I was wrong. In my previous article about the precious metals market, I made the following conclusion:
“In my opinion, now gold and silver are sending very strong, medium and long-term BUY signals. Money managers trading gold/silver futures are very bearish about precious metals and history teaches that each time there is big pessimism the market is ahead of a strong move up”
Since this article (May 30, 2018), gold and silver prices have fallen by 7.7% and 12.7%, respectively, and now many gold bulls are wondering whether the precious metals market is still in its bull market phase or, perhaps, it has entered a bear cycle.
“During the past two months, gold equities have been performing better than bullion. In the past, rallies in the gold equities have been an early signal of an improving gold market. When I look at how well the gold equities have held up relative to the drop in the gold price, I’d say that’s a very positive sign. Also, there’s a seasonality factor to consider. We are entering the fall, which often has been good period for gold and silver.
I’m optimistic about the price right now. It is a good time to be buying. Investors’ sentiment is extremely bearish for gold. So, if you are brave enough to act as a contrarian, it’s time to buy this sector!”
I guess the first statement is incorrect – since June 27, 2018, one of the most popular gold mining ETFs (GDX) has gone down 14.9% while gold lost 3.9% so, definitely, gold stocks performed much worse than bullion.
However, the last statement (“Investors’ sentiment is extremely bearish for gold”) is true – according to the Commitments of Traders report (COT report), the pessimism among big speculators trading gold futures has reached an all-time high.
So, the question is:
Are we really ahead of another leg up in precious metals?
Let me look a bit closer at recent developments in precious metals and a few other markets, correlated with gold and silver.
According to the latest COT report (released on August 28, 2018), big speculators (or the so-called “money managers”) were holding the largest net short position in gold futures, measured against the total open interest (the red circle on the chart below). What is more, most recently, the ratio defined as:
Gross short position held by big speculators in gold futures/gross long position held by these traders
...has hit the highest reading in history (the blue circle on the chart below). Definitely, these two measures support a thesis that there is extreme pessimism among speculators trading gold futures:
Source: Simple Digressions and the COT data
Now, I concur with Mr. McEwen that extreme pessimism demonstrated by the speculative segment of the precious metals market coincides with cyclical market bottoms. Indeed, that was the case in late 2015 when the speculators were extremely pessimistic about gold and silver and the market finally bottomed out.
Summarizing – if history teaches us something, there is a good chance that the precious metals market may be ahead of a cyclical bottom.
The Chinese demand for gold and silver bullion is strong. To remind my readers, the amount of metals withdrawn from the Shanghai Gold Exchange is a popular proxy for the Chinese demand for gold and silver. And, as the charts below show, this year the Chinese have withdrawn large amounts of metals:
Source: Simple Digressions and the Shanghai Gold Exchange
For example, between January and August of 2018, the Chinese withdrew 1,366 tons of gold, the second largest result since 2014. Interestingly, the highest demand was reported in 2015 when the precious metals market was bottoming and the Chinese, contrary to their Western fellows (panicking at that time), were hoarding gold. These days we see a similar pattern - the West is dumping gold and hoarding Apples and Amazons (I discuss this issue below), but the Chinese, taking advantage of low prices, are accumulating gold again.
As for silver – yes, the Chinese demand is also strong, but I have to note that, generally, the Chinese are not interested in silver too much. Simply put, one ton of gold is worth around 80 times more than one ton of silver so the Chinese demand for silver is rather marginal.
If the gold/silver ratio means something, we should be very close to the bottom
A gold/silver ratio is one of the most popular metrics describing the state of the precious metals market. For example:
Every time the ratio hits 80 or more, the precious metals market bottoms out soon
Now look at the chart below:
The chart shows the gold/silver ratio (lower panel) and gold prices (upper panel). The three circles plotted into the lower panel point to these historic moments when the ratio had hit 80 or more:
- The red circle identifies the beginning of a vicious bull market in gold in 2003.
- The blue circle points to the start of the bull market of 2008-2011.
- The black circle depicts the beginning of the current bull market (2015/2016).
Now, if history repeats and the gold/silver ratio above 80 is still a good indicator, we should expect an end of the current medium-term bear cycle in gold (it means that the big question mark on the chart above may become another circle soon…)
As a rule, the US dollar goes opposite to gold. It means that those applying this rule are pretty sure that the precious metals market is supposed to drop further – since February 2018, the greenback has been in a bull market phase. However, according to the COT report, a net long position held by big speculators betting on a stronger dollar is elevated now:
Source: Simple Digressions and the COT data
In other words, there is big optimism among speculators trading US dollar index futures. Very often it is a sign of an aging bull, no matter whether I am talking about the US dollar, gold or other instruments. If that is the case, the current bull market in the US dollar may be tricky for those betting on this currency.
Note: I am not writing that we are ahead of an end of a bull market here. Quite contrary – in my opinion, the US dollar has some room to go up further, but this move may be filled with vicious swings and turnarounds. If that is the case, making money on this market will not be easy.
As a rule, strong prices of US treasuries support the precious metals market.
Now, according to the COT report, two weeks ago the big speculators trading US 10-year treasury notes futures held the largest net short position since 2008 (the green circle on the chart below):
Source: Simple Digressions and the COT data
However, last week saw a large outflow of traders betting on lower prices of US treasuries – all of a sudden a gross short position held by these traders was reduced by 100 thousand contracts (one of the largest cuts I have ever seen). Interestingly, it looks like some traders had panicked. Despite huge short bets (established in July and August), the prices of US treasuries have been in a modest upward trend since middle May 2018, which means that the shorts were losing money. Simply put, it seems that these traders have overshot and now they are leaving the market en masse and… accepting losses.
Now, I am very curious about the next COT report – if the pattern initiated last week continues, we may see the treasuries strengthening significantly. If that is the case, the precious metals market will get a very strong support.
But wait a moment – where is the (smart?) money going?
Now the final chart. In my opinion, this chart shows where the real enemy (of the precious metals market) is:
The lower panel of the chart shows the S&P 500 / Gold ratio. A rising ratio (red arrow) means that the money flows into the US stock market. In other words, it is a better idea to invest in Amazons or Apples than in gold or gold mining stocks.
Now, the pattern was initiated in 2011, and most recently, it reached the same level as shortly before the beginning of the last severe financial crisis (2007-2008). Does it mean something? Well, I have no idea. Generally, the relative strength charts are helpful to identify where the money flows. However, they are less helpful (or, at least, not that good as a gold/silver ratio) to identify the market’s turning points.
As a result, the only thing I want to tell is this:
A rising S&P 500 / Gold ratio is a clear indication of the status quo. Since 2011, it has been the US stock market where the money has been flowing into. Now, a flattening ratio could be a very interesting indication of an incoming real turn in financial markets. In such a case, the precious metals market may regain its safe haven status. However, the ratio is still quite far from flattening…
In this article, I am trying to defend a thesis that the precious metals market is close to its cyclical bottom. Here are the facts supporting my thesis:
- Extreme pessimism among big speculators trading gold futures
- Strong demand for gold bullion in China
- Gold/silver ratio above 80
What is more, it looks like US treasuries are bottoming now (it is not a fact but a mere mental speculation). As a result, there is a good chance that the precious metals market will get additional, strong support from treasuries.
However, as discussed above, there are two facts supporting a bearish thesis on gold:
- The US dollar is in its bull market cycle now.
- Today, the money flows into US stocks. In other words, despite an ongoing financial meltdown (trade wars or currency crises in Venezuela, Turkey, Russia, India etc.), gold has lost its safe haven status, at least temporarily. Paradoxically, it looks like the only safe haven left is the US stock market with Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) breaking above $1 trillion in market capitalization and many other stocks beating all-time highs.
As a result, although I share Rob McEwen’s bullishness, I do not expect the next leg up in the precious metals market right now. However, if the three facts supporting a bullish thesis on gold are still viable, we should see the current bear phase easing or even dissipating very soon.
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Disclosure: I am/we are long CEF, GDX.
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.