Gold: Last Friday Was Likely The Bottom

Includes: AGQ, GLD
by: Dave Kranzler

China's gold consumption is set to exceed 1,000 tonnes for the year, having reached about 800 tonnes in the first half, state-owned China National Gold said on Friday. China National Gold, the country's largest producer, said Beijing should take advantage of the current rout in prices to build reserves of the bullion to ensure economic and financial safety. - The Economic Times (an English-language Indian daily newspaper)

After flirting with the $1200 level for several hours last Thursday (June 27), gold dropped down to $1179 (August futures basis) then popped back over $1200 during Asian trading hours. It sold down to $1191 on a re-test of the $1200 level, right as the Comex opened, and has since staged a rapid $58 dollar move higher. Is this test and re-test of the $1200 level THE bottom?

Several people asked me that question yesterday (Monday, July 1). There's no way to know for sure, but there are several indicators, which have worked as bottom signals over the last 12 years that are at record extreme levels. I will discuss a couple of my favorite indicators and analyze why I believe these indicators are marking a bottom in the price of gold, with the caveat that volatility could take gold briefly below $1200 one more time.

With the physical market demand per the quote above being the primary fundamental support for the price of gold, my favorite indicator is the relative gross long, gross short and net positions of the big banks and hedge funds, which actively trade Comex gold futures. We can track this activity using the weekly Commitment of Traders (the disaggregated COT report) futures positions report published by the CFTC.

As I have discussed in previous articles, when the "Commercial" category of trader - which is primarily composed of Wall Street banks - has a very small net short position and the "Large Trader" category - which is primarily the big hedge funds - has a very small net long position, it has always correlated with market bottoms. I have posted a good chart example of this dynamic in this article: Comex Gold Positions.

In general, by way of background, the commercial category is almost always short on a net basis because the banks that comprise this sector are Comex market makers and have to run positions that are usually net short to accommodate the hedge funds, who are naturally net long.

As per the latest COT report (link above), the commercials have reduced their net short position to 35,200 contracts. This category of trader has not had a net short position in Comex gold this low in more than 10 years. Furthermore, the COT report distinguishes the percentage of open interest held by the four or fewer largest traders, which are universally assumed to be the banks with the largest Comex gold inventory - JPMorgan, HSBC and Scotia).

Stunningly, these banks went long Comex gold on a net basis a few weeks ago and have been increasing the size of both their gross long position and their net long position each successive week. The last time the big banks had a net long position was at the bottom of the 2008 correction in the metals. Also, it is thought (the disaggregated COT report only goes back to 2006) that the gross long position of the commercial category is at an all-time record level, which would mean that the gross long position of the four or fewer largest banks would also be at a record level.

The significance of this is that, historically, the commercial sector has a remarkable track record of re-positioning its net exposure to the gold market in advance of moves either up or down. This fact has been catalogued ad nauseum by analysts who study the Comex. To put the current net short position of the commercials in context, going back to the beginning of 2013, the net short position of the commercials peaked on January 22, at 195,950 net short contracts. From that high to the current 10+ year low, the commercials have covered an incredible 160,750 contracts. That translates into over 16 million ounces of silver, or 490 tonnes - roughly 25% of the annual global mining output of gold. One has to wonder why the big banks have covered up their short position to this extent, with the biggest banks repositioning to be net long.

Conversely, the large trader hedge fund category has assumed a record 77,000 contract gross short position. At some point, the hedge funds will have to cover this massive short position or face coming up with the gold to deliver (which never happens). This will likely fuel a massive short-covering rally. Given the long/short positioning as just described by the big banks and hedge funds, it is my view that this extraordinary positioning by the banks is likely a bottom - finally.

Another indicator I like to use is the investor sentiment. I subscribe to a newsletter that tracks's Market Vane Sentiment Survey. This service creates a sentiment index based on brokerage analyst and market advisors. Recently the sentiment index for gold has declined to a record low 32%. It has bounced the past couple of days to 37%. Historically a sentiment reading in the mid-high 40s was a definitive contrarian signal to buy and a sentiment reading in the 80s was a contrarian signal to sell. With investment advisor and Wall Street analyst sentiment index at a record low - that is, with everyone standing on one side of the boat - it is time to move to the other side of the boat and buy gold.

The last bottom signal I want to present is the extraordinary amount of physical gold being imported by the eastern hemisphere countries. Per the quote and link at the top, if China continues buying gold at the rate it imported in the first half of 2013, it will likely import close to 2000 tonnes. This would represent close to 80% of the annual output of all global gold mines. In addition, based on India's import numbers through the end of June, the World Gold Council projects that India will import around 1000 tonnes. The annual global mined output of gold averages 2500 tonnes. This amount will decline this year if the price of gold remains below $1300/oz, as several mines around the world have been mothballed because the price of gold is now below their average cost of production.

India and China's combined gold imports thus will likely exceed the amount of gold supplied by mines this year. This doesn't account for the gold buying by the rest of the world. Given this incredible supply/demand imbalance, at some point the price of gold will have to rise quite a bit to restore a more "normal" supply/demand function.

While short term it's impossible to predict the direction of any market, especially futures-driven commodities markets, at some point technicals, fundamentals and "sentiment," will restore a market to its primary trend. Of these, I consider the dramatic repositioning by the big Comex banks as described above as the most significant of the signals. Over the course of the last 12+ years I've been involved in the precious metals market, the banks always seem to get it right.

If you agree with my view, the best way to play the sector is to start buying physical gold and silver. If the demand by the east described above continues like this, at some point the premiums over the spot price to buy gold and silver bullion coins will be quite hefty. If you want to take more of an "intermediate" trading view, I recommend, GLD, long-dated call options on GLD. For a really aggressive play, I like AGQ (2x long silver ETF). I recommend the latter because the returns on silver are naturally "leveraged" to the returns on gold and AGQ is 200% times the return on silver.

Disclosure: I am long GLD, AGQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The fund I co-manage is long physical gold, silver and mining stocks