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I’m considering posting my gold market sentiment model results on the blog later this month.

Over the next several posts I’ll aim to introduce the model I have been using to manage gold market investments over the past 8 years.  I used the model systematically every day for 4 years running a $100m gold market hedge fund and then another 4 years running a $160m UCITS gold fund.

I developed the model in the early 2000’s when I noticed that central banks’ and gold miners’ were exiting the gold options market, and it was being taken over by the investor community.  Finally a real investor driven window into investor gold price expectations was coming available.  The options market has been used for years in equities markets to measure investor sentiment by comparing the demand for upside exposure (call market prices and activity) to downside exposure (put market prices and activity).

I collected the put and call premiums on all available strike prices on gold exchanges from 2002 to 2006 and plotted the resultant aggregate ratio over time.  What I noticed was that prior to big rallies in the gold price, sentiment actually deteriorated (i.e. demand for calls dried up and demand for puts was accelerating).  Conversely prior to gold price falls (back then it went up the escalator and down the lift regularly) sentiment was often improving (i.e. call demand was increasing more than put demand).

You can see that sentiment was a contrarian indicator, i.e. investors as a whole were getting the short term price direction completely wrong.  When they were overly bullish (and Bloomberg was full of positive stories about the yellow metal) the available market was fully invested – so any bad news was hit hard and investors headed for the exit.  When they were overly bearish the available market was under-invested – so any good news was met by above average buying and the gold price tore higher.

I set the parameters in 2006 and they haven’t changed since.  A back-tested accuracy rate of 70%, was followed by 70% and 65% accuracy in the hedge fund and the UCITS fund.


The gold market is unique in many ways from other financial markets.  Its performance is often uncorrelated (and even negatively correlated) to the vast majority of asset classes.  In addition the return drivers for gold prices are often unclear and subject to frequent displacement.  For months it will be driven by a negative correlation to the US dollar, only to suddenly ignore US dollar movements and become a function of real yields, or physical bar demand or an escalation in geopolitical tensions.

The difficulty in modelling the price of gold stems from another of its unique qualities; it does not intrinsically generate a return.  Cash-flow based valuation techniques such as Net Present Value or Dividend Growth Models cannot be used to generate a reference point for gold’s intrinsic value.  The same could be said for commodities in general, however again gold is unique in that its pool of above ground supply is never extinguished; unlike energy or other metal products whose supply is constantly being consumed and future demand has to be met by future production.  In the case of gold every ounce of gold ever mined still exists.

The lack of a verifiable source of valuation leaves the determination of gold’s current value firmly in the hand of its majority holders (central banks), gold miners and most importantly these days – investors.

Since around 2000 both central banks and gold miners have reduced their influence over gold prices dramatically.  During the 1990’s central banks were very active in the gold market, their activities ranging from pre-announced selling programmes to premium generating activity such as the granting of call options and leasing their gold reserves to gold miners.  The gold miners were keen to borrow as this allowed them to sell gold in the spot market (years ahead of actual mine production) and deal in the gold options market in the now under-active practice of “gold price hedging”.

Since 2000 these activities have all but dried up, and now gold price movements are driven primarily by investment demand, albeit supported by physical demand from the jewellery and to a lesser extent the industrial market.  The options market is dominated by investor behaviour where investor sentiment can now be meaningfully tracked.

As often happens when the market gets too bullish or too bearish, conditions become ripe for a reversal. Unfortunately, the crowd is too caught up in the feeding frenzy to notice. When most of the potential buyers are “in” the market, we typically have a situation where the potential for new buyers hits a limit; meanwhile, we have lots of potential sellers ready to step up and take profit or simply exit the market because their views have changed. The put/call ratio is one of the best measures we have when we are in these oversold (too bearish) or overbought (too bullish) zones.

The model excerpt graph below shows the warning signals, when market reversals were nearby.

GMSM Aug 2011

Source: Gold Market Macro

In the next few posts I’ll elaborate on the model and start to show the performance over time to help you manage your gold market portfolios.