Gold’s Record Selling Overhang

Gold’s mighty new bull market this year has been amazing, the result of heavy buying by investors and speculators alike.  But these latter traders have pumped so much capital into gold futures that this metal now faces a record selling overhang.  Since the hyper-leveraged nature of futures trading demands an ultra-short-term focus, speculators’ excessive bullish bets on gold pose major near-term downside risks.

Gold’s price trends are overwhelmingly dominated by global investment demand.  Even though it has only accounted for about 1/5th of total demand in recent years, investment is wildly variable.  With the rest of gold demand relatively stable, it is fluctuating investment demand that ultimately sets gold prices at the margin.  Gold’s young bull in 2016 is largely the result of an influx of massive investment buying.

These investors are usually strong hands, expecting to hold gold for the long term as a unique and essential portfolio diversifier that moves counter to stock markets.  Gold investors generally buy gold outright, or at worst using the decades-old legal limit of leverage in the stock markets of 2.0x via the leading GLD SPDR Gold Shares gold ETF.  Thus normal short-term price volatility doesn’t spook investors into selling.

Futures speculation is an entirely different game.  These traders don’t actually buy and sell physical gold, but merely the contractual rights to buy or sell it later in the future at set prices.  This is a side game of pure gambling, nothing like investment.  Futures speculators never have any intention of buying gold to own it, and they short sell gold they don’t own.  Their world is virtual, totally divorced from supply and demand.

But unfortunately the gold-futures price set by their trading has long been considered the benchmark world gold price!  The gold-futures bets speculators are collectively making as a herd not only drive but dominate most short-term gold action.  Since real investors make their buying and selling decisions based on this essentially-fictional gold-futures price, futures trading has a disproportionate impact on gold.

The sad fact that paper-gold trading far outguns physical-gold trading in determining short-term pricing has long vexed gold investors.  This is a major problem because futures speculators’ time horizons are vastly shorter than normal investors’.  The extreme leverage inherent in futures trading forces its entire focus to be ultra-short-term.  These elite traders have to be momentum players to survive, there’s no other option.

A single US gold-futures contract traded on the CME’s COMEX market controls 100 troy ounces of gold.  That’s worth $135k at $1350 gold, a serious sum of capital that excludes all but the biggest traders from the futures realm.  If futures had the same maximum margin as stocks of 2.0x, the incentives and time horizons of futures speculators would closely match long-term investors’.  But regrettably that’s not the case.

This week, the minimum cash margin required to be deposited for each gold-futures contract was merely $6k.  For just $6000, speculators can own the price action of 100 ounces of gold.  At $1350, that works out to maximum leverage of 22.5x!  Every 1% move in the gold price is instantly amplified into 22.5% gains or losses for speculators.  That’s exceedingly risky if not insane, extreme leverage creates extreme risk.

Gold-futures speculators running minimum-margin maximum-leverage would be wiped out, take 100% losses of their capital bet, with just a relatively-small 4.4% adverse move by gold against their bets!  Such hyper-leverage is nearly impossible for investors to imagine.  And even if conservative speculators keep triple the minimum margin, that’s still 7.5x leverage which is far beyond anything investors will ever experience.

Such extreme leverage demands an ultra-short-term focus, forcing all futures speculators to be myopic momentum players.  In order to survive, all they can care about is which direction gold’s next 5% move is heading in.  The long-term trends, whether gold is enjoying a secular bull or mired in a secular bear, are almost completely irrelevant.  Gold’s likely coming daily and weekly performances are all that matter.

And unlike investors, futures speculators can earn huge amplified gains whether gold is rising or falling.  They are totally agnostic, they don’t care either way as long as they bet right.  They buy long-side gold futures if they expect gold to rally in the near future.  They short sell gold futures if they expect gold to fall in coming weeks.  Also unlike investing, these futures contracts formally expire in a matter of months.

This further compounds the extreme short-term focus of futures speculation.  Since these traders have no desire to end up owning physical gold, they have to exit all their positions before their contracts reach maturity.  This is done by executing the opposite trades.  Longs are closed by selling gold futures, while shorts are closed by buying them.  This collective gold-futures trading action greatly impacts gold pricing.

Imagine gold’s prevailing supply-and-demand-driven trend as a straight line, rising in bull markets on mounting investment demand or falling in bear markets on waning investment demand.  Futures trading temporarily forces gold off this core fundamental line, in bulls and bears alike.  Excessive gold-futures buying or selling briefly pulls gold above or below where it should be based on prevailing fundamentals.

And that’s the problem facing gold today.  Futures speculators as a herd have become wildly bullish on the yellow metal, ramping their leveraged long bets to record levels!  This chart superimposes gold on the total long and short gold-futures contracts held by speculators, as reported by the US Commodity Futures Trading Commission in its famous weekly Commitments of Traders reports released every Friday afternoon.

CoT reports are current to the preceding Tuesdays, so July 5th was the latest data available when this essay was published.  It revealed speculators’ total gold-futures long contracts held has soared to 440.4k!  This level is astounding, the highest seen in the 17.5 years of our dataset running back to early 1999 and almost certainly the highest ever witnessed.  Speculators’ gold-futures longs are at all-time record highs!

So what you might wonder, why does this matter?  With a mighty new bull market in gold underway for the first time in years, doesn’t it make sense for futures speculators as a herd to be overwhelmingly bullish today?  They are ultra-short-term momentum players by necessity, and gold’s trend this year has been sharply higher.  So why not be excessively long with hyper-leveraged bets?  I hear this argument often.

The problem is speculators’ collective gold-futures bets have long proven a powerful contrarian indicator for gold!  Given the extreme risks they choose to take and the amount of capital they throw around, the futures speculators are no doubt elite traders.  But they’re still susceptible to the same popular greed and fear, the herd groupthink that plagues all investors and speculators.  Their emotions peak at the wrong times.

Futures speculators get the most bullish as a herd, as evidenced by high longs and low shorts, right as gold is hitting major interim peaks.  They wax the most bearish, with low longs and high shorts, just as gold is carving major short-term bottoms.  These guys are wrong at price extremes just like everyone else.  I’ve observed this phenomenon unfold in real-time for many years, and the historical data proves it.

This chart encompasses the great recent gold bull and bear.  Gold powered 166.5% higher between its stock-panic low in November 2008 to its latest secular peak in August 2011, a mighty run.  Then gold suffered a brutal 44.5% loss by December 2015 after the Fed’s first rate hike in nearly a decade.  These were major secular events by any standard, in which futures speculators’ bets marked major interim highs.

These short-term peaks in the gold price are highlighted in this chart with light-blue columns.  The vast majority of major interim highs gold hits in bull and bear markets are driven by speculators ramping their long gold-futures bets to major highs.  Gold experiences short-term toppings whenever speculators get excessively bullish.  And their long peaks are always short-lived, as they must soon unwind these big positions.

So regardless of how awesome gold’s young new bull market is today, or how many years it is likely to power higher on balance based on strong fundamentals, speculators’ new record-high long positions are a serious near-term threat.  We’ve just witnessed what is likely the most epic expansion of speculators’ leveraged upside gold bets in history.  And they never plateau after a peak, they always soon collapse.

Remember the only way for futures speculators to exit long positions without taking physical delivery of gold which they don’t want is to sell gold futures.  As this chart shows, that subsequent gold-futures selling unfolds rapidly and is proportional to the preceding long ramp.  So gold faces potentially-extreme gold-futures selling pressure in the near-term until speculators’ excessive longs are largely unwound.

This next chart zooms in to this same dataset over the past 3.5 years or so, offering more detail.  Almost all of gold’s major interim highs in recent years resulted from futures speculators getting too bullish.  And those all saw gold soon fall sharply as these traders aggressively sold gold futures to offset and close their excessive long positions.  This year’s epic extreme long ramp utterly dwarfs anything seen in recent years.

At this scale the major contrary implications of speculator gold-futures long bets surging to high levels in recent context are even clearer.  These elite traders buy aggressively, driving gold up to major interim highs.  Then something spooks them and they quickly start unwinding these risky hyper-leveraged bets through offsetting selling.  And that drives sharp gold selloffs until overall futures bets are normalized.

Back on New Year’s Eve 2015 when gold remained universally despised and languished near major secular lows, I made a ridiculed contrarian bullish call on gold.  I published an essay called “Fueling Gold’s 2016 Upleg” in which I concluded, “The bottom line is gold is poised for a mighty upleg in 2016” largely because “resulting bearishness left gold-futures speculators’ bets at epically anomalous levels”.

Around gold’s major 6.1-year secular low in mid-December driven by that initial Fed rate hike, the total longs held by futures speculators were way down at 191.2k contracts.  That was a major low as I pointed out at the time, and as you can see here.  With futures speculators so overwhelmingly bearish as evidenced by relative-low longs and high shorts (183.0k contracts), they would soon have to do some major buying.

In the 6.7 months between that secular low and gold’s latest major interim high last Friday, gold has powered 29.9% higher to enter its awesome new bull.  But this was largely driven by futures speculators adding an astounding 249.2k long contracts while covering 82.8k shorts, both of which mean buying gold futures aggressively.  That was the equivalent of utterly massive amounts of notional gold buying.

Speculators buying an additional 249.2k long contracts equates to 775.0 metric tons of gold being purchased in the futures market, causing a proportional price impact!  The 82.8k short contracts they covered in that span equates to another 257.5t of buying.  In just under 7 months, these traders bought the gold-futures equivalent of a staggering 1032.4t of gold!  That far eclipses gold investment demand over that span.

The best proxy for investment demand is the capital flows into that leading American GLD gold ETF.  In Q1, the latest quarter where comprehensive global gold supply-and-demand data is available, fully 80.6% of the rise in world gold demand came from GLD buying alone!  During that same 6.7-month span of gold’s new bull, total GLD differential buying was only 351.1t.  That’s only about a third of speculators’ demand!

So while 2016’s massive ongoing investment demand will likely offset significant gold-futures selling by speculators, it won’t be sufficient to absorb the majority of their selling.  So gold faces serious downside risks in the near-term until speculators’ excessive longs are mostly unwound.  Record gold-futures long positions mean a record gold-futures selling overhang, and that will likely unfold rapidly due to futures leverage.

With a new bull underway, I don’t think speculators’ gold-futures longs will have to fully retreat to their late-2015 secular-bear levels that sunk as low as 186.7k contracts.  Between 2009 to 2012, gold’s last normal years before the Fed’s extreme QE3-driven market distortions starting in 2013, speculators’ total gold-futures longs averaged 288.5k contracts per the weekly CoTs.  That’s a reasonable downside target.

Merely to mean revert back to that normal average well above recent years’ depressed levels, speculators will have to sell 151.9k gold-futures contracts to offset and close their excessive longs.  That works out to the equivalent of an incredible 472.4t of gold!  And because gold futures are so hyper-leveraged, selling in them quickly cascades.  Early sellers drive gold’s price lower, forcing more traders to exit before they’re ruined.

The more speculators sell gold futures, the faster that benchmark gold-futures price falls, forcing even more speculators to exit their long positions.  Futures selling rapidly feeds on itself.  So normalization selling after speculators make excessive long bets is fairly rapid, unfolding over a month or a few on the outside.  Even assuming 3 months, that equates to an overwhelming 157.5t of gold selling per month!

GLD’s biggest monthly build in 7.0 years happened in February, and it was only 108.0t.  GLD’s average monthly build in the first half of 2016 was merely 51.3t.  So there is simply no way even excellent gold investment buying can hope to offset the magnitude of gold-futures selling by speculators after their long bets soared to this all-time record high.  And that’s not even counting new gold-futures shorting.

As speculators close their excessive longs by selling gold futures, the falling gold price will motivate other speculators to add new short positions.  These are created by selling gold futures just like when longs are closed.  With speculators’ downside bets on gold near major lows recently, there is big potential shorting that will likely flare up before it is exhausted.  That compounds gold’s near-term downside.

We had a little taste of what cascading gold-futures selling can do back in May, even without new short selling.  Heavy speculator gold-futures buying pushed gold to a new bull-market high at the end of April, catapulting their total longs to a then-record 389.7k contracts.  Gold drifted sideways for a week or so, but soon Fed hawkishness spooked futures speculators into selling.  So gold fell 6.5% in just over a month.

Speculators rapidly exited just 67.8k long gold-futures contracts during May, the equivalent of 210.8t of gold.  And that was offset by only 43.7t of gold buying via GLD shares.  So the next gold selloff driven by these excessive bullish bets held by speculators will likely be considerably larger.  May also had the benefit of strong gold seasonals, but now gold is languishing in its weakest time of the year seasonally in mid-summer.

The catalyst that ignites the cascading gold-futures selling triggering the collapse of that record selling overhang will likely be Fed hawkishness.  Despite the proven historical fact gold thrives in Fed-rate-hike cycles, myopic futures speculators have falsely convinced themselves rate hikes are gold’s ultimate nemesis.  Fed hawkishness not only drove May’s selloff, but gold’s late-2015 one )  dragging it to major secular lows.

Top Fed officials really want to hike rates, as they have no conventional easing ammo left for the next market crisis if they don’t.  After the surprise victory of that successful British vote for independence from the domineering EU bureaucrats in late June, federal-funds-futures-implied odds of Fed rate hikes at its upcoming FOMC meetings collapsed to zero.  Futures traders went so far as to actually expect a cut!

This stock-market-obsessed Yellen Fed will never act unless rate-hike expectations leading into any particular FOMC meeting are well over 50%.  The FOMC doesn’t want to surprise the stock markets and spark a major selloff.  So Fed officials have herculean jawboning ahead of them to once again work to convince traders that more rate hikes are still coming.  Hawkish talk will once again spark gold-futures selling.

So while I remain very bullish on gold in the coming years for core fundamental supply-and-demand reasons, this metal faces serious risks for a major short-term selloff.  Whenever speculators grow too bullish as a herd, making excessive upside bets on gold, major interim tops occur.  And the subsequent cascading gold-futures selling to normalize speculators’ collective positions is invariably fast and furious.

Such futures-driven selloffs offer the best buying opportunities ever seen within ongoing gold bull markets!  If you want to add more gold via physical coins or that GLD ETF, you’ll almost certainly get a much better entry point after speculators’ excessive longs are largely unwound.  This is also true for silver, since silver follows gold.  Speculators’ silver-futures longs also just hit a new all-time record high last CoT week!

A futures-driven gold selloff will also hit the lofty stocks of the gold and silver miners and explorers.  As I explained last week, they are certainly due for a correction after such record summer gains.  That is a great boon for investors and speculators alike looking to add more gold-stock and silver-stock positions near lows as we are.  So anyone interested in precious metals needs to watch speculators’ gold futures very closely.

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The bottom line is gold faces a record futures selling overhang today.  Speculators have succumbed to euphoric groupthink again, becoming incredibly bullish as a herd.  They just ramped their upside gold-futures bets by an extreme amount to an epic new all-time record high.  All these excessive longs will have to be unwound by selling before expiration, and once futures selling starts it rapidly snowballs.

Gold sees major interim tops in bulls and bears alike whenever speculators’ long positions surge up to relatively-high levels, let alone extremes.  While these elite traders don’t control gold’s long-term trends driven by fundamentals, their collective trading can sure bully gold around over the short term.  But the unwinding of speculators’ excessive gold-futures longs offers some of the best mid-bull buying opportunities.

Adam Hamilton, CPA

July 15, 2016

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