Indicator Shows Gold Could Finally Be Bottoming

By: Michael J. Carr of Street Authority

Stocks moved up the fourth week in a row and have delivered a large gain in the first 10 months of the year. For now, there is no reason to expect a reversal in the trend.

Stocks Continue Setting New Highs SPDR SP 500 (NYSE: SPY) added another 0.15% last week and is now up 25.55% for the year, including dividends.

To put this performance into perspective, we can review data for the SP 500 index going back to 1928. This year's performance would be the 22nd best year out of 86. After such a strong performance, many investors expect a decline, and the question becomes, "How bad will the decline be?"

In the past, large gains have been followed by losing years 43% of the time. Overall, 28% of the 86 years have closed down, so there is a slight bearish bias for 2014.

In each of the years that showed a gain larger than this year's, stocks cooled off in the next year and showed a loss or smaller gain. This information should be used in the next few weeks as we prepare expectations for 2014.

Earnings are likely to determine whether 2014 is an up or down year, and for now, earnings remain supportive of higher prices. Earnings reports for the third quarter are strong with about 69% of the companies in the SP 500 that have already reported beating expectations, slightly better than the recent trend in this measure.

Based on earnings, the SP 500 should be trading at about 1,800, which is near the current price. That would be about 17 times the expected full-year earnings. Traders will start looking ahead to next year soon, and based on earnings, the SP 500 could top 2,000 in 2014. This supports higher prices for now. Seasonal tendencies and momentum both argue for more gains in the short term, and we are likely to see prices continue moving higher into the end of the year.

Last week, a reader emailed me that they were concerned about the possibility that I am wrong and prices could turn down suddenly. That is certainly possible. Their question was whether put options could help to protect wealth if that happens.

To answer this question, I will assume a reader has a $10,000 account and provide some examples.

A put option on SPY expiring in January with an exercise price of $177 is trading for about $4.55. One contract would cost $455. If the market falls about 10% from Friday's close of $176.21 to about $158.60, this option would be worth at least $18.40.

Here's how the math works: We start with $10,000 and subtract the cost of the option ($455). That means we have $9,545 invested in stocks, and we are assuming the portfolio matches the market change. The option is worth $1,840 if the market falls 10% and $0 if the market is unchanged or rises 10%. That value is added to the stock portfolio to obtain the value shown in the table below. For the 10% gain, for example, we have $9,545 gaining 10% and the option being valued at $0.

If the market declines 10%, the put option will pay off and be worth the cost. If the market doesn't decline, the insurance will cost 4.6% of the portfolio's value for two and a half months' worth of insurance. Fully insuring the portfolio over a full year with at-the-money puts would cost more than 20%.

Out-of-the-money puts would offer cheaper insurance. A put with an exercise price of $170 costs about $2.20. That math looks like this:

The cost of insurance is reduced to about 2.2% a year with this option.

Obviously, there are an unlimited number of variations with this approach, but I would like to show just one more for a deep out-of-the-money put option with an exercise price of $160. This option only costs about $0.80 and would only be worth $1.40 if the market falls by 10%. The low-priced option would not offer much protection:

For those considering put options as portfolio insurance, it is important to understand the cost.

When evaluating the cost of insurance, you should carefully consider the risk. The market has fallen by 4% or more in a single day on about 1% of all trading days since 1928. The 20 worst days in market history have seen declines of about 8.5% or more.

Usually, these days occur when the market is already falling -- 69.6% of the worst 1% of days occurred when the SP 500 was below its 200-day moving average, and 63.6% of the worst 0.1% of days occurred when the SP 500 was below its 200-day moving average.

Until the market turns down, investors should consider staying fully invested.

Gold Investors Are Bearish SPDR Gold Shares (NYSE: GLD) declined 2.69% last week and is now down 21.65% since the end of 2012. As GLD fell this year, investors finally turned bearish. Holdings in GLD, measured in tons, have fallen steadily since January after holding steady in the initial year of gold's bear market.

The number of tons held by the ETF shows the level of investor demand for the metal. Gold prices peaked in the fall of 2011, and investors seemed to continue holding gold, possibly believing that a resumption of the bull market was likely. Their selling now indicates bearishness, and bearish sentiment is usually seen at major market bottoms.

Finally, we have an indicator that shows gold might be bottoming, and investors should be watching for a buy signal.

This article originally appeared on ProfitableTrading.com: Market Outlook: Indicator Shows Gold Could Finally be Bottoming

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