Gold’s Primary Driver Bullish

Gold has been fairly volatile so far this year, seeing plenty of big daily surges and selloffs.  But with all these largely netting out to the sideways grind of recent months, gold’s price action has been frustrating for bullish and bearish traders alike.  Gaming gold in these strange central-bank-distorted times requires closely watching its primary driver, the collective bets of American futures speculators.  They portend a rally.

Just last week, the venerable World Gold Council published its latest comprehensive analysis of global gold supply and demand.  The intersection of these core fundamentals ultimately determines prevailing gold price levels.  And since bringing new gold mines online takes well over a decade, supply levels only change very gradually.  So gold prices are mostly determined by the shifting tides on the demand side.

The largest component of global gold demand remains jewelry, which accounted for about 4/7ths of the total in Q1’15 according to the WGC.  But this is also relatively static, with Q1’s 600.8 metric tons running about 5% over the 5-year quarterly average.  The real action is on the investment front, where demand fluctuates considerably with the prevailing winds of sentiment.  So that’s what dictates gold price levels.

In the first quarter, global gold investment demand ran 278.8t per the WGC.  While that’s merely about a quarter of total gold demand, its impact is disproportionately high since it’s the most-volatile component by far.  This was about 15% below the 5-year quarterly average, quite anemic.  With the world’s stock markets endlessly levitating thanks to extreme central-bank money printing, gold investment demand has withered.

Gold has always led the alternative-investment category, which thrives when conventional stocks and bonds are struggling.  That’s when investors remember the great wisdom of prudently diversifying their portfolios.  But when stock markets seemingly do nothing but rally thanks to the central banks, investors greedily ignore alternatives to put all their eggs in one very-risky stock basket.  And gold falls deeply out of favor.

With global investors really pulling back from gold as they chase stock markets, their influence on gold’s price has naturally waned.  This receding investment tide has left one group of traders with an incredibly disproportionate impact on the gold price.  American futures speculators’ collective bets are dominating gold with investors missing in action.  So the key to gaming gold’s coming price trends lies in their holdings.

This has been true for the past couple years, since gold’s brutal stock-market-levitation-fueled collapse in Q2’13.  The metal plummeted 22.8% then in its biggest quarterly loss in 93 years!  That scared investors away from gold, giving American futures speculators free reign to run amuck.  But even though the track record since of them driving gold prices is crystal-clear, it’s still not common knowledge in the gold realm.

The gold market is maddeningly opaque, with very few bothering to try and understand it.  Even on days with very large price moves on the order of 2%, the financial media superficially glosses over the real causes.  It attributes gold’s moves to fleeting world news, such as central-bank jawboning or some geopolitical event.  But it is American futures speculators’ buying and selling that drives gold those days.

Unfortunately, futures trading isn’t easy to understand.  It is a radically-different arena than stock trading, a hyper-leveraged zero-sum game only played by a small fraction of the world’s traders.  And the reams of data produced by their collective buying and selling is complex and challenging to interpret.  On top of that, its resolution is limited to only weekly which degrades its utility to game daily gold price action.

But if you take the time to understand it, gold’s price behavior not only makes much more sense but its likely near-term direction becomes much clearer.  Today American futures speculators’ collective bets imply gold is in for a major rally.  Gold’s primary driver is looking very bullish today, in stark contrast to the ubiquitous bearish sentiment out there.  American future speculators are very likely to be buying big soon.

Their collective holdings are published once a week by the Commodity Futures Trading Commission in its famous Commitments of Traders report.  While released late Friday afternoons, the positions data on the CoT reports is current to the preceding Tuesday.  And though complex, it can ultimately be distilled down into the futures positions held by hedgers and opposing speculators.  It’s the latter that dominate gold.

Hedgers either produce or consume gold in commercial operations, so their interest in the futures market is merely for locking in gold prices to smooth operating cashflows.  And their supply and demand for gold and therefore gold futures is usually consistent.  Speculators, on the other hand, are simply taking the other side of hedgers’ trades to make directional bets on the gold price.  Their positions fluctuate wildly with sentiment.

Our chart this week looks at the total number of long and short gold-futures contracts held by American futures speculators since early 2014.  The green line shows their total longs, the red their total shorts, and the yellow the total deviation from the normal-year averages of these positions between 2009 to 2012.  The gold price is superimposed on top in blue, and is incredibly correlated to speculators’ bets.

With gold investors largely missing in action, it’s American futures speculators’ bets that are dominating gold’s fortunes these days!  There’s nothing more important for gold traders to understand in these surreal times.  Gold is highly correlated with both speculators’ long and short bets in gold futures.  So seeing where these are running compared to recent precedent offers great insights into where gold is heading next.

Carefully studying and digesting this chart is essential for all investors and speculators interested in gaming gold.  This metal has only enjoyed major rallies in recent years when speculators bought gold futures, both adding new long contracts and covering existing short ones.  This dynamic fueled the sharp gold rallies in February 2014, June 2014, and January 2015, and will absolutely drive gold’s next big surge.

Conversely it was speculators’ gold-futures selling that forced all gold’s major selloffs in recent years.  Whether they sold existing long contracts, added new short ones, or both, gold fell sharply in the face of this temporary supply pressure.  This ignited gold’s steep selloffs in March 2014, May 2014, September 2014, and February 2015.  And the next time big futures selling arrives, gold will certainly fall again.

Thus the gold price is highly positively correlated with American speculators’ total gold-futures longs, and highly negatively correlated with their gold-futures shorts.  The blue gold-price line mirrors the green total-longs line, while moving in lockstep opposition to the red total-shorts line.  Speculators’ collective gold-futures bets have been all that mattered for gold prices in recent years, trumping everything else.

And this is likely to continue until investors start returning en masse, since their absence is what left futures speculators with such an outsized influence on gold price levels.  A second factor contributing to this is the extreme leverage inherent in gold-futures trading.  A single gold contract controls 100 ounces of the yellow metal, which is worth $120k at $1200 gold.  Yet hardly any capital has to support those bets.

Since the Federal Reserve’s Regulation T in 1974, leverage in the US stock markets has been legally limited to 2 to 1.  If that was also the case for gold, speculators would have to keep $60k in their account for each gold contract they wanted to trade.  But futures are the Wild West of trading, where normal rules don’t apply.  Today the minimum maintenance margin on a gold-futures contract is a vanishingly-small $4k.

That means American speculators can run leverage of up to 30 to 1 in gold futures, incredibly high!  So while $1 risked in the stock markets can control $2 worth of stock at most, $1 risked in gold futures can control $30 of gold.  This extreme 30x leverage gives futures speculators a wildly-disproportionate impact on gold price levels.  And without that far-larger pool of investor capital to overshadow this, speculators dominate.

With such hyper-risky leverage, futures speculators can’t afford to be wrong for long.  At 30x, a mere 3.3% gold move against traders’ positions will wipe out 100% of their capital risked.  And it doesn’t take gold long to move 3%+, it last happened just a week ago.  Futures speculators’ losses can even mushroom way beyond that if they meet margin calls to hold on to trades moving against them.  It’s an exceedingly-risky game.

So when gold starts rallying, futures speculators start buying.  They add new long-side contracts, hoping to chase gold’s gains as momentum builds.  And they rush to cover existing shorts, which means buying offsetting long contracts.  Buying longs to cover shorts has the same bullish price impact as buying new longs, propelling gold higher.  And the CoT data reveals that speculators are once again poised to buy big.

Despite gold generally swooning since early 2014, American speculators have been adding to their long-side gold-futures exposure on balance.  Their total long gold-futures positions have carved a solid uptrend since early 2014, which is rendered in the chart above.  And today, their total long-side bets are languishing at the bottom of that trend channel at support.  That’s about as low as they’ve dropped recently.

Each other support approach in recent years was followed by major buying, which soon catapulted the speculators’ total long-side gold-futures bets back up to resistance.  The trading range of that uptrend channel is roughly 50k contracts.  And that’s a heck of a lot of gold buying!  Convert that into the metric tons that world gold supply and demand is measured in, and we are talking about a staggering 155.5t!

The World Gold Council’s latest fundamental data shows global gold investment demand ran 820.6t in all of 2014.  Render that in monthly terms, and it’s about 68.4t per month.  Past surges of speculators’ long-side bets from support to resistance of their uptrend channel have only taken a month or two.  So that equates to new marginal gold demand on the order of 77.8t per month, more than doubling average levels!

And we haven’t even gotten to the bullish part yet.  American speculators have no obligation at all to buy new long-side gold-futures contracts.  They will only do that voluntarily once gold has rallied enough to convince them its upward momentum is sustainable.  But covering shorts is a totally different story, as that is a legal contractual obligation.  Shorting gold futures involves first borrowing them, debts that must be repaid.

So unlike new long-side buying, short covering is compulsory.  Once gold starts rallying, speculators are forced to rush to cover these hyper-leveraged downside bets.  This process unfolds rapidly as it quickly feeds on itself.  The more gold-futures contracts speculators buy to close their shorts, the quicker the gold price rallies.  The faster and higher gold climbs, the more other speculators are forced to cover their own shorts.

Since early 2014 speculators’ total gold-futures short positions have also formed a tight trading range, meandering sideways between 75k-contract support and 150k-contract resistance.  As of the latest CoT report before this essay was published, their total downside bets ran near 134k contracts.  This is way up on the high side of their trading range, as the chart above reveals.  That means big short covering is coming.

And that’s very bullish for gold!  After each shorting peak of recent years, speculators soon bought to cover enough gold futures to drive their total shorts back down to 75k support.  This has happened no less than 3 times since early 2014!  And each short-covering spree was relatively fast, unfolding over a few months or so.  Unwinding enough shorts to return to support again will require about 59k contracts of buying.

That’s the equivalent of another 183.5t of gold demand over several months, or around 61.2t per month!  That’s serious additional demand, around 9/10ths of normal average monthly investment demand.  That short covering has to be done, and the gold gains it triggers are likely to motivate the other speculators on the long side to resume their buying.  With gold’s primary driver so set up for major buying, gold looks really bullish.

The ironic thing about American futures speculators is they are always wrong as a herd when gold is topping or bottoming.  For all their sophistication, they are as susceptible to popular groupthink greed and fear as everyone else.  So as the chart above shows, they are the most bullish when gold is high and ready to roll over.  And they’re the most bearish when gold is bottoming and due to soon surge.

This is readily evident in their collective bets.  Around gold tops, their total long-side positions in gold futures are high while their short-side ones are low.  The opposite is true near gold bottoms, with low longs and high shorts.  And that’s what we’re seeing today, with long-side contracts way down at their uptrend’s support and short-side contracts nearly back up to their trend channel’s resistance.  This is great news for gold!

And some gold-buying catalyst is likely soon approaching.  Though it feels like this metal has just been grinding sideways on balance, it has actually spent the past half-year climbing in a new uptrend.  And gold has been very resilient through this latest surge in speculator shorting, meaning they aren’t getting much bang for their buck in their risky hyper-leveraged bearish bets.  Gold is fairly strong given the level of shorts.

Sooner or later something is going to happen to get investors thinking about gold again, likely the lofty central-bank-levitated world stock markets rolling over.  As investors start rediversifying into gold to help protect their portfolios, their buying will drive an upside breakout.  And that will send the necessarily-technically-oriented leveraged futures speculators scrambling to cover their high shorts, accelerating gold’s gains.

Investors and speculators can ride this coming buying in gold’s primary driver with the metal itself or the gold ETFs.  These are led by the flagship American GLD SPDR Gold Shares.  But if you want to amplify the gains in gold, deploy in the beaten-down gold-mining stocks.  They are trading at fundamentally-absurd price levels, and poised to soar dramatically in the coming years as gold mean reverts higher.

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The bottom line is gold’s primary driver in recent years has been the collective positions of American futures speculators.  Their hyper-leveraged bets have given them outsized influence on the gold price in recent years as investors pulled back.  And today speculators’ gold-futures bets are very bearish, low on the long side and high on the short side.  This is very bullish for gold, portending big futures buying nearing.

When speculators’ gold-futures selling reverses back into buying, this process tends to unfold relatively quickly over a few months or so.  And this futures buying alone has the potential to literally triple normal monthly gold investment demand over that span.  That would certainly fuel a sharp gold rally, likely even large enough to pique investors’ interest.  So gold looks very bullish today with its primary driver poised for big buying.

Adam Hamilton, CPA

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