Gold: Is This Rally Sustainable?

| About: SPDR Gold (GLD)
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Summary

Despite an ongoing rally in gold prices, the American investors are still cutting their gold holdings.

On the other hand, the COT report delivers the data supporting a bullish thesis on gold (for example, the US dollar seems to be ripe for a trend reversal).

As a result, the big picture is very unclear. Therefore, I advise caution.

The SPDR Gold Shares (NYSEARCA:GLD) is one of my favorite indicators applied for measuring the state of the gold market. However, some of my readers criticize me for using this indicator. There are two main arguments against it:

  • doubts about the reliability of the data delivered by GLD
  • reservations about the efficiency of the trading signals delivered by GLD

I am quite far from discussing these arguments because it would probably be extremely boring for the readers. What is more, I do not want to make a fuss about it. Instead, I would say this:

"As far as any indicator works I will be using it. GLD is no exception from this rule"

I guess that this statement comes from Karl Popper's works. For example:

"…he (Karl Popper) goes on argue that scientific theories are distinguished from non-scientific theories by a second sort of boldness: they make testable claims that future observations might reveal to be false. This boldness thus amounts to a willingness to take a risk of being wrong. On Popper's view, scientists investigating a theory make repeated, honest attempts to falsify the theory, whereas adherents of pseudoscientific or metaphysical theories routinely take measures to make the observed reality fit the predictions of the theory"

Of course, I realize that being too scientific in financial markets may be a nice recipe for a disaster but over the last year GLD worked quite well as an indicator. Additionally, it worked even better combined with the COMEX data:

Source: Simple Digressions

As the chart shows, in 2016 the price of gold was following the flows reported by GLD and the COMEX:

  • In April the outflow of 3 tons was followed by stagnant gold prices
  • Between May and July lower inflows of gold were followed by a distribution phase (August - September)
  • Since August the gold was leaving GLD and COMEX vaults (especially in November and December); hence, much lower prices of gold in the fourth quarter of 2016.

However, it is history. The main question is, as usually, "What now?".

Since the end of 2016 as many as 19.4 tons of gold left GLD and COMEX vaults (17.2 and 2.2 tons, respectively). It means that despite the fact that in the same period gold prices went up by 3.2%, the American investors cut their gold stakes. If my indicator still works this rally in gold prices should stop soon.

On the other hand, if the pricing power has shifted from the USA to, for example, China, the indicator should be useless. The chart below shows gold withdrawals reported by the Shanghai Futures Exchange (SFE):

Source: Simple Digressions

The chart shows that in 2016 the Chinese did not stop accumulating gold. Yes, they cut their demand a little bit but 1,970 tons of gold withdrawn last year is still an impressive figure. To strengthen my thesis I have plotted another chart. This time it shows the SFE withdrawals against the annual world gold production:

Source: Simple Digressions

As the chart shows, since 2013 the Chinese have been absorbing 62% - 81% of world's annual production of gold.

Now, because every year huge amounts of gold are disappearing in the Chinese pockets it is only a question of time when the pricing power shifts to the Far East. When will it happen? I do not know but one of the first indications that something big has just happened would be the time when my indicator is not working anymore.

However, using Mr. Popper's approach, the GLD suitability has not been falsified yet.

The price of gold is supported by the gold dollar index and three major currencies

Gold dollar index

In one of my articles I reminded the so-called Gold dollar index, which is defined as:

"The GolDollar Index was invented by Tom McClellan (of McClellan Financial) and is calculated by multiplying the price of gold by the U.S. Dollar Index. Its purpose is to cancel the effects of currency fluctuations on the price of gold. By comparing it with the spot gold index we can determine if there is inherent strength/weakness in the price of gold"

Most recently the gold dollar index bounced off its long - term trend line:

Source: Simple Digressions

It looks like the gold dollar index is supporting the bullish thesis on gold.

US dollar

The general rule is: "When the US dollar goes up the price of gold goes down". I discussed this relationship a few times on Seeking Alpha. Today I want to refer to the Commitments of Traders report and show the current net position held by the so-called "commercials". To remind my readers, "Commercial" is an entity:

"…that it is commercially engaged in business activities hedged by the use of the futures or option markets."

What is more, due to their huge financial power, these entities (mainly banks) are considered as price makers. The chart below shows the current net position held by "Commercials" in the US dollar futures:

Source: Simple Digressions

The chart shows that huge net short positions held by Commercials are, in most cases, indicative of the top printed by the US dollar index (the area marked in yellow). Now Commercials hold a huge short position in the US dollar index futures (60.3 thousand contracts, as of January 3, 2017). Although it is not the extreme reading it is close to the previous extremes. Simply put - it looks like the last strong rally in US dollar prices is close to its end. If I am correct, the US dollar should weaken soon and…gold prices should be supported by the weakness in the greenback.

This thesis is additionally supported by the decreasing open interest in US dollar futures:

Source: Simple Digressions

The chart shows another interesting pattern, characteristic of the failed tops. Generally, when any financial instrument prints a local top and the open interest is lower than before, it is indicative of an incoming trend reversal. Note that in March 2015 the US dollar index made a top at 100.2 (point A). At that time the open interest was standing at 148 thousand contracts. On January 3, 2017 the index made another top (103.2 - point B). This time the open interest was standing at a mere 85 thousand contracts. Simply, the traders' interest in playing US dollar index futures is dissipating. Hence, the top may be close.

British pound and Japanese yen

According to the COT data, the British pound and the Japanese yen, two major world currencies, are sending a message that they are ready to strengthen against the US dollar. Look at the Japanese yen:

Source: Simple Digressions

The red, horizontal line indicates the oversold conditions for the Japanese yen. Generally, each time the Commercials hold a huge net long position in the Japanese yen futures (close to the red line) the yen is appreciating. The only major exception was the period between January 2013 and January 2016 - during that period a different pattern was visible (the decreasing net long position during a strong downward trend, which is a good indication of an incoming trend reversal). Now we are once again very close to the red, horizontal line, which may be considered as an incoming trend reversal.

A similar pattern is being drawn by the British pound:

Source: Simple Digressions

Here the British pound has just left the oversold condition (the area marked in yellow) so, similarly to the Japanese yen pattern visible in the period between January 2013 and January 2016, this major currency may be close to its bottom.

Now, the above discussed charts draw a developing pattern where the US dollar is going to go down and the British pound and the Japanese yen are going to go up. It is a logical sequence - very often a weak US dollar is followed by its stronger peers (in this case GBP and JPY).

If I am correct, this sequence should support the bullish thesis on gold.

Summary

The data delivered by the COT report discloses a developing pattern where the US dollar is ripe for the trend reversal. This pattern is additionally supported by the Japanese yen and the British pound. If I am correct, a weaker US dollar may boost gold prices (applying a popular rule that gold prices go opposite to the US dollar).

However, according to the GLD data, the American investors are still cutting their holdings of gold. Combining these two sets of data (the COT report and GLD) I have mixed feelings about the current rally in gold. The COT report supports a bullish thesis on gold while the GLD data delivers a totally different scenario (a bearish thesis).

Disclosure: I am/we are long GDXJ.

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.