The precious metals market has been flat this year up to now. Fortunately, it is quite easy to explain this phenomenon because a logical answer (let me assume that there is some logic in financial markets) is in the Commitments of Traders reports (COT reports). What is more, these reports provide an interesting clue as to what conditions have to be met to push gold prices higher.
What drives the paper gold market?
Bull market phase
In the beginning of 2016 gold entered a bull market phase. The prices went up from $1,061 per ounce of gold on December 31, 2015 to $1,373 per ounce on August 2, 2016 (an increase of 29.4%).
According to the COT reports, during this cycle the money managers increased their gross long position by 198 thousand contracts while their gross short position was cut by 69 thousand contracts. So a net long position went up by 267 thousand contracts. Indeed, it was a very healthy bull market because higher gold prices were driven by the longs (money managers holding a gross long position in gold futures) with the shorts leaving the market (cutting their short positions).
Then, in early August 2016 a strong correction started. Why am I using a word "correction"? Look at this data:
- Between August 3 and the end of 2016 the longs cut their positions by 161 thousand contracts
- In the same time the shorts increased their short bets by 57 thousand contracts
- As a result, a net long position held by money managers was reduced by 218 thousand contracts
The data shows that the move down in gold prices was driven by the longs cutting their exposure to gold. The shorts correctly smelled the opportunity and increased their short bets but the size of this increase was far less impressive than that showed by the longs. So the longs were a leading side.
In my opinion, bull markets are led by the longs and bear markets are led by the shorts so a move down led by the longs should be considered as a correction during a bull cycle. Therefore, applying this definition, the move initiated in August 2016 was a typical correction.
Now, let me look at this year's developments. Since the beginning of 2017 gold prices have gone up by 12.4%. What forces were standing behind this move? Here are the figures:
- Longs - an increase of 57 thousand contracts
- Shorts - a decrease of 73 thousand
- As a result, a net long position held by money managers went up by 130 thousand contracts
So, a net long position held by money managers went up by 130 thousand contracts (which is typical for a bull cycle) but this increase was led by the shorts cutting their short bets on gold.
Using different wording, contrary to the first half of 2016 (when gold was in a healthy bull market driven by the longs adding fresh positions), the current move up, initiated in the beginning of 2017, has nothing to do with a healthy bull market stage. In my opinion, it resembles a consolidation phase. This observation is particularly evident when the price action of silver is plotted against gold's price action:
Note that since the beginning of 2017 silver was trading in the narrow range of $15.5 - $18.5 per ounce (look at the red, horizontal line on the upper panel of the chart).
Summarizing - this year's price action of gold and the data delivered by the COT reports indicate that gold is consolidating before a larger move. As usually, the main question is whether this move will be up or down. As usually, I do not know but below I discuss three factors that could help to find a clue.
Metal exchanges are not the best tools to predict prices but sometimes they can deliver helpful hints. Let me take a ratio defined in the following way:
Open interest in gold futures traded at the COMEX / the amount of gold ounces held at the COMEX
The ratio very smartly connects the paper gold market (gold futures) with the physical gold market (the COMEX gold stocks).
Note: Contrary to other authors, I am using total gold stocks reported by the COMEX (registered + eligible) instead of the gold held in the "Registered" category. Simply, the gold held in the eligible category can be very easily upgraded into the registered category (by issuing a warrant, which is just a piece of paper) so, in my opinion, the denominator should disclose the total stocks.
The chart below shows the ratio defined above (in the upper panel of the chart I have plotted gold prices):
Source: Simple Digressions and the COMEX data
It is very easy to spot that since the end of 2014 the ratio was rapidly going up indicating that the size of the paper gold game (futures) was increasing sharply, compared to the gold stocks reported by the COMEX. Then, in the beginning of 2016 a strong bull market in gold began.
However, since April 2016 the ratio reversed and started a free-fall. Gold prices followed the ratio and between August and December 2016 a strong correction dragged the prices of gold from $1,370 to $1,130 per ounce.
Now it looks like a bullish pattern is back again. Since the beginning of 2017 the ratio has been going up, supporting gold prices. Let me provide a few figures:
- Since the beginning of 2017 the gold stocks at the COMEX went slightly down from 9.2 million ounces at the end of 2016 to 8.9 million ounces as of November 27, 2017
- In the same time the total number of outstanding contracts held by the participants trading gold futures (the open interest) went strongly up from 401.5 thousand contracts to 531.6 thousand contracts
As a result, the ratio has been in its upward trend since the beginning of 2017. What is more, it has been going up at relatively stable gold prices.
Summarizing - if my discussion is correct, the gold market is preparing for a bigger move up (higher ratio precedes higher gold prices). However, despite this optimistic thesis, it is hard to predict when this move is going to start.
The US dollar is a big threat for the precious metals market. As a rule, gold goes opposite to the greenback (although I could very easily indicate a number of cases when both instruments were going in tandem).
As the chart below shows, until early September the US dollar was weakening bit since then it recovered a little bit:
Now the question is: is the greenback in another bull cycle? In my opinion, it could be. Let me analyze the last move up (indicated by the blue arrow on the chart above). This move can be divided into two stages:
- Impulse: a period between early September and early November; during that period the US dollar went up from 91.5 to 95.0
- Correction: early November - now
The table below depicts the changes in gross positions held by big speculators trading US dollar index futures. The first stage is marked with the blue line and the second one with the red line:
Source: Simple Digressions and the COT data
The first stage was typical for an emerging bull cycle: the shorts (speculators holding a gross short position) were leaving the market cutting their short bets by 3.0 thousand contracts and the longs (speculators holding a gross long position) increased their bets by 0.2 thousand contracts. So during this stage the shorts were a leading party (short-covering).
On the other hand, the second stage is a typical correction during a bull cycle: the shorts are still cutting their bets and the longs, still very dubious about the chances for a bigger move up, are cutting their exposure.
Understand me well, the most important thing during the current correction is the fact that the shorts are not aggressively increasing their short bets. If they were, I would say that another leg down is incoming but the facts do not support this thesis. Therefore, in my opinion, there are more chances to see a stronger US dollar in the coming future then a weaker one.
If I am correct, a stronger US dollar could be a headwind for the precious metals market.
US equities and the bitcoin mania
As I discussed in one of my latest articles on gold - paradoxically, the hyperboles drawn by US equites and the bitcoin may attract prudent investors to the precious metals market. Since October 30, 2017 (when the article was published) the S&P 500 index went up by 2.1% and the bitcoin soared by 63.0%.
The thesis presented in my article is even stronger now.
The precious metals market has been flat this year so far. Although today gold prices are 12.4% higher than in the beginning of 2017, silver has been fluctuating around $17 per ounce and gold mining ETFS, GDX and GDXJ, returned 9.6% and 1.1%, respectively. Interestingly, this year the US dollar was weakening most of the time so I should say that the precious market was not only flat this year but also relatively weak. My thesis is supported by the data delivered by the COT reports - gold prices were driven by the shorts leaving the market and the longs only slightly increasing their bets.
In the second part of this article I discuss a few factors that could have a strong impact on gold prices in the medium term. Two factors support higher gold prices (the COMEX data and the US equities / bitcoin mania) and the third one, the US dollar, supports lower gold prices.
Which alternative do I subscribe to? Well, I am slightly optimistic about gold in the medium term (one year from now). An aging bull market in US equities (plus a possible bitcoin crash) should bring more and more investors to gold and silver and even a stronger US dollar should o not stop this trend. However, to make my thesis alive I would like to see the gold longs being more aggressive than up to now.
In December, I am starting another section of my Marketplace service called "Unorthodox Mining Investing." This time I will focus on mining developers. In short, a mining developer is a company transitioning from an explorer to a producer. For example, on November 20, 2017, I published a piece on MAG Silver, which is a typical developer.
Last, but not least, a new section will result in a subscription rate hike. However, those subscribing now and in December are allowed to do it at lower prices. If you are interested, please, visit my Unorthodox Mining Investing page.
Disclosure: I am/we are long GDX, CEF.
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: I hold a long position in U.S. dollar index futures.