Update On GOFO - Factors That Will Spark A Big Move In Gold

Includes: RGLD
by: Dave Kranzler

With gold sentiment quite negative and shorts at extreme levels, upside price risks cannot be ignored especially amid evidence of consistent physical demand. Historical seasonal patterns suggest that this is likely to strengthen later in the quarter, which in turn could prompt a short-term squeeze. - UBS, London Metals Group

I believe a bottom was established in gold on June 28 -- (see Why Last Friday (June 28) Was Likely A Bottom) -- and now I'm going to review some key factors that I believe will spark the beginning of the next big move higher. As you can see from the chart below, this big, painful 2-year correction in the price of gold is very similar to the corrections in 2006 and 2008:

Click to enlarge

I've marked on the chart where "false bottoms" occurred (black circles) and true bottoms occurred in 2006/2008 and likely 2013 (green circles). The first two big corrections both had a "false" bottom and a "true" bottom. I believe this set-up is now in place for the current correction.

I remember vividly back in 2008 wondering in late October of that year, after gold had given me hope in September that turned out to be a false bottom, "what is going to stop the entities shorting paper gold on the Comex from driving the price back down to $250?" As it turned out, the Great Financial Collapse followed by massive QE sparked a 3 1/2-year run in gold up to $1900.

Just like in 2008, it is likely that we won't know what the ultimate event that will occur, which will trigger the next move to a new record in gold until after it has occurred, but I'll review some factors that I believe will play a big role in fueling the next leg higher.

First, and what may in fact be the "unforeseen event" that will trigger the initial push higher, is yesterday's bankruptcy filing by the City of Detroit. Not only will this event serve as a catalyst to trigger more, and even bigger, municipal bankruptcy filings, but it will force large U.S. Treasury/dollar investors to take an even closer look at their investments in the U.S. dollar and their role in funding U.S. Government deficit spending and debt accumulation. In other words, yesterday's event in Detroit could spark a large-scale loss of confidence in the dollar, which will light a serious fire under the price of gold.

The second factor is the condition of the physical market. The market for delivery of large quantities of physical gold bars over in Europe and Asia has become extraordinarily tight. I wrote an article last week that explained in detail what the LBMA Gold Forward (GOFO) rate is and the significance of a negative GOFO. When I wrote that piece, GOFO had gone negative three days in a row -- a rare occurrence. As of today, GOFO has been negative for a historically unprecedented 10 days in a row -- LBMA GOFO.

This is indicating that there's likely a severe delivery "short squeeze" of gold going in London. We know that in the first half of the year, China imported 1000 tonnes of gold. This has been documented ad nauseum. It is highly likely that this enormous amount of gold importation, combined with the record amount of gold imported into India and other big gold buying countries for the first six months of 2013 has created a massive shortage of bars available for delivery. The negative GOFO rate for 10 days in a row is evidence of this situation. If this situation is not resolved soon, it is very possible that we'll see the shortages of gold in the physical market trigger a massive short-squeeze covering in the Comex paper market.

Which brings me to my third factor, the record gross short position in Comex gold futures. As has been widely reported, for several weeks the gross short position in Comex gold has been hitting new record levels almost on a weekly basis. In fact, last week it hit a new record. The short interest in gold has been fueled largely by the hedge fund category of trader. Even more interesting, as I've documented in previous articles, the three largest bank traders on the Comex have positioned themselves net long Comex gold for the first time since the bottom of the previous bear market in 2001. The combination of a severe shortage of physical gold available for delivery in Europe and Asia and the massive short position in Comex futures could well fuel a short squeeze in gold that would quickly send gold up and over the previous record price level of $1900.

Finally, another factor that could be the "unforeseen" trigger that fuels gold a lot higher from is the possibility that China announces the backing of its currency (the yuan) with gold. A Russian newspaper yesterday reported that Chinese officials have been considering making this move -- China/yuan/gold -- which would likely create a serious gold rush as most of China's trading partners would need to bolster their foreign currency reserves with a lot more gold in order to make their respective currencies "fungible" with the yuan. This move could also trigger many Central Banks to reduce their dollar holdings and reallocate their reserves to yuan, which would further fuel the price of gold in dollars.

Based on all these factors, not only am I more confident that Friday, June 28 marked the bottom of this brutal 2-year correction in the precious metals, but I am also confident that the next secular bull market move higher will take gold to a new record high. If you agree with my outlook, the best way to play a trading move is to get long GLD or long-dated calls on GLD. I also recommend that everyone who wants to preserve their wealth and use gold as an investment should accumulate physical gold and silver. You can express a leveraged view on gold by getting long Royal Gold (NASDAQ:RGLD), which is a large gold mining royalty company that benefits on a "leveraged" basis as the price of gold moves higher.

Disclosure: The fund I manage and am invested in is long physical gold and silver and mining stocks. 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.