Gold: Where Is The Love?

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Includes: GLD
by: Boris Mikanikrezai

Summary

In my baseline scenario, the trend remains bearish for gold in 2014.

Speculators have now expanded their short positions.

The options market positioning suggests downward pressures to resume in the short term.

On June 5, 2014, I wrote an article in which I developed my constructive macro/bearish gold thesis. If you do not have time to read it, here is the summary:

1-In my baseline scenario, the trend remains bearish for gold in 2014.

2-The speculators' futures positioning suggests gold prices are going to break below their June and December lows.

3-The options market positioning indicates that the recent sell-off in gold prices is not likely to continue, at least in the very short term (ST).

In this article, I aim to re-assess the situation. While the main premise of my bearish outlook has not changed, I discussed the speculators and the options market positioning in order to understand where we are going:

1-In my baseline scenario, the trend remains bearish for gold in 2014

2- Speculators have now expanded their short positions

3- The options market positioning suggests downward pressures to resume in the ST

Exhibit1: Gold prices have remained unchanged since January 2014

Source: Reuters

Assumption 1: Bearish Trend in 2014

This hypothesis is currently being tested by the market. I was proven wrong in Q1 2014 as gold prices rose by almost 20% from late December 2013 to the middle of March 2014 from their June lows of $1,180/toz to nearly $1,400/toz.

By the end of December 2013, I expected that the monetary demand for gold would continue to have a negative impact on gold prices such as what happened in 2013 when the selling of gold for private investment (via gold-ETFs) pushed prices down dramatically by nearly 30%. This scenario failed to materialize in Q1 2014.

However, as gold prices failed to break above the $1,400 magical level in March, many investors developed quite legitimate concerns about the sustainability of the rally. Interestingly, the precious metal began to fall although a modest rally occurred in June as the demand for "safe-havens" picked up. Year to date, the price of gold remained broadly unchanged.

Assumption 2: Speculators have now expanded their short positions

Exhibit 2: The net speculative length in gold is now low

Source: CFTC, Mikz Economics

This hypothesis has been proven correct. As noted here, speculators covered their short positions from the end of 2013 into Q1 2014, which pushed gold prices up. I expected that speculators to re-build their short positions aggressively given their bearish sentiment. As seen in Exhibit 2, from July 2014, the net-long speculative length fell dramatically by 75% from 125,726 contracts to 30,923 contracts at the end of September. The net-long speculative length is currently near the lowest level seen in November 2013 (15,961 contracts).

Exhibit 3: Gold-ETFs have remained broadly stable since January 2014

Source: Bloomberg, Mikz Economics

Given the extreme low level of the net-long speculative length, there is a greater risk of short covering if market participants' expectations failed to materialize. However, if gold prices continued to fall, speculators could maintain their bearish bets such as what they did from February to August 2013. In order for gold to decline, the monetary demand has to fall. While private demand for gold declined significantly in 2013 through ETF liquidation, it appears to be more stable in 2014 (Exhibit 3). I have no means of predicting ETF flows quantitatively but I forecast further outflows into the year's end based on a positive U.S. economic outlook. However, if my expectations fail to materialize, so that investment demand continues to remain stable, speculators will eventually cover their short positions and a sustainable rally is likely to occur.

In sum, speculators have now expanded their short positions and I expect the net-long speculative length to remain low over the medium term.

Assumption 3: The options market positioning suggests downward pressures to resume in the ST

Back in June, I did not forecast a ST collapse in gold prices akin to the 2013 sell-off. My view was based on the options market positioning, suggesting that market participants were not biased for the downside price action despite the sharp sell-off from May 27 to early June. My view was eventually proven correct as gold experienced a ST rally (one month) from June to July.

The options market positioning is, in my view, a reliable indicator in order to gauge traders' sentiment. The method consists of computing risk reversals. A risk reversal can be defined as the difference between the implied level of volatility on a call option (upside protection) and the implied level volatility on a put option (downside protection). The higher the risk reversal, the more optimistic traders are about the future direction of the gold price because upside protections (call options) are more expensive than downside protections (put options). In my analysis, I compute the 25-Risk Reversal on a 1-month horizon, aka R25, which is the difference between the implied volatility of the 25-delta call and the implied volatility of the 25-delta put.

As noted, from May 27 to early June, gold prices declined significantly by 4% or $150/toz. Meanwhile, R25 remained stable. In other words, traders were not worried about the sell-off, suggesting that it would not last and a short covering rally would be likely. This view was proven correct as the sell-off was followed by a one-month mini-rally from $1,240/toz to $1,250/toz.

Exhibit 4: Traders are currently biased on the downside in the ST

Source: Bloomberg, Mikz Economics

This time is different…

From August 2014, market participants expressed a significant renewed interest in downside protections while gold prices accelerated their decline. As seen in Exhibit 4, R25 decreased from +0.28 on August 6 to -2.46 on October 7. This suggests that traders are much more worried about the recent decline than the sell-off at the end of May. Even though gold prices bounced back from their lows of $1,185/toz on October 6, the current mini-rally is likely to come to an end and the downtrend should resume in the ST.

In sum, while the options market positioning suggested that the sell-off in late May would not continue in the very short term, the current decline is taken more seriously by market participants. They expect a continuation of the downtrend in the ST.

In sum, my constructive bearish gold hypothesis is currently being tested. While speculators expanded their short positions from August 2014, gold prices may decline only if the monetary demand falls. Given the stable level of ETFs holdings in 2014, I recognize that it is tempting to forecast a continuation of the trend. However, based on my positive U.S. economic outlook, I expect a further Western investor disinterest that is likely to result in a decline in ETFs holding. If this view proves correct, gold prices could decline sharply into the year's end. Furthermore, the options market positioning suggesting that downward pressures are likely to resume in the ST despite the current mini rally. It is important to note, however, traders should wait that the current mini-rally runs out of steam before starting to build a short position.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.