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In this article, I will impartially examine gold (GLD) by questioning the assumptions that many make about this precious metal. Through this analysis, I will attempt to isolate the fundamental drivers of this material and provide a trading recommendation as to where I believe price is headed in the future.

What Drives Gold?

The first thing that comes to mind when individuals think of purchasing gold is inflation. For the majority of my life, gold has been advertised as the ultimate hedge against inflation in that as inflation increases, physical assets increase as well and by owning gold, individuals will preserve or increase their buying power. This relationship between gold and inflation simply isn't true.

Myth #1: Inflation

Inflation increases prices in that there are more dollars chasing the same amount of goods. For a good to actually increase in price due to inflation, there must be sufficient demand for the good such that individuals with dollars are willing to pay greater amounts of money for the same amount of the good or service. Let's pose and test a basic question: does gold increase in price as inflation increases? In order to answer this question, I have correlated monthly changes in the Consumer Price Index (a popular measure of inflation) with monthly changes in spot gold prices. The chart below shows this correlation.

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The relationship between inflation and gold prices simply isn't there. As inflation increases, gold moves in a direction entirely unrelated. Mathematically speaking, these two variables have a .18 correlation, which is considered to mean little to no correlation is present.

Myth #2: Financial Panic

Well, if inflation doesn't direct gold prices, what about the stock market? It makes sense that as the world markets tank, investors flock to "safe" assets which will "preserve" buying power, right? Wrong. The basic idea here is that in the event of market collapses, investors will flee to gold and preserve their purchasing power. Let's test this belief by correlating weekly market returns with weekly gold returns.

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It can clearly be seen that once again, popular theories don't hold weight against data. If gold was a method of preserving value in the event of financial volatility, then there would be a negative correlation between the S&P 500 and gold or a clearly-defined relationship as points deviate from the mean. Neither of these factors is present. In fact, the correlation between the stock market and gold is .04, which basically means that there is no relationship present.

Myth #3: Supply and Demand

Another myth that individuals espouse is that there is some sort of supply shortage in which the natural demand for gold is driving up price. This is radically incorrect. According to the World Gold Council, the demand is currently being met and slightly exceeded by supply, on average. Additionally, there is over 44 times the average quarterly demand for gold sitting in stocks. In any other commodity, this type of supply, demand, and storage situation would lead to price collapse. Imagine if we had 44 times our quarterly consumption of wheat already sitting on the shelves in some form or fashion - wheat prices would be a fraction of what they are today! Simply said, a supply and demand relationship is not influencing the price of gold in any tangible way.

Sentiment

I've worked within the trading industry long enough to know that there are only three things which drive prices: supply, demand, and sentiment. We've talked about supply and demand and found that these factors are ultimately irrelevant and powerless to influence gold's price behavior. That leaves us with the only other possible factor: sentiment. It is my belief that the only factor which is driving gold right now is sentiment.

The best way to determine sentiment is to monitor the Commitments of Traders (COT) reports. The Commodity Futures Trading Commission requires large traders and commercial players to disclose their position on a weekly basis so as to prevent position limit infractions and potentially manipulative behavior. These charts make excellent timing tools in that they show us where the professionals are positioned. It is very important to understand that these positions are put on by people who literally must make money on their trader or search for a new line of work. In light of this reality, traders and investors should highly regard COT reports. The chart below shows the past four years of COT data. The red squiggly line at the bottom of the chart shows the total position of large professional traders - people who are paid to be right. The green line shows commercial hedgers - people who intentionally pay to be wrong by hedging their production. The blue line shows small traders - people who, for the most part, are amateurs just having fun. In many markets, small trader positions act as a strong contrarian signal in that the amateurs are almost always wrong.

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  1. The region in the chart marked as "1" represents the time period between 2009 and the middle of 2011. During this time period, professional traders, on average, maintained positions totaling around 180,000 contracts. The price of gold increased 100% (or $800 per ounce). The standard contract represents 100 Troy ounces, which means that during this time, professional traders earned around $14.4 billion in profits.
  2. During the second time period, labeled "2", professional traders cut back on their position. Between the middle of 2011 and 2012, traders booked profits on about 50,000 contracts. The selling by these large traders caused the market to stop its multi-year bull-run for several quarters. Commercial hedgers (the green line) also cut back on their positions due to the fact that decreasing prices allow a player who is naturally short to decrease its hedge exposure.
  3. It gets really interesting at point "3". Notice the large leap in traders' positions during the past quarter. This coincides with the speculation and announcement of QE3. QE3, as you probably know, is the Federal Reserve's announcement that it will continue to essentially print money in order to stimulate business. Printing money eventually leads to inflation. The popular belief about inflation increasing the price of gold is simply incorrect, as we've discussed. Professional traders know this, but realistically they put these trades on hoping that the amateurs are unaware of the lack of relationship. Ultimately, trading is a zero-sum game and the only way these guys make money is through the systematic transfer of wealth from the uninformed to the informed. If you notice, immediately after traders put large positions on leading up to QE3, professionals cut back their positions by around 30,000 contracts. Let's talk about why.

As we've discussed, the only things which drive markets are supply, demand, and sentiment. Both supply and demand are not influencing gold. Sentiment is the driving force here. Something very significant happened which caused these traders to cut back on their positions by nearly 15%. For the most part, these professional traders are following the trend: as price increases, they are long and as price decreases they are out of the market or short. A very important shift in sentiment occurred during the first week of October, which was the failure of gold to resume its uptrend, technically established in 2008. What this tangibly means is that the trend is no longer increasing and traders are cutting back their positions to book profits or quickly cut losses. I have circled this rejection (in red) of the uptrend on the chart following the recommendation.

The Recommendation

I view this market weakness coupled with the pullback in trader positions as a shorting opportunity. The inability of gold to make new highs coupled with the fact that the recent highs correspond perfectly to technical resistance points makes a short thesis strong in terms of reward versus risk. Specifically, traders should consider shorting GLD at a break below $161. An initial stop-loss should be placed at $171 to protect capital in the event that gold continues its uptrend. Investors should take profit on one-half of their position at $140. This has been an area of resistance in the past and I believe it will continue to inhibit price direction in the future. Investors should close the remaining position at $124. This trade is very favorable in that it provides $2.90 for every $1.00 the trader is willing to risk. Probabilistically speaking, if this analysis even has a 35% chance of being correct, individuals should consider shorting GLD. The table and chart below show the breakdown of this recommendation as well as an annotation of the significant price levels.

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Source: Prepare To Short Gold