Precious Metals Are Rallying. How Much Upside Potential Is There?

Exactly one week ago, gold was trading close to its multi-year low and a lot of observers were convinced that gold was ready to collapse to $1,000 per oz in a similar fashion as it did in April and June of 2013.

However, gold has repeatedly misguided investors in the past and it did so once again. A rally has started in the precious metals complex, namely, triggered by the Fed's announcement that it would not raise interest rates in the short term.

The rally looks constructive so far. Chart-wise there is plenty of upside, evidenced by the RSI reading in the 50ish area (upper pane) and a rising MACD (lowest pane).

Gold has been hovering between the $1,280 – $1,320 area for almost two years now. The long-term consolidation pattern is a constructive development, as it will function as a solid foundation for a new rally.

However, all of this does not give any additional insight into the strength of the new rally that started last week. What indicator provides reliable information to that end?

The Indicator

Our empirical evidence shows that the weekly Commitment of Traders (COT) report provides the best clues, in particular the evolution of the short positions of commercial traders.As readers probably know, the COT reports highlight the futures positions of large speculators, small speculators and commercials in the COMEX gold and silver futures market.

We often get the feedback from readers that gold and silver prices are manipulated because of the COMEX, so why analyze futures positions?

While it is true that the futures market is the epicenter of manipulation, it also provides clues for the direction of the prices of precious metals, because it reveals the positions of ‘da boyz’, so why not use those insights?

To that end, the key is to follow the movement of the short positions of commercials. In particular, it is the rate of change in accumulation of short positions that mostly determines the duration and strength of a rally. The opposite is true as well: the rate of change of the reduction of commercial shorts provides clues about the duration of the price decline.

The previous Commitment of Traders (COT) Report for futures positions held at the close of trading on Tuesday March 17th 2015 is shown below (courtesy of Sharelynx, annotations on the chart are ours). The chart contains week-on-week data since April 2012. Note that the latest COT report of this week showed only a strengthening of positions: surprisingly better in gold, less so in silver.

As readers can easily observe, the four substantial price rallies in the last three years are indicated with the green dotted line on the upper pane.

Note what happened with the short positions of commercial traders in each of those four instances: the blue bars on the second pane grew very fast. The faster the accumulation of shorts compared to prior rallies, the higher the probability that the rally will be short-lived.

That pattern has become pretty clear since June 2013. Look at the intermediate tops (marked by 1, 2 and 3) and the rate of change of commercial short positions during each rally. The rallies have been consistently shorter, while commercials bought faster and more short positions during each rally.

The opposite is true as well here. During the big price decline from October 2012 till June 2013, commercials were slow in covering their short positions. On the other hand, mainly after the intermediate tops 2 and 3 (see chart above), the short covering process went very fast. That pattern is even more outspoken since the last intermediate peak at the end of January.

Based on the data we can conclude that the current setup in gold is truly perfect, and it points to a meaningful rally, at least in the short term.

The Setup

In other words, the ongoing cycle of selling seems behind us and a new short-term cycle should have started last week. Whether this rally will be short-lived or not depends on how fast commercials will buy shorts compared to previous rallies.

A similar view on the Commitment of Traders report in silver paints a less bullish picture. As seen on the next chart, the reduction of commercial shorts in the last month was impressive, but in absolute terms the short positions are not at an extreme low. When compared to previous intermediate bottoms, this is a good setup but not THE perfect setup (not as good as in gold).

Let's zoom in on the below chart. Note how each rally since June 2013 (annotations 1, 2, 3 and 4) has been sold each time in a more aggressive way. Commercial shorts added more shorts with each rally, and they did so faster. That is reflected in the shorter duration of each subsequent rally.

Although the absolute number of commercial shorts does not stand at an extreme low, there is certainly the possibility of a substantial rally. Again, the setup is good but not perfect. It is the change during the rally that will determine its strength and duration.

Mind that there is a major divergence on the chart, and we are not sure at this point what that means, although we have an interesting working assumption. The open interest has been steadily rising; it currently is close to its all-time high of 2008 (not visible on the chart).

Rising open interest in an uptrend pushes the price higher. Rising open interest in a downtrend, as seen on the chart above by the green bars until June 2013, pushes prices lower.

What is interesting is that, at this time, more and more effort is needed (rising open interest) to push the price lower, with a diminishing effect on the silver price itself. We have a strong feeling that this points to selling exhaustion, which if correct, would set the scene for a trend change.

The Conclusion

The perfect setup in gold combined with a good setup in silver (though not perfect), along with the U.S. dollar seemingly entering a cooling-off period, points to a short-term rally in metals. This has also been confirmed in the price action of mining companies.

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Charts courtesy of: Sharelynx, the place to be for gold and silver charts

Courtesy of http://goldsilverworlds.com/