who bought in 2001 represents about 6% of the total market. I'm in that 6% group, trying not to be Fearless, as are long time iTulip readers. We characterize this investor group's market sentiment as Fearless as shown below with data highlighted in green. They bought into the market early between $270 and $300 in 2001 and 2002. We are dangerously self-assured because we are up over 100%. Fearless is a dangerous mindset, and to those of our readers in this group we advise extra diligence to avoid confirmation bias leading you to make overly optimistic interpretations of data.
Next into the bull market we have the Ambivalent group who bought into the next period of price increases, shown in the chart highlighted in yellow. On this correction they are flat to up 94% over a relatively short period of time. The gold ETF was introduced in November 2006 when gold was trading around $625. Anyone buying before that had little choice but to buy physical gold or, that bane of gold investors, the gold mining stock. We have been 100% against buying gold stocks since 2001, initially arguing that most gold companies are run very badly so unless you have access to management and the skills to assess them over time, like Warren Buffet, forget it. Next came inflation that ramped input costs faster than miners could raise prices. Double whammy of death for mining stocks, we said, but what do we know? We're just a little web site that argues for sticking to a well developed investment thesis and against trading.
Finally we have the Fearful group highlighted in orange. These guys always jump in late and are shaken by each correction. The Fearless early adopters are inured, and that is their cross to bear. The Fearful group are like rabid rabbits, scared by every change in the market, brand driven so not really comfortable buying something the Wall Street hasn't blessed.
Let's start by looking at gold market sentiment composition at the recent top March 17 when gold traded at $1011. Note the market only has a small 11% Fearful composition, with 74% Ambivalent, and 15% fearless at that gold price. Needless to say, this is a bullish crowd: mostly green and yellow Ambivalent and Fearless investors.
Fast forward to today. At this time we figure the market now is composed roughly of 47% Fearful group who bought because the price was going up and is anxious because the price fell below their purchase price. How dare it!. Another the 47% comprise the Ambivalent group who bought below the current price but is now only even or no quite up doubt what they paid. That's a lot of orange and yellow highlights. The Fearless group that bought early and never sold is mere 6% of the market.
No wonder the market is anxious! Something like 94% of gold investors in the market today are either Fearful or Ambivalent. That's the good news. The bad news is that it's probably going to get worse before it gets better. Here's our correction case based on our precious update in March were we explained that a $200 correction from $974 was expected. That takes us to call it $780 in this correction, more or less.
In this scenario fully 52% of investors are Fearful, 40% are wondering if they've done the right thing, and only 5% make up the Fearless lunatic fringe.
But what if the 2001 iTulip investor thesis continues to hold up, that the dollar is down for the geopolitical and financial market count due to Risk Pollution and Debt Deflation as the FIRE Economy unwinds?
Before that, a nod to the gold price forecasting master Jim Sinclair at who has postulated a $1630 gold price for years. Years ago he put forward an intermediate dollar bottom price for gold that at time appeared as outlandish as the iTulip $2500 dollar bottom and gold peak price. Market sentiment of the current group of investors might look like this if Jim is right: lots of green and yellow Ambivalent and Fearless investors.
Today's gold holders, even if they waited and bought at $1,000 will at last be rewarded with a 45% gain net of taxes and other transaction costs. And if the iTulip long term case come to pass?
Of course, every gold investor I'm talking to here today is a Fearless winner in that case.
Gold Trading Genius vs iTulip Gold Buy and Holder
Hard to make money trading. Trading on net can lose you your money and waste your time compared to buying and holding, depending on what you are buying and selling and whether the asset in question is in a bear or bull market. The key issues are transaction costs and the long term market trend.
Transaction costs are fees you pay on trades and taxes on capital gains. If they are high, as in the case of gold, then you want to spend your time developing a thesis for a long term multi-year trade, take a position, and hold it. ETFs and stocks on a discount brokerage account are examples of low transaction cost assets that you may want to trade, but not necessarily.
If transaction costs are low, then you may want to trade an asset if you have special information that gives you an advantage over investors on the other side of the trade. Special information that can be used to make short term trades if transaction costs are low includes:
- A unique investment thesis that you believe works and is not widely known and used so that the advantage is not already arbitraged away. For example, the iTulip "Small trade within big trade" thesis is that short term speculative gold price movements are range bound within a long term dollar depreciation trend ongoing since 2001. (The article that follows offers a theory of the "Small trade within the big trade.")
- A Unique Systemic Thesis. For example, the iTulip 1999 thesis that explains how stock bubbles work that led to our March 2000 sell call and our theory of how housing bubbles work, allowing us to call a housing bubble top in 2006.
- Legally obtained and usable inside information. For example, we learned in June 2007 from a call with an investment bank that the Fed planned to do creative things at the discount window instead of lowering rates drastically to zero post housing bubble crash as they did following the tech stock bubble crash – useful information if you were otherwise planning to bet on 1% interest rates in 2007.
Trading versus Holding: Nine Genius Gold Trades versus The Buy and Hold Gold Thesis
Let's say you're me or an early iTulip reader with an interest in gold. You bought gold in 2001 for around $270. You don't watch Jim Cramer and get infected with the TV and Internet trading virus. You stay focused on a long term investment thesis. You watch don't the markets obsessively, like a rabbit for hawks, reacting to ever rustle in the trees, selling when you think the price is about to fall and buying when your research and intuition tells you prices are headed up again. You are armed with a thesis, and your energy goes into testing it on occasion, but you don't sell until the assumptions that underlie the thesis appears to no longer hold. Here's how you stack up against me and iTulip readers who never trade within an investment thesis.
For our comparison, it's not fair to compare the average gold trader to the iTulip gold long term holder. Let's say our trader is not just any trader. No, he is an ultimate genius trader. Like a character from an on old Twilight Zone episode, he has tomorrow's newspaper in hand to guide his gold trades. And he isn't neurotic about it. Every year there is one big trade and he makes it, but no more often than that, perfectly every time. He catches the exact top and bottom of each major move. His transaction costs are limited to the spread between the buy and sell prices of gold and the horrific "collectibles" tax charged by the IRS; the government wants you to own property so the capital gains tax rate on the sale of a primary residence owned for two years is 0% but does not want you to own gold so taxes capital gains at 28%. Our genius trader minimizes this transaction cost by trading only once per year.
The charts below show the buy price paid by the gold trader, a quantity of 100 ounces, the total buy cost for 100 ounces at the price shown, the sell price not spot price, a total sale value, gain from the sale (the genius trader never takes a loss!), the 2.5% spread that the trader is paying twice to sell then buy back in again the future, and the aforementioned awful taxes. Finally the chart shows the net gain of transactions costs, the percentage net gain, and the cumulative gain after each genius trade.
Here are the Nine Genius Gold Trades compared to the Buy and Holder since 2001.
For all his hard work the gold trading genius made 86% versus the buy and holder who did nothing but check the thesis once in a while and cleared 155% after taxes if selling today.
But the spread doesn't count if you aren't buying bullion, you may object. Fine. Noting gold ETFs were not available until November 2004 when gold was already trading over $420, let's assume the trader genius sold gold bullion at the peak price in 2004 then and bought GLD at the low.
Better, but still not that great: 104% net gain versus 155%. This does not take into account the money our genius spent on newsletters, or hundreds of hours reading and pondering conflicting opinions on Internet sites, and executing trades. Trading a high transaction cost asset like gold doesn't stack up to sticking to a solid investment thesis.
In reality, no one can trade like the genius trader, with perfect timing and execution, so the comparison between a real world trader and our long term holder will likely show break-even or even a net loss – over the course of a seven year bull market.
If you are like the trader in our example, don't fell bad. I had lunch a few months ago with a rarefied class of investment manager, a manager of wealth managers. His clients are so high net worth that they do not entrust their wealth to a single wealth manager or multi-family practice but several for management diversification on top of portfolio diversification.
We get to talking about my track record and he's impressed but by way of due diligence asks what I got wrong. I explained that my errors have been a tendency to under-estimate the willingness of governments to intercede in markets to prevent a self-reinforcing cycle of credit contraction, default, and asset price deflation from spilling over into the real economy and producing deflation.
He asked when I got into gold and I told him 2001. He commented that was good timing then asked me how many times I sold and bought in again, "Everyone I know who purchased that long ago sold out their position at least once by now."
I replied by asking "Why? If an investment thesis holds, why give it up? Mine in 2001 was that the dollar was going to get thrown under the bus to save the indebted US from deflation. I still think that's true."
We sat there in an uncomfortable silence until I change the subject.
Moral of the story: In a bull market, buy and hold an asset with high transaction costs. Instead of trading, spend your time trying to figure out if you bull market is over.
Is the gold bull market over?
What we are really asking is whether the factors driving gold and commodities prices since 2001 are no longer in force. Next, for our subscribers, we dissect our now seven year old bull market in commodities to decide if the trend we identified in 2001 is over or if this is just another correction.
The FIRE Economy and the Dollar Ratchet ($ubscription)
If the US was Argentina the dollar would already have crashed. But the US is not Argentina. The dollar declines, as the FIRE Economy unwinds, buffered by the support of foreign governments, by the process of the Dollar Ratchet.
iTulip Select: The Investment Thesis for the Next Cycle™If the US was Argentina the dollar would already have crashed. But the US is not Argentina. The dollar declines, as the FIRE Economy unwinds, buffered by the support of foreign governments, by the process of the Dollar Ratchet.
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