Commitments of Traders

As many of our readers probably know, the recent developments in the commitments of traders report on COMEX gold futures have been quite positive, in that a large percentage of the speculative net long position was liquidated. This has to happen from time to time in order for the market to consolidate and fresh firepower to accumulate on the sidelines.

Before looking at the details, we want to point out that the widely held opinion that the commercial hedgers represent the 'smart money' in gold futures is wrong. The hedgers have been net short gold since it first crossed above the $270 level back in 2000. Pray tell, how 'smart' is that?

In reality, most of the hedger positions are in fact just that: hedges. There are offsetting position somewhere else on their books, either in the form of bullion, delivery commitments by miners that have sold forward, or other otc derivatives contracts. If that were not the case, all the bullion banks would have been bankrupted by the bull market by now. Alas, that has not happened and none of them have ever reported any large losses in connection with their gold trading. As such they are actually not very useful as an indicator of the directional bets made by the so-called 'smart money'. It is the big speculators that actually fit the 'smart money' bill better.

In light of the above we want to proceed to relate in what ways the most recent commitments of traders (CoT) report strikes us as positive.

First of all, there is the fact that speculative net long position in toto have been reduced by approximately 31,000 contracts last week alone. This is a big number and follows a string of smaller reductions in the preceding weeks.

However, it is the details of the report that we find intriguing. For one thing, big speculators that have held short positions have also reduced their shorts by  a quite large 8,358 contracts. This is actually a positive, as during the entire gold bull market to date,  speculative shorts by the big spec category of traders have always been of a short term tactical nature rather than bets on a beginning bear market.  The fact that these positions have been reduced tells us that they are still regarded as mere short term tactical commitments.

The other positives we gleaned are that commercial hedgers have increased their gross long position by 5,200 contracts concurrently with reducing their gross short position by over 25,700 contracts. Experience tells us that additions to gross long positions by commercial traders are usually a sign that physical gold demand is considered to be strong.

Lastly, the small speculator category has reduced its long/short ratio further, to about 2.6:1, by closing out nearly 6,000 long positions and adding about 2,300 contracts to its gross short exposure. The ideal ratio seen at significant lows is usually 2:1, so we are still a bit away from that, but any further short term weakness in gold would probably take care of that quickly.

At the same time, a number of sentiment surveys, ranging from Market Vane to Mark Hulbert's HGNSI show a marked improvement. An amalgam of survey data is contained in sentimentrader's 'public opinion' chart depicted below.


Gold, public opinion, via the excellent service As can be seen, this indicator is now well in bullish territory – click for higher resolution.


Gold Bears Are Wheeled Out

An important anecdotal signal has been delivered by the trusty Financial Times. This statism and fiat money supporting financial and economic newspaper has a storied history of wheeling out gold bears – quite often presenting absurd arguments – near important lows in the gold price.

This has happened again yesterday. The article in question is 'Gold Bugs Beware, the Bubble will Burst' by one Mark Williams whom we have never heard of before.

The article is chock-full with erroneous arguments and long refuted canards, and we want to pick out a few of them to show how ludicrous it actually is.

Williams starts out by saying:

"Gold is losing its glimmer. Last month, gold prices dropped more than $300 an ounce – the largest short-term fall in more than 20 years. This suggests that a decade-long bull market is ending. Gold’s recent volatility is spooking investors and destroying demand.”

This first paragraph is nonsense from beginning to end. The short term fall in the gold price may have been the 'largest in more than 20 years' in nominal terms, but in percentage terms it represents not even a blip on the radar. Both the current bull market and the 1970's bull market have seen far more violent corrections. Corrections, even sharp ones, are a perfectly normal feature of bull markets. Does Mr. Williams think it would be a healthy sign if the market only went up? Besides, as we have pointed out a short while ago, the gold price may have suffered a decent correction in dollar terms, but it remains close to its highs in terms of many other currencies, and remains especially strong in terms of commodities. In short, the real price of gold has actually not declined at all.

As to the assertion that the recent 'volatility is destroying demand', nothing could be further from the truth. On the contrary, the sell-off in the New York futures markets has spurred a strong surge in physical demand across the world, primarily in Asia, as recent media reports indicate. In silver, demand in India has become so strong that there are now 'supply issues'. It appears that demand is just fine. Moreover, as readers of this blog know, the most important feature of gold demand is actually reservation demand. This part of the gold demand can not be measured or quantified and must therefore be estimated by indirect means – mainly by analyzing the important fundamental drivers of the gold price. Almost all of these continue to look bullish.

Williams then says:

The difference from the current gold bubble and the previous one is that investors are now armed with exchange traded funds (ETFs), derivatives that increase their ability to run from gold if necessary. Several hedge funds have become dominant holders of ETFs. Investors now are responding to uncertainty in the eurozone by selling gold and other commodities and buying less volatile US dollars. ETFs, the vehicles that helped push gold to stratospheric levels, are now pulling it down to earth.”

First of all, it is simply asserted without further explanation that gold is in a 'bubble'. To this we would note that rising prices alone are not evidence of a bubble. We have discussed this in the past and dismissed this argument repeatedly, so we won't go into it again. Suffice it to say that the bull market in gold does as of yet not sport the characteristics typically associated with bubbles.

To say that people 'prefer less volatile dollars' is truly an audacious assertion. The dollar rises whenever there are liquidity issues, carry trades blow up and euro-land banks come under funding pressure. It is by no means a sign that people 'prefer' dollars over gold – rather it is a sign of desperate maneuvers  numerous market participants are forced to undertake on account of the financial crisis. Perhaps someone should tell Mr. Williams that the supply of dollars has increased by 51% since early 2008 alone. The supply of gold has increased by about 4% over the same time span. Besides, the US dollar has been one of the world's weakest currencies over the past decade, which is quite a feat considering the opposition. The dollar may be undervalued against many other fiat currencies at this time (on a purchasing power parity basis at least), but the fluctuations between fiat currencies are basically a battle between one-armed opponents.

As to exchange traded funds, this argument shows that Williams has not the foggiest idea about the gold market (which doesn't keep this fount of 'high quality financial journalism' that the FT reminds us it is every time we copy/paste a snip of one of its articles from publishing him of course).

ETF's have made it easier for investors to invest in gold, that much is certainly true. Alas, the amount of gold held by these ETF's is largely irrelevant in the bigger picture. The total global gold supply is between 165,000 to 170,000 tons at a minimum, of which the biggest gold ETF GLD holds a mere 0.7%.

How exactly are the changes in the holdings of an entity warehousing 0.7% of the global gold supply supposed to be relevant for the price of gold?

In addition to that, we would note that the holdings of GLD have in fact barely budged in the recent gold correction – a sign that the holders are long term oriented and don't really care about occasional short term corrections.

Williams continues:

“The current gold bubble has lasted nearly three times as long as the previous one. Over the past decade, gold prices quadrupled, rising by 17 per cent per year on average. For many investors, gold seemed to defy basic investment logic – year-on-year double-digit returns without the fear of double-digit losses. By 2005, more and more investors tried to rationalise why gold was no longer a fringe investment. It was a hedge against a weak dollar, global turmoil, incompetent central bankers and inflation. As trust in the financial system declined, gold would naturally rise, they reasoned.”

There it is again, the unsubstantiated assertion that the bull market is a 'bubble'. Apart from that, it is incorrect that it has 'lasted three times as long as the last one'. The man has apparently not even looked at a chart. The 1970's bull market lasted ten years and gained nearly 2,500%. The current one has lasted ten years to date as well, but has so far only gained 540%.

Furthermore, there have been substantial corrections in the course of the present bull market, although it is true that gold has ultimately gained every single year since the year 2000 (that obviously doesn't make it a bad investment). It is of course possible, even likely,  that there will be a down year at some point. So what? As to the reasoning of the few investors holding gold (only 0.8% of the world's financial assets are invested in gold, and only an estimated 0.2% of all institutional investment assets are invested in gold or gold stocks, which is basically a rounding error), their reasoning has been and continues to be 100% correct – Williams makes it sound as though that were not so, but obviously it actually is so.

Williams then says:

“But ETFs have not been around long. In a bear market, derivatives that attracted billions of dollars could easily turn into a huge wrecking ball, as ETF investors run for the door. Since August, the volume of ETF trading has gained pace, signalling [sic,ed.] shifting investor sentiment. Many ETF speculators still hold large positions, but recent price drops erode the belief that gold is a “safe haven” investment, prompting greater selling.”

Again, the amount of gold held by ETF's is irrelevant to the bigger picture. As to the recent correction 'prompting more selling', Williams asserts this without providing a shred of evidence, mainly because there is in fact no such evidence. We have of course heard this line of argument many times before, especially during the last liquidity crisis in 2008. It was wrong then and continues to be wrong today.

Williams continues:

“In the last few days, despite continued economic uncertainty, gold has dropped more than 10 per cent. Silver – gold’s shadow – has dropped 22 per cent over the last month. Gold bugs attribute these drops to profit taking, increased margin requirements, and a bull that is taking a short breather. But what if they are the early signs of a fundamental market shift?”

For there to be a 'fundamental market shift' the fundamentals must actually change, or there must at the very least be a decent prospect that they will soon change. Mr. Williams may not be aware of it, but the 'most influential financial journalist' of the influential paper he has written his article for is openly calling for 'more money printing' by the central banks, which in our opinion reflects the establishment consensus. So where's the fundamental shift?

Williams concludes:

If gold is falling in a weak economy, and investors are willing to own US dollars again, imagine how it will perform when the global economy eventually moves from chaos to prosperity, and more traditional investments – those that produce products, dividends and jobs – come back in fashion. Gold has lost its shine. “

When we have moved back from 'chaos to prosperity' Mr. Williams can perhaps send us a post card.

Since when is gold not a 'traditional investment'? We would venture to say that it has a longer tradition than most other types of investment assets. It is furthermore not really sensible to compare gold to stocks and bonds. If anything, it should be compared to other forms of money, i.e., competing currencies. People obviously do not buy gold for dividends or because they want to 'create jobs'. They buy it to protect their savings from the depredations of the State and its central banking bureaucracies.

Meanwhile, if you want to read a truly bizarre 'explanation' for Tuesday's decline in the gold price, we recommend this brief market report from the NYT, entitled 'Gold Falls on Pessimism That Rally Can Last'. What on God's green earth is that sentence supposed to mean? Anyway, it quotes the habitually wrong about gold Kitco analyst Jon Nadler, who recommends 'sell everything'. That of course would leave one with a pile of ever depreciating dollars, so perhaps one should be careful about blindly following his advice.

Anyway, the most important point about this anecdotal evidence is that we know from experience that the Financial Times always brings bearish articles on gold near the end of corrections. It is one of the most reliable contrary indicators we know of. In that sense, analyzing the CoT report may be almost regarded as superfluous, but it serves of course as further confirmation. Naturally, we are not certain whether the correction is definitely over. There may be another retest of the lows made in September, and even lower levels may eventually be seen. The US dollar's chart still looks bullish to us at the moment and a further rally in Uncle Buck may give gold a hard time. Dr. Marc Faber e.g. says that a bigger correction is possible in his opinion, and one should be very careful of fading him.

However, what the data are telling us is that it is probably time to at least consider getting back into the market on weakness. Most likely there will be an extended period of consolidation,  but one can not really be sure of that either. There have been historical instances of short term losses of 20% and more being regained in a very short time (e.g in late 1978, gold lost 23% in three weeks and regained the entire loss in the following four weeks; similar feats were repeated in 1979).

Gold, daily. We have no MACD buy signal yet, but the metal looks pretty oversold in the short term. Note that the correction tested both the 200 day moving average and a zone of lateral support defined by a previous consolidation period – click for higher resolution.




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8 Responses to “Gold – Positive Signals Emerge”

  • Floyd:

    Correlation is typically a coefficient in the range of -1,+1.
    As such 0.49 does imply some sort of positive relation.
    I believe that r^2 (r squared) serve human intuition better. It follows that ~25% of the variation in gold and stock are related (statistically).
    That is not match.
    One can attribute that to the effect of the money supply growth affecting stocks and gold similarly (if not overdone).

  • Ian Bruk:

    Dear Authors: I am so impressed with your blog. Reading the following made me think this is, maybe, someone as knowledgeable (sp?) as Acting-Man.

  • amun1:

    For a trader, gold might be a play here, but for a long term holder, I think it will get cheaper. No specific reason, but this stock rally is too frantic, especially right in front of earnings. I earlier thought the market would rise slowly going into earnings, and then get a pop with the “surprise” when everything beat the estimates. Now I think they might sell on the news.

    Also, VXX is outperforming the VIX. Lot of call sellers out there driving VIX down, but somebody thinks it’s temporary because they’re not dumping VXX. Finally, Alcoa is hovering at a low level going into earnings and a lot of the high beta names have failed to hold up as well as the leaders like AMZN and AAPL. Rather than the laggards catch up, the leaders might take a hit. We may be about to see some real selling of every asset class, including treasuries.

    • amun1:

      BTW, I’m not trading for a big drop. Just very cautious about buying anything right now.

    • Amun,
      I share the misgivings about the bounce in stocks. Note though that over recent years, gold’s correlation with the stock market has been 0.49 – or ‘no correlation at all’. It sometimes rises with the stock market, sometimes falls when stocks rise, sometimes rises when stocks fall….it’s pretty arbitrary. I do think the stock market’s gyrations are quite relevant to gold stocks, but less so for the metal. All that said, I also think the current rebound in gold must be ‘played by ear’. The corrective phase as such is probably not over, but as I mention in this article, there have been instances in the past when sharp corrections were quickly recovered again. It isn’t really knowable in advance how the current situation will play out, but my hunch is that gold will probably build a large triangle before the next advance gets underway in earnest.

      • Floyd:

        Correlation is typically a coefficient in the range of -1,+1.
        As such 0.49 does imply some sort of positive relation.
        I believe that r^2 (r squared) serve human intuition better. It follows that ~25% of the variation in gold and stock are related (statistically).
        That is not match.
        One can attribute that to the effect of the money supply growth affecting stocks and gold similarly (if not overdone).

        • I was actually assuming a range of 0 – 1 in this example, but it could well be that I am mistaken about the range that was used by the researcher whom I have the number from – in which case we would have to state that there is a slight positive correlation, due to money printing no doubt.
          However, note that the research report I have the data from did specifically mention that the 0.49 number implied ‘no correlation’, hence my assumption of a 0 – 1 range. I will check up on that and report back on what I find.

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