Contrary Gold Futures

With gold awakening from its usual summer slumber, traders are getting more excited about its prospects. Presumably this shifting sentiment will even grow to encompass futures traders, who've been incredibly bearish on the yellow metal for months now. While traders hold futures guys in high esteem, they are just as susceptible to groupthink as everyone else. They are actually a powerful contrary indicator for gold.

Just a month ago, it seemed like you couldn't even give gold away. Bearishness abounded, and commentary and analysis were overwhelmingly pessimistic and calling for major new lows soon. Go back and skim the stuff published on gold in mid-July, and you'll quickly see what I mean. Because it had languished in a correction since August 2011, shedding 18.8%, everyone was very negative on it.

Unfortunately this is typical in the markets, as traders tend to mentally extrapolate short-term trends out into infinity. When a price has been rallying for months, they assume it will continue powering higher indefinitely. And when a price has been falling, they convince themselves it will keep on grinding lower. These false assumptions blindtraders, rendering them incapable of buying low and selling high.

Peer pressure feeds in as well, as traders feel very uncomfortable being bullish when everyone else is bearish and vice versa. There is comfort in the crowd's warm embrace, running with the herd to ensure acceptance. Succumbing to this groupthink is the main reason the great majority of traders lose money. They don't buy until everyone is bullish, which only happens after prices have already run high.

And after buying high, a fool's errand, they get frightened into selling when everyone is bearish. Of course that only happens after prices have already seriously sold off. Buying high and selling low is not the recipe for building a fortune, but for financial ruin. And amazingly even the large majority of futures traders, with all their alleged sophistication, stumble into this deadly trading trap. They run with the herd.

Contrarianism is the only remedy for groupthink, being brave when everyone else is afraid and vice versa. The best time to buy low is when no one else wants to buy, and the best time to sell high is when everyone else wants to buy. This is simple in concept, but incredibly difficult psychologically in execution. It takes many years of trading experience, and an iron will, to actively fight the herd.

I know how brutally hard contrarianism is because I've painfully forged myself into one over decades. Back in mid-July when the trading world was so darned bearish on gold, I was bullish. I wrote an essay then explaining that the summer doldrums leading to major seasonal lows that time of year were par for the course for this entire secular gold bull. These lows soon yield to gold's major autumn rally, which is indeed now underway.

As a group, futures traders didn't expect this upside move even though gold does it almost every year like clockwork. There are as few contrarians per capita in the futures world as there are in any other pool of traders. How can I dare make such a heretical assertion? Futures traders' biases are laid bare in the Commodity Futures Trading Commission's giant Commitments of Traders report, published weekly.

If you are not up to speed on the CoT, I wrote an essay explaining how bullish it was for gold a month ago when pessimism still dominated. In gold and many other futures markets, the CoT reveals how many futures contracts are open at any given time, which group of traders holds them, and whether these groups are taking the long side or short side of the trade. This last datastream reveals futures traders' sentiment.

The only time traders will make long-side bets on something is when they expect its price to rise. So playing the long side indicates bullishness. And it is only rational to sell futures short when traders expect their underlying price to fall. So shorts show bearishness. And incredibly in the entire history of gold's spectacular secular bull over the past decade or so, futures traders are the least long right before major uplegs get underway!

Of course futures are a zero-sum game, every single contract has a trader on its long side with a different trader taking the opposite short side. The only way to make money in futures is if your counterparty loses it. Capital merely changes hands, it isn't created or destroyed like in the stock markets. But while longs and shorts are always perfectly balanced, they flow and ebb among the major categories of traders.

The CFTC essentially divides futures traders into two categories, hedgers and speculators. Hedgers are formally known as commercials in the CoT, and are large traders who are actively involved in either physically producing or consuming the underlying commodity. In the gold world, this includes miners on the production end and jewelers on the consumption end. Hedging is why futures markets exist in the first place.

But hedgers can only hedge because speculators are willing to take on the risks the hedgers want to offload in order to smooth their operating cashflows. The CFTC farther divides speculators into two sub-categories, large speculators and small speculators. These are formally known as non-commercials and non-reportables in the CoT reports. And it is these speculators, large and small alike, that are contrary indicators for gold.

In my usual CoT analysis thread, I look at net long and short positions held by each category of traders. That is the most logical strategic approach in a zero-sum game where total longs and total shorts are always perfectly equal. But this week we're digging deeper, looking at the total long-side gold futures contracts held by both large and small speculators. These vaunted traders are victims of some serious groupthink.

Our charts superimpose gold over the weekly CoT data of total spec longs (green) and total spec shorts (red). As you'll see, the futures traders are always wrong near major lows in gold before massive uplegs. Since the great majority of them aren't contrarians, they give up on gold after corrections or long consolidations. But that is exactly when gold is the cheapest and ready to start surging higher again.

Trading is all about buying low and selling high, so if gold futures traders were prudent contrarians you'd expect them to be the most bullish right before major uplegs. But this hasn't been the case. For gold's entire secular bull, a gargantuan 638% run higher over a decade, futures traders as a group haven't been able to get this right. As this chart shows, speculator longs in gold futures hit major lows near gold lows just before major uplegs.

The green line shows the total long positions held by large and small speculators per the CoT reports. I highlighted major lows in this series over the years with light-blue columns. Before today, there were 8 major lows in speculators' total longs. Look at gold's performance after each of them. Every single time the metal soon started rallying, usually enjoying one of this bull's super-profitable massive uplegs.

While total longs coincide with low gold prices before major surges, notice where the light-blue columns hit the red total-shorts series. Speculators' short positions in this metal tend to be at highs, near highs, or at least on the high side of their secular trading range every time gold is cheap and poised for a major advance. Futures traders are truly not contrarians, so the smart thing to do is make the opposite bet from what they are making!

For my entire trading life, over a quarter of a century, I've constantly heard variations on the theme that futures traders are smart while stock traders are dumb. And though I'm certainly biased on this question as a lifelong stock trader, this oft-voiced aphorism simply isn't correct. True contrarians, battle-hardened traders who walk the walk in fighting the crowd, are as rare in the futures world as they are in the stock markets.

When speculators' total long positions in gold futures collapse to major lows, there has literally been a 100% chance throughout this entire secular bull that gold is right on the verge of surging higher. You'd be hard-pressed to find a better strategic contrarian indicator than the biases of gold futures traders. And this brings us to the reason why I wrote this essay this week, a major new low in total spec longs today.

Before gold's recent major correction, it topped just under $1900 in August 2011. As an actual contrarian, I wrote an essay one trading day before this top warning that gold wasvery overbought so a sharp correction was imminent. Believe me, it is never easy fighting the crowd. Whenever I make a contrary call like that, getting bearish while everyone else is euphoric, I get raked over the coals with scorn.

But in the timeless words of a 1990s alt-rock song, "[bleep] the naysayers cause they don't mean a thing". In the markets capital flows away from the mainstreamers who get greedy at highs and scared at lows to contrarians. We grow rich while those who can't fight groupthink slowly bleed away their fortunes. The subsequent gold correction carved a decisive low in mid-May, during a full-blown capitulation.

Around that week gold bottomed, total spec longs fell to 216.0k contracts. In late May they slumped again to 217.3k. Then after recovering a bit as gold bounced in early June, they fell to 220.1k at gold's major seasonal low in late July. In early August's CoT, they retreated again to 218.2k. But amazingly in the most recent CoT as of this writing, with August 14th data, total spec longs in gold futures fell to a new low of 215.5k!

To put this into perspective, gold spec longs haven't been this low since April 2009 just after the stock panic's secondary low. Gold was trading near $880 that week! How did it do since? Pretty freaking awesome, as you can see on the charts. Futures speculators, as evidenced by their lack of longs in the latest CoT, are as bearish on gold today as they were just before it more than doubled in a massive multi-year run!

They've been wrong as a group before every other major upleg in this entire secular gold bull, and I'm betting big money that they are wrong again today. Traders who are not contrarians, who get afraid when everyone else is scared, are going to fail. Succumbing to popular fear always leads to both selling low and failing to buy low. And futures traders are as bearish on gold now as they've been in several years.

This next chart zooms in a bit to examine the huge drop off in futures-speculator enthusiasm for gold when this metal is consolidating or correcting. The same major long lows highlighted above are highlighted here as well. I was interested in the total drops in spec longs from the preceding highs before these lows. They are shown in green, with the corresponding spec-short drop in red, along with how long these declines took.

Since futures speculators aren't contrarians, their long bets rise during gold uplegs and contract during gold consolidations and corrections. I suspect that the magnitude of these contractions reflects the degree that sentiment shifts among these traders. So the bigger the drop off, the more pessimism exists on gold and therefore the higher it is likely to run. The greatest example of this was 2008's stock panic.

While gold fared better than pretty much everything else but the safe-haven US dollar, it still took a major hit. Between July 2008 and November 2008 in the panic's dark heart, gold plunged 27%. Gold futures speculators naturally freaked out with such an epic selling event driven by a once-in-a-century fear superstorm. In just over 9 months, the total long-side contracts held by large and small specs plummeted 54%!

If the futures traders were right, gold would have continued plunging. But instead it started surging. Over the next 33 months, gold would blast an astounding 167% higher. For comparison, the benchmark S&P 500 stock index only gained 32% over this span. When futures traders were the most bearish, had the fewest upside bets on gold, was exactly the right time to buy aggressively into the yellow metal.

And now as of the latest CoT read in mid-August, spec longs have fallen 42% over 22 months to a major multi-year low. Even though gold remains high in a secular sense, nicely weathering a correction and high consolidation, futures traders have largely given up on it. This is by far the biggest decline in spec longs since the stock panic. And considering how bullish that long low was, this one ought to be too.

With longs this low, with futures traders as a group as bearish on gold as they are today, there is a very high probability that we are on the verge of a major new upleg in gold. Worst case, this metal is likely to at least power higher during its strong season between now and May. Odds are new all-time record gold highs will be seen well before then. And this new gold upleg may even continue rallying higher after that.

Also note that spec shorts are fairly high today as well. They've generally run in a trading range between 50k and 100k contracts. They've recently been almost as high as they were during the stock panic, an incredible opportunity to be long not short. And the only time they've been higher was in 2011 as gold surged to new record highs while climbing the wall of worry. This setup today is amazingly bullish all around.

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The bottom line is futures speculators as a whole are no more contrarian than stock speculators. They wrongly get greedy when prices are high and scared when prices are low. And since their positions are so carefully documented by the CFTC, they are a fantastic contrarian indicator. When gold futures speculators wax the most bearish is right before major new uplegs in gold start getting underway.

And today the gold futures long positions of both large and small speculators just hit a major multi-year low. These traders haven't been this bearish on gold since soon after the stock panic's secondary lows, just before gold more than doubled over the subsequent years. So if you are mentally tough enough to fight the crowd and buy low, today's opportunities in gold and its beaten-down miners' stocks are vast.

Adam Hamilton, CPA

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