Gold has proven a rare bastion of strength during recent weeks’ market carnage, and there is plenty of abundant fuel for a gold upleg. Here’s why…
Gold and its miners’ stocks have proven rare bastions of strength during recent weeks’ market carnage. They are powering considerably higher while nearly everything else burns. The markets’ major sentiment shift is accelerating a young gold upleg, which ought to grow much larger as speculators and investors continue returning. Their collective gold positioning remains very low, making for abundant gold upleg fuel.
October’s outperformance by gold and gold stocks has been impressive. As of Wednesday, the flagship US S&P 500 broad-market stock index had plunged 8.8% month-to-date. That heavy selling was led by the market-darling mega tech stocks, pummeling the NASDAQ down 11.7% MTD! Stock investors are starting to pay the piper for getting far too complacent in bubble-valued markets, the reckoning is underway.
But contrarians prudently positioned in gold and its miners’ stocks have enjoyed large divergent gains as flight capital floods in. Gold has surged 3.4% MTD despite the US Dollar Index’s strong 1.3% rally. The long-forsaken gold stocks have nicely amplified those gains, refusing to get sucked into the maelstrom of heavy stock-market selling. The leading HUI gold-stock index has blasted 8.2% higher MTD, 2.4x gold’s upside!
While mid-October’s stock-market plunge out of the blue jumpstarted gold, its young upleg was already stealthily underway. Gold bottomed at $1174 in mid-August after getting pummeled by all-time record gold-futures short selling by speculators. It quickly rebounded as high as $1210 in late August, but drifted back down as low as $1183 in late September. This anemic gold upleg was already 7+ weeks old in mid-October.
Though gold didn’t respond much the first day the S&P 500 plunged 3.3%, the next day’s 2.1% follow-on selling galvanized gold interest. It rocketed from $1194 to $1223 that day, a huge 2.5% rally that made for its biggest up day since late June 2016’s surprise pro-Brexit vote in the UK! Those massive gold gains propelled the HUI a huge 7.4% higher that day. Capital was deluging back into this moribund contrarian sector.
While the gold and gold-stock gains in recent weeks were impressive, they remain quite small. From their respective mid-August and early-September lows, gold and the HUI were only up 5.0% and 13.9% as of the middle of this week. That’s hardly even upleg territory, a mere start. Gold’s last major upleg unfolded in roughly the first half of 2016. While it was on the smaller side by historical standards, it offers perspective.
Gold surged 29.9% higher in just 6.7 months, catapulting the major gold stocks as measured by the HUI 182.2% higher in largely that same span! So what we’ve seen in recent weeks is nothing compared to the last major gold upleg, let alone far-bigger previous ones. Today’s young gold upleg is only getting started. And with gold upleg fuel still abounding, odds are it and the resulting gold-stock upleg will grow much larger.
Gold bull-market uplegs usually unfold in the same telescoping fashion. They are initially ignited by gold-futures speculators covering shorts. These traders are usually the only buyers at major lows following corrections when sentiment is hyper-bearish. They buy offsetting gold-futures long contracts to close out their existing short contracts at profits. This short covering is the spark that first kindles major gold uplegs.
That short covering soon burns itself out, as short-side traders have relatively-little capital compared to the other gold buyers. But it often propels gold high enough for long enough to entice long-side gold-futures speculators to return. They command much more capital than the shorts, and their buying soon becomes self-feeding. The more gold-futures contracts they buy, the more their peers start chasing that momentum.
That long-buying second stage eventually evokes gold uplegs’ third stage, the primary one and largest by far. All the gold-futures buying extends gold’s rally enough to get investors interested in returning. They control vastly more capital than futures speculators, so once they start buying gold is off to the races in a major new upleg. Unlike short-lived gold-futures buying, gold investment buying can run for many months on end.
Stage-one gold-futures short covering is the initial trigger that ignites stage-two gold-futures long buying. And all that futures buying together eventually jumpstarts stage-three investment buying. As investors start to return to gold in a material way, gold’s upleg accelerates in a self-sustaining virtuous circle. The more capital investors pour into gold, the more it rallies. The more gold climbs, the more investors want to buy.
Today’s young gold upleg is starting to follow that usual three-stage pattern of fueling buying. And since vast amounts of gold-futures short covering, gold-futures long buying, and investment buying still remain based on current positions, this gold upleg is likely to power way higher before it eventually gives up its ghost. Gold looks exceptionally bullish today with upleg fuel abounding, portending much bigger gains to come.
What gold-futures speculators and gold investors are actually doing and likely to do in coming months is discernable from two key datasets. The first is the weekly Commitments of Traders reports published by the CFTC, which detail speculators’ collective positions in gold futures on a weekly basis. The second is the physical gold bullion held in trust by the leading and dominant American GLD SPDR Gold Shares gold ETF.
We’ll start on the gold-futures side, as that’s where gold uplegs’ stage-one and stage-two buying comes from. This chart shows large and small speculators’ total long and short gold-futures contracts held, in greed and red respectively. Gold is superimposed over the top in blue. Despite gold’s sharp rally when the S&P 500 plunged, the great majority of likely gold-futures buying is still yet to come which is really bullish.
Gold’s woes that ultimately birthed today’s young upleg are recent. This classic contrarian investment actually fared pretty well from early 2017 to mid-2018, climbing higher on balance and holding above a rising support line for 17.4 months. Gold was trading at $1302 in mid-June before enormous gold-futures short selling erupted on a sharp USDX rally. That extreme short selling snowballed into a record shorting spree.
From mid-June to mid-August, speculators’ gold-futures shorts skyrocketed a stupendous 156% or 156.4k contracts! That catapulted them to an extreme new all-time record high of 256.7k, as you can see above in red. That shattered the previous record of 202.3k from August 2015, which helped spawn that last major gold upleg in H1’16. Gold fell 9.9% in 2.1 months when that epic record short ramp was underway.
In early September I wrote an extensive essay on those record gold-futures shorts explaining why they were so darned bullish. There’s nothing more bullish for gold than extreme speculator shorts because of how short selling works. These traders reverse the normal trading order by first selling high before later attempting to buy back low. But speculators don’t actually have the gold futures they want to sell short.
So they must effectively borrow gold futures to short them. And these debts legally have to be paid back soon. Mechanically gold-futures shorts are repaid and closed by buying offsetting long contracts. Thus speculators’ excessive gold-futures shorts are literally guaranteed proportional near-future buying! And the incredible leverage inherent in gold futures means this short covering often unfolds fast, over a couple months.
Back in early September, the minimum margin required for controlling each 100-troy-ounce gold-futures contract was $3100. This week it’s $3400. At $1200 gold, 100 ounces are worth $120,000. But a trader running at the margin limits can effectively buy or sell that much gold with crazy 35.3x leverage! In stock markets the legal maximum has been 2x for decades now. At 35x, trading gold futures is extraordinarily risky.
For every 1% the gold price moves against traders’ positions, like rallying when they are short, they lose 35% of their own capital risked. A mere 2.9% gold rally would wipe out fully 100% of their capital at 35x leverage! And in mid-October on the S&P 500’s second big down day alone, gold surged 2.5%. That was driven by frantic speculators rushing to buy longs to cover their extreme near-record gold-futures shorts.
The weekly CoT reports are current to Tuesday closes, but aren’t published until late Friday afternoons. So the latest-available data on speculators’ gold-futures positions when this essay was published was current to October 16th, the CoT week straddling that sharp 5.3% 2-day plunge in the S&P 500. Just as I warned in early September, speculators’ near-record short-side bets resulted in record short-covering buying.
That CoT week speculators bought to cover an astounding 48.1k gold-futures short contracts! That was a new all-time record high, shattering the previous CoT-week record of 41.5k from March 1999. Covering of this magnitude is exceedingly rare. Out of the 1033 CoT weeks since early 1999, only 11 witnessed short covering over 25k contracts. That frenzied short covering is why gold’s price exploded higher that day.
Remember major gold uplegs are initially ignited by stage-one gold-futures short-covering buying. And despite speculators panicking as stock markets plunged and covering nearly 1/5th of their near-record shorts in a single CoT week, their remaining shorts are still extreme. They were running way up at 205.0k in that latest CoT report, which would’ve been a record high before late July 2018. Much more covering is coming.
To just mean revert back down to mid-June levels before this summer’s record orgy of shorting, these elite traders still have to buy to cover another 104.7k contracts! That’s 2.2x what they did in that initial CoT week, and the equivalent of a huge 325.6 metric tons of gold still due to be bought from short covering alone. Short-covering buying out of extremes tends to unfold rapidly, over just a couple months or so.
So assume 7 more CoT weeks of speculators covering shorts on balance, which works out to 46.5t of gold per week. According to the World Gold Council’s definitive fundamental data, in the first half of 2018 total global gold investment demand averaged 21.9t per week. So speculators’ buying to cover alone could boost this by 2.1x over the next couple months! That will naturally propel gold considerably higher.
Eventually gold will power high enough for long enough to convince long-side gold-futures speculators to start buying again. As the higher green line above shows, they control a lot more capital than the short-side guys. While they wield that same extreme leverage, their buying is totally voluntary. They don’t need to first borrow in order to buy low then sell high. Their collective bets just bounced off a deep 2.7-year low.
Merely to mean revert back to their 52-week high of 356.4k long contracts, these speculators would have to buy another 119.4k from the latest CoT week’s low levels. That’s the equivalent of another 371.5t of gold. Stage-two gold-futures long buying by speculators generally unfolds over 3 to 6 months. Assuming the conservative latter gives us about 25 more weeks of buying on balance, averaging out to 14.9t per week.
That alone would boost baseline global gold investment demand from the first half of this year by 68%! And that’s not including that stage-one short-covering buying. You better believe gold will power a lot higher from here if world investment demand swells by 2/3rds for a half-year or so on gold-futures long buying. Massive gold upleg fuel remains on both the short and long sides of gold futures with current positioning.
When gold surged 29.9% higher to enter a new bull in the first half of 2016, speculators’ total shorts fell by 82.8k contracts while their longs soared by 249.2k. That made for 332.0k of total buying. Including this first CoT week of buying on that mid-October stock-market plunge, gold’s young upleg today easily has the potential to see at least 152.7k contracts of short-covering buying and another 129.3k of long buying.
That adds up to 282.0k contracts, equivalent to a colossal 877.1 metric tons of gold! World investment demand in H1’18 totaled just 570.1t for comparison. With the buying fuel for this upleg running around 85% of what drove early 2016’s 30%ish one, this gold upleg should have no problem rallying over 25% from its mid-August lows. That would carry gold to $1467, a major bull breakout above the previous $1365 peak.
Nothing excites investors more than new bull-market highs, which motivates them to chase the strong momentum. They allocate larger fractions of their vast pools of capital into gold, leading to sustained buying dwarfing anything the gold-futures speculators can manage. This stage-three investment buying is what makes gold uplegs awesome. All the futures buying leading into it is ultimately just a triggering mechanism.
This next chart looks at American stock investors’ capital flowing into and out of gold through the lens of that dominant GLD gold ETF. Unlike most gold fundamental data only available quarterly, GLD’s holdings are published daily. They offer a near-real-time view into whether investors are buying or selling gold. I wrote a whole essay in late September explaining the mechanics of GLD and its importance to gold prices.
GLD’s mission is to track the gold price, but GLD shares’ supply and demand is independent from gold’s own. Thus GLD’s managers have to equalize excess GLD-share buying or selling pressure directly into physical gold itself or this ETF’s share price will decouple. So GLD effectively acts as a conduit for the vast pools of American stock-market capital to slosh into and out of gold. GLD’s changing holdings reflect this.
When investors are buying GLD shares faster than gold is being bought, the GLD-share price threatens to breakaway to the upside. GLD’s managers prevent this by issuing enough new GLD shares to satisfy the excess demand. Then they plow the resulting proceeds directly into gold bullion which boosts this ETF’s holdings. So rising GLD holdings mean investment capital is flowing into gold, which naturally bids it higher.
But the opposite happened in recent months as investors dumped GLD shares faster than gold was being sold. GLD’s share price would’ve failed to the downside if its managers hadn’t stepped in to sop up that excess supply. They raised the capital to buy back GLD shares by selling some of its gold bullion held in trust for shareholders. Thus falling GLD holdings reveal investment capital flowing out of gold, pushing it lower.
GLD’s physical-gold-bullion holdings held for its investors peaked at 871.2 metric tons in late April, and started to shrink as stock investors pulled capital from gold. Strong stock markets and that extreme gold-futures-shorting-driven gold selloff contributed to the bearish sentiment and mass exodus. But that gold-negative trend reversed sharply when the stock markets started plunging in mid-October, a major inflection.
Gold tends to rally when stock markets weaken, making it the ultimate portfolio diversifier. Between late April and early October, GLD’s holdings relentlessly dropped 16.2% or 141.0t. GLD’s capital outflows in Q3’18 were the worst by far since Q4’16 when Trump’s surprise election victory really goosed the stock markets and thus hammered gold. By early October, GLD had gone an incredible 2.6 months without any builds!
Remember the S&P 500 clawed to more all-time record highs in late August and late September, so gold was deeply out of favor with investors. Why prudently diversify small fractions of stock-heavy portfolios with counter-moving gold when stock markets seem to do nothing but rally indefinitely? But that trend reversed hard that very day the S&P 500 plunged 3.3% out of the blue in mid-October, GLD demand exploded.
As stock investors shocked from their euphoric and complacent stupor rushed to buy GLD shares, there was so much differential buying pressure it forced a major 1.2% holdings build! That was the largest in 6.7 months, and the first build at all since late July. One serious day of stock-market selling was all that was needed for investors to remember gold. That differential buying pressure persisted in subsequent days.
GLD’s holdings enjoyed further 0.8% and 0.6% build days late that week and early the next, and have seen additional builds this week. This early stage-three investment buying spawned by renewed fears that stock markets can fall too has already boosted GLD’s holdings by 2.7% or 19.5t in just a couple weeks. And while stock selloffs help initially ignite gold investment buying, it soon becomes self-feeding.
Investors love chasing winners, so buying begets buying. The more anything rallies, the more investors want to buy it. The more capital they deploy into it, the more it rallies. That last major gold upleg back in the first half of 2016 was also sparked by a stock-market correction, with the S&P 500 retreating 13.3% in 3.3 months. As of this week this latest stock-market selloff was still a large pullback at 9.4% over 1.1 months.
That early-2016 correction bottomed in mid-February, as gold was just nearing $1250. But once it had been ignited, that big differential GLD buying pressure continued until early July ultimately pushing gold lots higher to $1365. Most of that gold upleg happened after the stock markets had already bottomed and started marching higher again. The thing that killed that gold upleg was finally a new record high in the S&P 500.
Between mid-December 2015 and early July 2016, GLD’s holdings soared 55.9% or 352.6t higher which was a major driver of that 30%ish gold upleg. To revisit those bull-to-date-high GLD-holdings levels today, this ETF would have to add another 252.6t of gold to its holdings from its recent early-October low. So there’s again plenty of room for massive stage-three gold investment buying to catapult this upleg far higher!
Investors were and remain radically underinvested in gold, it barely even registers in their portfolios any more. When GLD’s holdings sunk to 730.2t in early October, that was a deep 2.6-year low. American stock investors hadn’t been less deployed in gold since mid-February 2016 when gold’s last upleg was still young before powering much higher. Like gold-futures speculators, investors too are positioned for big buying.
So gold upleg fuel abounds today! Gold-futures speculators still have massive stage-one short-covering buying left to do, and have barely even started their also-huge stage-two mean-reversion long buying. And the big stage-three investment buying that will ultimately follow the gold-futures buying is already getting underway early. Such enormous buying likely coming will drive gold’s young upleg much higher.
And while it’s not strictly necessary beyond ignition, I suspect stock-market weakness will persist and fuel even more gold investment demand. As I warned at the end of September when the S&P 500 remained near record highs, Q4’18 is the first quarter ever that would see Fed quantitative tightening run at its terminal $50b-per-month pace. I wrote an important essay detailing why that is this stock bull’s death knell.
To merely unwind half of the Fed’s $3.6t of QE-conjured money created in preceding years, QT would have to run at full steam for 30 months! These QE-inflated stock markets trading at bubble valuations are going to struggle greatly with QT underway. So October’s stock-market weakness is likely the start of a major bear market, not a temporary correction before new record highs. That will greatly boost gold demand!
The gold miners’ stocks will really leverage gold’s coming gains as its young upleg grows. When gold’s last upleg surged 29.9% higher in the first half of 2016, that HUI major-gold-stock index skyrocketed an enormous 182.2% higher in roughly that same span! While that was extreme 6.1x upside leverage, 2x to 3x is common and expected. Gold stocks are already amplifying gold’s surge since mid-October by 2x.
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The bottom line is this young gold upleg is accelerating, greatly boosted by this month’s unexpected plunging stock markets. Despite speculators’ record gold-futures short covering on that drop, the lion’s share of that stage-one gold-upleg-driving buying is still yet to come. And stage-two gold-futures long buying is barely starting. So abundant buying fuel remains to propel gold dramatically higher in coming months.
That futures buying ultimately ignites the far-larger stage-three investment buying, which soon takes on a life of its own. But the shock of that out-of-the-blue stock-market plunge started attracting investors back to gold early. They remain radically underinvested in gold, with huge buying to do to reestablish some normalcy in portfolio allocations. Weaker stock markets will accelerate this overdue shift of capital back into gold.
Adam Hamilton, CPA