Gold Shorting Exhaustion

Gold’s been on an incredible roller-coaster ride over the past couple months, whipsawing like crazy.  And contrary to popular rationalizations, these swings had absolutely nothing to do with fundamentals.  Their sole driver has been American speculators’ extreme shorting of gold futures, which has battered gold’s price around in the absence of investment demand.  But this epic gold shorting looks exhausted.

The core mission of all trading, whether long-term investing or rapid-fire speculation, is buying low and selling high.  That’s the only way to multiply wealth in the financial markets.  Short sellers execute this same strategy, but reverse the order.  They borrow assets they don’t own, sell them presumably high, and later hopefully buy them back low to repay their debts.  The key to shorting is selling high, not selling low.

And that makes the recent gold action perplexing.  As of mid-August, American speculators’ total gold-futures short positions were almost back down to normal.  Gold was trading just over $1300, which sure wasn’t high by recent standards.  Gold had averaged $1669 in 2012 and $1409 in 2013, and was still deep in cyclical-bear-market territory with a 30.9% loss over 3.0 years since its August 2011 secular-bull high.

Yet American speculators still decided to aggressively borrow and sell gold futures, a spree that would snowball into an exceedingly extreme shorting episode.  Some catalysts certainly contributed.  A record rally in the US dollar was getting underway, spooking many futures speculators into dumping gold.  Meanwhile that crazy Fed-spawned US stock-market levitation continued killing demand for alternative investments.

These coupled with American futures speculators’ extremely bearish bias on gold unleashed a deluge of gold selling, the vast majority on the short side.  Futures trading is an exceedingly unforgiving game, with super-dangerous inherent leverage.  Every futures contract controls 100 troy ounces of gold, which is worth $120k at the $1200 gold prices today.  Yet the margin required to hold each contract is merely $4k now.

So futures speculators running minimum margin can wield incredible 30x leverage to the gold price.  That compares to the legal limit in the stock markets continuously since 1974 of just 2x!  At 30x leverage, a mere 3.3% adverse move in the gold price would wipe out 100% of the capital risked by speculators.  The risks involved in gold-futures trading are just mind-boggling, greatly limiting the number of willing participants.

Short selling obviously makes the most sense for high-priced euphoric markets that have been rallying for years.  That’s the highest-probability-for-success time to sell high.  But gold is the exact opposite, a low-priced despairing market that’s been falling for years.  It takes cast-iron hubris to make leveraged downside bets on a market that is already extremely low and universally loathed, it’s certainly not prudent.

Thus gold-futures short selling is finite and self-limiting.  There are only so many speculators out there willing to borrow already-dirt-cheap-and-despised assets in a risky leveraged attempt to sell them high.  And the lower this short selling batters prices, the more the desire to keep shorting wanes.  Lower prices squeeze out profit opportunities for speculators, and entice already-short traders to cover and realize their profits.

So short selling always runs in relatively-short spurts, ramping up fast but quickly peaking in selling exhaustion.  And I suspect that’s exactly what’s happening in gold now.  This past weekend, the short sellers had a perfect catalyst to keep selling aggressively.  The citizens of Switzerland voted down that referendum that would have forced their national central bank to engage in massive new gold buying.

Yet rather than plunge on that bearish news, gold instead rocketed 3.8% higher the next trading day!  In this dark sentiment wasteland with investors missing in action, that had to be driven by major short covering by American futures speculators.  We won’t know for sure until a few hours after this essay is published, as late Friday afternoons are when the CFTC releases its famous Commitments of Traders reports.

These CoTs detail aggregate long and short futures positions held by hedgers and speculators, current to the preceding Tuesdays.  While hedgers use the futures markets to lock in prices for commodities that they physically use in their businesses, speculators are purely gaming price moves.  And with investors largely absent, American futures speculators have been utterly dominating recent years’ gold-price action.

This first chart looks at this group of traders’ total long and short positions held in gold-futures contracts over the past couple years, per the weekly CoTs.  The gold price is superimposed on top, revealing the nearly-perfect inverse correlation between gold levels and American futures speculators’ total shorts.  When they sell short, gold drops on the additional “supply”.  Then when they buy to cover, gold surges.

Exactly a month ago, gold plunged to a deep new 4.6-year low just over $1140.  As this chart makes crystal-clear, the driver was extreme short selling by American futures speculators.  That week they were ramping their total gold-futures shorts to at least 162.5k contracts.  I say at least because the CoT reads are as of Tuesdays only, so within that hyper-bearish gold-low CoT week they were likely even higher!

Even on this short-term chart, the outsized massiveness of that short selling is readily evident.  At Zeal our weekly CoT data goes back to January 1999, deep in gold’s last secular bear.  And in the entire 15.9-year span since, there’s only been one other episode of greater speculator short selling.  And that happened following gold’s worst quarter in 93 years in 2013’s second quarter, a once-in-a-century selling anomaly.

After gold plummeted 22.8% that quarter, speculators got so caught up in the extreme bearishness that they sold their way to a staggering 178.9k gold-futures short contracts.  That was the greatest levels of speculator shorting by far since at least early 1999, and likely ever.  American futures speculators had never been more convinced that gold would keep on spiraling lower, and their leveraged downside bets proved it.

Yet they were dead wrong.  One of the most ironic things about futures speculators is they aren’t very smart as a herd.  You’d think such a sophisticated group of traders would understand psychology better, that buying low and selling high is effectively the same as buying fear and selling greed.  Yet in gold they keep on choosing to sell fear, to sell low.  Their bets are the most bearish right as gold is bottoming.

Gold-futures speculators’ total positions, especially their shorts, are a strong contrarian indicator for gold.  Major new gold rallies and uplegs are born right when speculators’ leveraged downside bets happen to be peaking.  Interestingly these excessive shorts are actually the main reason gold bottoms and soon rallies.  Speculators have to buy gold futures to offset and cover their shorts, and that demand sparks upside action.

From shorts’ probably-all-time record high in July 2013, the speculators’ short covering took 16 weeks.  And concurrent with that span, gold powered 12.8% higher even in the absence of investment demand and the ongoing extreme liquidations in GLD shares.  Short covering is a powerful upside driver for gold prices for months at a time, which is certainly a very bullish omen after the recent speculator short-selling peak.

Before this latest speculator gold-futures shorting binge, the gold price was stable all year near $1300.  But between mid-August and mid-November, American futures speculators alone borrowed to sell another 90.6k contracts.  This ballooned their total short position by a staggering 126% in just 13 weeks!  No wonder gold prices were so weak in recent months in the face of such a massive deluge of new supply.

This speculator short selling alone over that little span was the equivalent of 281.9 metric tons of gold, which works out to 21.7t per week.  This was just too much gold too fast for the markets to absorb.  Per the World Gold Council, global investment demand in the first three quarters of 2014 averaged about 18.2t per week.  So American futures speculators’ extreme short selling alone overwhelmed world demand.

Without that shorting binge, gold’s major support zone around $1200 never would’ve failed 5 weeks ago.  And the sentiment scene in gold would feel considerably less universally bearish today.  But the great thing about futures short selling is all those leveraged downside bets legally soon have to be covered.  Futures trading is a zero-sum game, so futures exchanges enforce margin rules with an iron fist.

When gold rallies and moves against speculators’ short positions, they soon have to close them out or risk facing margin calls and catastrophic losses greater than their capital risked.  The only way to cover and close a futures short is to buy an offsetting long contract.  This has an identical price impact on gold as a bullish speculator buying a new long-side contract.  So the higher the shorts, the bigger the coming buying pressure.

After what’s almost certainly the second-most-extreme episode of speculator gold-futures shorting in all of history, there’s going to be lots of buying coming.  We’re already seeing it.  In the latest CoT week before this essay was published, positions as of Tuesday November 25th, American futures speculators bought to cover 18.5k short contracts.  That magnitude of short covering is pretty rare even in recent years.

Since the Fed’s artificial stock-market levitation started crushing gold in early 2013, there have been 99 CoT weeks.  And including this latest one, only 6 saw short covering exceed 18k contracts.  And odds are that is just the beginning, that there is a lot more buying to come.  Since 2013 proved an extremely-anomalous year for gold, its last normal years were 2009 to 2012.  That’s a baseline gold will inevitably return to.

During that last normal span, American speculators’ total gold-futures shorts averaged 65.4k contracts.  So merely to return to such reasonable levels, this one group of traders still needs to buy to cover 66.4k more contracts or the equivalent of 206.5 tonnes of gold!  And since short covering feeds on itself as resulting rallying prices force other shorts to cover, major short-covering rallies tend to unfold within several months.

And speculators’ extreme and irrational bearishness with gold already so beaten down has not only manifested in their short positions, but their longs too.  As the next chart shows, in that normal baseline period from 2009 to 2012 before the Fed’s QE3 manipulations speculators’ total gold-futures longs averaged 288.5k contracts.  Today even though we’ve seen steady long-side buying all year, they’re down at 200.3k.

To merely mean revert back to normal and reasonable levels, speculators will have to buy another 88.2k long gold-futures contracts.  That equates to another 274.5t of gold!  Together with the short-side mean-reversion buying, speculators would have to buy gold-futures contracts controlling 481.0t of gold to return to normal-year levels.  That’s well over half of total global investment demand last year, a vast amount!

The total deviation of both speculators’ longs and shorts from their 2009-to-2012 averages is shown by the yellow line in these charts.  And in this latest CoT week even after the short-selling exhaustion and rapid initial covering, this deviation still remains very high.  That represents massive mean-reversion buying still left to be done as the epically-bearish sentiment plaguing gold inevitably gradually dissipates.

This next chart extends the same data back years earlier, giving some essential context illustrating just how extreme American speculators’ gold-futures bets are these days.  Speculators’ longs are way too low in historical context, and their shorts far too high, even given today’s gold levels and the weak price action of the past couple of years.  2013’s extreme Fed-driven anomaly simply can’t and won’t last forever.

Thanks to the Fed’s implied backstop of the stock markets with its QE3 bond-monetizing campaign and all the related jawboning, investors abandoned alternative investments in early 2013.  Gold can’t suffer its worst quarter in 93 years very often, such events are exceedingly rare by their very nature.  That once-in-a-lifetime selloff helped catapult speculators’ gold-futures shorts to their highest levels since 1999, if not ever.

It’s kind of understandable that emotional futures speculators would get caught up in the epic levels of bearishness such an extreme selloff spawned.  But to see similar levels of gold-futures shorting a few CoT weeks ago after gold had essentially stabilized for over an entire year?  Supreme irrationality, surely the pinnacle of bearish bandwagon groupthink.  There was no justification for such extreme shorting.

Collective sentiment, traders’ greed and fear, drives short-term trading in gold and everything else.  And these perpetually-warring emotions are like the opposite ends of a giant pendulum’s arc.  Fear can only get so great, the pendulum can only swing so high, before everyone susceptible to being scared or duped into selling low has already sold.  And that leaves only buyers so the pendulum starts swinging back towards greed.

This should already be underway in gold.  Even though that “Save Our Swiss Gold” referendum voted on in Switzerland last weekend was widely expected to fail, traders universally believed its defeat would lead to another serious round of new gold selling.  Yet on that very news that should have encouraged the hyper-bearish futures speculators, they aggressively bought to cover.  Short selling has to be exhausted.

This has hugely bullish implications for gold and the entire precious-metals complex.  For the better part of two years now, traders have been universally betting that gold is dead as an asset class.  As the Fed-inflated stock markets relentlessly powered higher to dizzying heights, they forgot that stock markets move up and down.  Bulls are inevitably followed by bears, which prudent portfolio diversification protects from.

At some point likely very soon here, these overextended, overvalued and euphoric stock markets are going to decisively roll over.  And with the new bond buying from the Fed’s QE3 campaign gone, and launching QE4 a political impossibility with the new Republican Congress, the Fed won’t be there to arrest the next material selloff.  It’s going to snowball, and all of a sudden legions of investors will remember gold.

Gold, and all its derivatives from the popular GLD gold ETF to the stocks of the gold miners, are going to catch a massive bid.  Gold is one of the very few proven performers during general-stock bear markets.  And with bearishness so extreme and its price so irrationally low, the capital inflows from investors starting to return will have no problem catapulting gold much higher in relatively short order.  A huge upleg draws nigh!

And that brings us full circle to the mission of trading, buying low and selling high.  American futures speculators are again making the same stubborn mistake they do at all major gold lows, borrowing gold to sell it low.  But after a price has fallen on balance for years and just hit a major new multi-year low, and consensus bearishness is overwhelming, it seems far wiser to fight the crowd and buy low rather than sell low.

At Zeal we’ve been doing just that this year.  We’re lifelong hardcore contrarian traders who walk the walk.  We buy low when few others will in order to later sell high when everyone comes around and gets excited.  And in these dangerous lofty stock markets, the precious-metals sector is the cheapest and most despised by far.  So there’s nothing else that has such awesome upside potential in the coming years.

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The bottom line is gold’s recent support breakdown was driven solely by extreme shorting by American futures speculators.  And that orgy of short selling recently peaked at the second highest levels of speculator shorts since 1999, if not ever.  And instead of selling aggressively after the failure of that Swiss gold referendum, speculators scrambled to buy to cover despite the perfect downside catalyst.

That almost certainly means the recent extreme futures shorting is exhausted.  All traders with enough hubris to make leveraged downside bets on gold near major multi-year lows did it, and now they have to buy to cover.  And we are talking about hundreds of tonnes of gold here, vast amounts.  Extreme shorts are always very bullish because they soon must be covered, and that overdue buying has already begun.

Adam Hamilton, CPA

December 5, 2014

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