Gold has rebounded sharply higher in the past month, taking the early lead as 2017's best-performing asset class. Normally such a big gold surge would require heavy gold futures buying by speculators. But they've been missing in action, barely moving any capital into gold yet. Their collective bets on this metal remain very bearish. Since they are such a strong contrarian indicator, that's a very bullish omen for gold.
The sole mission of speculation and investment, and thus all the endless research that feeds into it, is to multiply wealth. Traders can't effectively buy low and sell high unless they understand what drives the prices of their trades. For years now, gold has had two overwhelmingly dominant drivers. Their capital flows fully explain the vast majority of all gold's price action, and thus are exceedingly important to study.
The first is the world-leading SPDR Gold Trust ETF (NYSEARCA:GLD). This acts as a conduit for the vast pools of American stock market capital to slosh into and out of physical gold bullion. Differential supply and demand for GLD shares relative to the underlying gold supply and demand is directly shunted into gold itself. GLD's physical gold bar purchases and sales as its holdings grow and shrink greatly impact gold prices.
Nothing has been more important for gold over the past year than the American stock market capital that flowed into then out of it via GLD. Speculators and investors can't understand where gold has been or where it's likely heading without studying and closely watching GLD's gold bullion holdings. Last week I wrote a comprehensive essay digging into this crucial GLD and gold relationship in depth, check it out.
But American speculators' gold futures trading often overpowers American investors' GLD share trading in bulling the gold price around over the short term. Futures speculators enjoy an outsized impact on gold prices wildly disproportionate to the capital they wield for a couple key reasons. First, the American gold futures price is gold's de-facto world reference price. It is the most widely followed and quoted gold read.
So when these traders buy or sell aggressively and thus rapidly force gold materially higher or lower, it has a big psychological impact on everyone else in the gold world. Gold futures are the speculation tail wagging the far larger investment dog in gold. Investors controlling vastly more capital than gold futures speculators get bullish or bearish, and change their trading behavior accordingly, based on gold futures action.
Second, gold futures traders enjoy a radically inordinate influence on gold thanks to the extreme leverage inherent in gold futures. While investors buy gold outright or with at most 2x leverage through GLD shares, gold futures speculators often trade gold with incredible 20x to 25x leverage! That means every dollar of capital bet on gold futures can have 20x to 25x the price impact of another dollar invested normally.
So futures speculators' collective buying and selling can really distort gold prices over the short term, even though gold investment demand will always ultimately prevail as gold's primary driver. There's a critical interplay between GLD capital flows and gold futures action. Parallel buying or selling on both of these fronts always drives gold higher or lower. Opposing buying and selling tends to offset and cancel out.
Unlike GLD holdings data which is available daily, speculators' collective gold futures trading activity is only published at a fuzzier weekly resolution. Late every Friday afternoon the CFTC releases its famous Commitments of Traders reports. These reveal what both hedgers and speculators have been doing in gold futures current to the preceding Tuesday. Watching them is essential to gaming gold price action.
This first chart looks at the aggregate gold futures long and short positions held by both large and small speculators, in contracts. Each gold futures contract controls 100 troy ounces of this metal. Total longs or upside bets on gold are rendered in green, while total shorts or downside bets are shown in red. The yellow line shows the deviation of both these bets from normal years' average levels between 2009 to 2012.
Speculators' gold futures data may look complex, but it's not difficult to understand. Gold's price over the past couple years or so is superimposed in blue. Gold is strongly positively correlated to speculators' total gold futures longs. Every significant gold rally in recent years was partially driven by big gold futures buying as evidenced by spec longs surging. Until this past month's rally, which we will get to.
Speculators' collective upside bets on gold are also a powerful contrarian indicator. Spec longs were high every time gold peaked in the last couple years, including this past summer. As I warned back in mid-July just after gold hit $1,365, it faced a record gold futures selling overhang due to specs' excessive longs. These hyper-leveraged traders were far too bullish, all-in on gold, implying they would soon have to sell.
The higher spec longs, the more bullish on gold these traders are. But that means they have already deployed most of their available capital, with limited firepower to push gold still higher once they're all crowded in. So gold rallies often peter out and then reverse once spec longs get excessive. The worst time to get excited about gold is when futures speculators are, since they are the most bullish when gold is topping.
Conversely, low spec longs show when these traders are bearish. They don't expect much upside from gold so they've liquidated large fractions of their leveraged long bets. That signals most of the gold futures selling has already happened, so gold is actually bottoming. Spec longs were really low back in December 2015 when gold was carving a major 6.1-year secular low. That birthed last year's strong new bull!
So the smart way to game gold's probable near-term price action is to do the opposite of what the futures speculators as a herd are doing. If they are betting big on higher gold prices as shown by excessive longs, expect an imminent correction. If they are convinced gold is heading lower as seen in low longs, expect a major rally to soon erupt. Fading the futures speculator mob is the surest way to win in gold trading!
Speculators' collective gold futures short positions work similarly, but in the other direction of course. In futures, traders can sell even if they don't own any contracts to sell. They effectively borrow them from someone else, and then sell them. These debts must soon be repaid, so speculators hope they can buy back the futures contracts at lower prices to return them. They then pocket any difference as profits.
In terms of gold price impact, there is zero difference between a speculator selling long contracts they already own or short selling ones they don't. A sale is a sale, they are functionally identical. But since speculators collectively hold fewer gold futures shorts than longs, shorting has a proportionally smaller effect on prevailing gold prices. But once again speculators bet wrong as a herd when gold is ready to reverse.
Gold's major secular lows in 2015 were accompanied by record-high spec short positions! Right when gold was bottoming ahead of major rallies, these guys were holding the largest downside bets. Then as gold subsequently topped, spec shorts had been bought and covered back down to low levels. So gold is most bullish over the near term when speculators are the most bearish as evidenced by excessive shorts.
Futures speculators are always wrong at extremes, when gold has either rallied or corrected too far for too long. High spec longs and low spec shorts are a key warning sign of a major selloff looming, just as I warned last summer. But low spec longs and high spec shorts signal the opposite, that gold is on the verge of embarking on a major new rally. This latter very bullish situation is exactly what gold is seeing today!
This chart zooms in to the past year or so, but let's start on Election Day. That night as Trump pulled into a surprise lead in the biggest battleground state of Florida, gold futures rocketed 4.8% higher to $1,337! A Trump win was universally assumed to be bad for stock markets and thus good for gold, which is the anti-stock trade since it tends to move counter to stock markets. As stocks rebounded, gold was sold hard.
This heavy post-election gold selling was universal, coming from both investors jettisoning GLD shares and speculators dumping gold futures. With capital rushing out of gold's two primary drivers, it was just hammered. In the 5 weeks between Election Day and the day after the Fed's second rate hike in 10.5 years in mid-December, gold plunged 11.5%! That was part of a larger 17.3% major correction since early July's peak.
Gold's two biggest plunges in its miserable Q4'16, one of its worst quarters ever, were fueled by heavy gold futures selling by speculators. Since such extreme leverage exists in this market, traders have to set tight stop losses. If they are running 20x leverage, a mere 5% adverse move in gold against their bets would wipe out 100% of their capital risked! So even minor 1%ish gold moves are major for futures traders.
In early October as gold drifted towards $1,300, it triggered a big mass of futures stop losses set near that key psychological support. The resulting mass stopping quickly cascaded, as the more gold futures fell the more stops were tripped unleashing even more selling. Another mass stopping happened just two days after the election when another key gold support zone at its 200-day moving average failed to hold.
These extreme early-October and mid-November episodes of gold futures selling perfectly illustrate how disproportionate its impact can be. Speculators dumped 43.4k and 45.6k contracts, respectively, in those two key CoT weeks, unleashing the equivalents of 134.8 and 141.9 metric tons of gold. That is far too much selling for the gold market to absorb in such short spans of time, which cratered the gold price.
For perspective, consider the latest global gold fundamental data available from the World Gold Council current to Q3'16. That 9-month year-to-date span saw massive gold investment demand, huge by recent years' standards. Yet it still only averaged 35.6t per week. So whenever gold futures speculators get spooked or forced into dumping 100t+ in single-week spans, gold is certainly going to get kicked in the teeth.
The resulting sharp drops really crush gold psychology, leaving investors and speculators alike much more bearish and pessimistic. They start to extrapolate that trend, expecting gold to keep falling farther. So they buy less or sell more, and gold's futures-driven selloff soon becomes self-feeding. It is amazing how much gold futures impact overall gold sentiment, these speculators' influence is wildly disproportional.
That extreme post-election selling initiated by speculators' gold futures stops being run finally ran its course by the day after the Fed hiked rates again last month. Futures speculators have long feared Fed rate hikes' impact on gold, which is supremely irrational. During the exact spans of all 11 previous Fed rate hike cycles since 1971, gold rallied an average of 26.9% higher! They have proven very bullish for gold.
By the time gold finally bottomed last month, its correction had ballooned to 17.3%. That is huge, but still shy of 20%+ new bear territory. In addition to heavy differential GLD-share selling, the other primary driver was heavy gold futures selling by the speculators. Over that entire correction span since early July, they had liquidated an astounding 174.0k long contracts while adding 32.2k short ones, serious selling.
That equates to 641.3 tonnes of gold, or nearly half of the 1389.2t of global gold investment demand in the first 9 months of 2016! Speculators had unwound fully 69.8% of all the long positions they had added to help drive gold's new 29.9% bull market between mid-December 2015 and early July. All this extreme selling along with GLD's blasted gold so low that it erased a staggering 75.4% of its bull's progress.
With speculators fleeing gold futures at a magnitude that defies belief, they had to be exhausting their selling as I wrote in mid-December. These traders only have so many contracts they can sell, so the more they've sold the less selling is still to come. And soon after gold's 10.6-month low in mid-December, these gold-futures spec long positions had collapsed back down to 255.7k contracts. That was a 10.4-month low.
American speculators hadn't held fewer gold futures longs since way back in mid-February before gold had even entered new bull market territory yet at a 20%+ gain. So with the great majority of the entire young bull market's gold futures long buying already unwound, spec longs are very low today. That is a super-bullish omen just like it was at past major gold lows. These traders have vast firepower to buy back in!
A week after that recent longs low, spec shorts surged to 138.6k contracts. That was also the highest level seen since early February, and way above last year's 95k-contract support line. While there was some modest covering in the latest CoT report available before this essay was published, shorts are still relatively high. That means speculators have to buy lots of gold futures to cover and offset their shorts.
With speculators very bearish on gold today as evidenced by low longs and high shorts, you couldn't ask for a more bullish gold setup. Just as in the past, gold tends to bottom right as these influential traders are reaching selling exhaustion. That leaves nothing but buyers, so gold soon starts rallying in major new uplegs. Indeed, one has already begun, despite futures speculators not doing any significant buying yet.
Major gold uplegs are usually born when speculators buy gold futures to cover their short positions. As they are legally obligated to pay back those borrowed contracts, and have to buy to protect their capital when gold rallies, short covering is involuntary. Speculators do it regardless of how they feel about the gold outlook. But that very short covering drives gold higher and starts to erode bearish bottoming psychology.
So the much larger contingent of gold futures speculators on the long side soon start buying as gold's short covering fueled rally convinces them it is reversing higher. That starts to turn sentiment bullish again, with buying begetting buying. Eventually that long-side buying drives gold high enough for long enough to get investors, with their vastly larger pools of capital, interested in starting to buy gold again.
While we saw modest spec short covering of 6.4k contracts as of January 10th, the last CoT data before this essay was published, there has been no material long buying yet. Since that 255.7k-contract trough of spec longs a couple CoT weeks ago, speculators have only added 2.4k contracts. That's practically a rounding error. Seeing gold blast 7.7% higher in just a month with no real gold futures buying is remarkable!
And there hasn't been any differential GLD-share buying either. Gold's initial rebound out of its deep post-election lows apparently came from Asia. There have been plenty of days in recent weeks where gold rallied significantly overnight when American traders were sleeping. That global gold demand that is pushing up prices without any help from gold's dominant couple drivers is going to ignite big buying.
Sooner or later gold will have rallied enough to convince both American gold ETF investors and gold futures speculators to return. And with specs' longs so low and shorts so high, they are going to buy with a vengeance to mean revert their excessively bearish bets back up to more-normal levels. In addition to higher gold prices, there are a couple more key catalysts that will soon spark big gold futures buying.
Gold futures traders are highly sensitive to the US dollar, since gold is ultimately the universal world currency. So as today's wildly overcrowded long US dollar trade inevitably reverses, speculators are going to flood back into gold futures. They will also aggressively buy when the overvalued US stock markets sell off and roll over into their long-overdue bear market, which will lower perceived Fed rate hike odds.
With speculators way too bearish today as their low longs and high shorts prove, there's heavy gold futures buying coming. It will catapult gold sharply higher in the coming months, as always happens soon after these guys as a herd get too pessimistic. Some combination of higher gold prices, a lower US dollar and/or stock markets, and less-hawkish Fedspeak is going to soon kindle serious gold futures capital inflows.
This coming major new upleg in this young gold bull can certainly be played with GLD or call options on it. But the gains in the gold miners' stocks will dwarf the gains in gold, since their profits growth greatly leverages gold's upside. As I discussed in depth a couple weeks ago, we're already seeing that. Over that recent single-month span where gold rallied 7.7%, the leading gold-stock index already surged 25.3% higher!
The bottom line is the gold-futures setup today is exceptionally bullish. Speculators grew excessively bearish in the wake of the election, dumping a colossal amount of long contracts while adding plenty of shorts. This huge liquidation left their longs low and shorts high, a strong contrarian indicator that has always signaled major reversals higher in gold. These elite traders as a herd are always wrong at extremes.
So big spec gold futures buying is coming soon, which will help catapult gold sharply higher again just like it did a year ago. It is already starting with initial short covering, but will soon expand into far-larger long buying as gold continues powering higher. After selling their longs to such low levels, these influential traders will need to buy big for months on end to restore normal positions. That's great news for gold!
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