Speculators’ bets became so excessively-bullish that they exhausted all their firepower. Here’s what it will take for gold to rally…
Gold has stalled out, drifting sideways to lower for nearly a couple months now. Traders are becoming more frustrated its preceding powerful rally has failed to resume. That is inexorably eroding this past summer’s bullish psychology. Corrective phases to rebalance sentiment are normal and healthy after strong uplegs. Gold had grown too overbought, exhausting traders’ near-term buying firepower in the process.
Bull markets are simply an alternating series of uplegs and corrections. Visualize the core bull-market trend as a rising straight line, and uplegs and corrections are like a sine wave oscillating around it. Prices power to new bull highs in uplegs, surging well above trend. That generates much greed, sucking in all available capital. Both speculators and investors interested in buying anytime soon pile in near bull highs.
That overdone buying late in uplegs necessitates corrections. They drag prices lower long enough to bleed off toppings’ excessive greed. The selling they spawn generates fear, eventually resetting traders’ buying potential and paving the way for the next upleg. The duration of corrections depends on how fast they can rebalance sentiment. They run on a continuum between big and quick to slow and drawn-out.
Gold’s last major interim high was 7 weeks ago, $1554 on September 4th. That followed a strong upleg, where gold powered 32.4% higher over 12.6 months. And like most uplegs, a large fraction of its gains accrued disproportionately in its final months. During the last 1/5th of this upleg which ran from gold’s decisive bull-market breakout in late June until its early-September peak, over half of its entire gains were seen!
That self-feeding buying frenzy last summer catapulted gold to extremely-overbought levels. The bigger and faster price gains, the greater the odds unsustainable overboughtness will result. After decades of study, my favorite indicator for quantifying overboughtness is where prices trade relative to their trailing 200-day moving averages. I developed a trading system around this over 15 years ago, called Relativity.
By early September gold had rocketed so far so fast that its price divided by its 200dma yielded a relative multiple of 1.166x. In other words, gold’s price had stretched 16.6% above its 200dma. That was the most-extreme seen in 8.0 years, since September 2011 right after gold’s last secular bull peaked! The current bull’s maiden upleg topped in early July 2016 after gold clocked a couple daily closes exceeding 1.15x.
What happened next wasn’t pretty, extreme overboughtness isn’t to be trifled with. Over the next 4.2 months into late 2011, gold plunged 18.3% in a severe correction that would later prove the start of a new bear market. And after that mid-2016 episode, gold dropped a similar 17.3% during the following 5.3 months. There are many more examples of major gold selloffs emerging out of extreme overboughtness.
It is such an ominous short-term omen because of how prices, sentiment, and buying firepower interact. Prices can only blast higher too far too fast when popular greed grows excessive. Big rallies breed greed, motivating traders to buy aggressively to chase the mounting gains. So they swiftly throw all the money they are willing to risk at that market. While that does quickly bid prices higher, it rapidly exhausts buyers’ capital.
The upward price velocity of uplegs is a direct function of how much buying speculators and investors are doing. The more they rush to buy, the more capital they throw at a hot market, the faster they expend their available buying firepower. Once that is tapped out and dries up, only sellers remain. Uplegs fail and roll over into corrections once all available buyers are essentially fully deployed. That just happened in gold.
The gold price has two dominant primary drivers, speculators’ collective gold-futures trading and investors’ investment demand. I discussed the former in depth in mid-September soon after gold’s latest peak, warning of a very-bearish gold-futures-selling overhang. Then a couple weeks ago I wrote on the fragile gold investment demand. Today’s essay melds these research threads to try and help frustrated traders.
Gold-futures trading overwhelmingly drives gold’s short-term price action for two reasons. Gold futures allow extreme leverage, greatly multiplying their capital’s collective impact on gold. And the resulting price happens to be the world’s reference one, which heavily colors gold’s overall psychology. Without a doubt the biggest mistake most traders of gold, silver, and their miners’ stocks make is not watching gold futures.
Most traders buy gold or gold ETFs outright, with each dollar deployed exerting that same amount of price pressure on gold. But gold-futures speculators punch way above their weight, giving them wildly-outsized influence on gold prices. This week each 100-troy-ounce gold-futures contact controlling $150,000 worth of gold at $1500 only required a maintenance margin of $4,500. That enables extreme leverage up to 33.3x!
So fully-margined gold-futures speculators can effectively multiply their capital’s price impact on gold up to 33x when buying and selling. Each dollar they deploy has the same price impetus as thirty-three dollars invested outright. Running extreme leverage is hyper-risky, as gold merely moving 3.0% against a position at 33.3x leverage will obliterate 100% of the capital risked! This necessitates an ultra-short-term focus.
While investors have time horizons measured in years, and normal speculators in months, gold-futures speculators are forced to think in terms of days or weeks at most. Their extreme leverage doesn’t give them the luxury of riding multi-month trends. All they can care about is what the gold price is doing and likely to do in the immediate future. This myopic focus renders most normal gold analysis irrelevant to them.
This chart superimposes gold over speculators’ total gold-futures long and short contracts, which are published weekly in the CFTC’s famous Commitments of Traders reports. Their longs or upside bets on gold are drawn in green, and shorts or downside bets in red. Note how gold’s price throughout this entire bull has closely mirrored what the gold-futures speculators as a herd are doing! That will continue to hold true.
In gold-futures trading, there are two ways to both buy and sell. Speculators can buy gold futures to add new longs, or buy to cover and close existing shorts. And they can sell to exit current longs, or sell to open new shorts. The gold price impact of buying and selling gold futures is identical whether it is done to open new or close current positions. Gold-futures buying and selling always drives gold’s uplegs and corrections.
Gold’s strong 32.4% upleg that peaked in early September was mostly fueled by specs adding 172.9k long contracts and buying to cover another 157.5k short ones. That added up to a huge 330.4k contracts of total spec gold-futures buying between mid-August 2018 to early-September 2019. That made for the equivalent of 1027.6 metric tons of gold buying! Keep that in mind to compare with investment buying later.
Note in this chart that this latest upleg’s strongest gold advances occurred when gold-futures specs were aggressively buying longs and covering shorts. This is evident in a rapidly-rising green line and a fast-falling red one. Conversely when specs’ positioning was stable, gold flatlined. And when they started selling, gold was dragged lower. Gold is hostage to specs’ gold-futures trading thanks to its extreme leverage.
I’ve actively traded for decades now, earning my fortune in the markets. In all that time, I’ve never once used margin. I think it is crazy. There is plenty of risk and great rewards to be won without taking on the wildly-amplified additional risks leverage entails. The large majority of speculators and investors share the same opinion on this. The fraction of traders willing to run 10x, 20x, 30x+ leverage is very small.
So both the pool of available gold-futures speculators and the collective capital they command is finite. Eventually their buying firepower gets exhausted, leaving them nothing to do but sell. While we can’t know exactly when that happens in real-time, we can certainly game the odds it is close. Both total spec gold-futures longs and shorts have carved trading ranges over the decades. These help define extremes.
As of the latest CoT week ending last Tuesday, speculators held 382.4k gold-futures long contracts and 94.2k short ones. These are really high and really low historically, suggesting there’s not much room to buy and drive gold higher. But there’s vast room to sell and pummel gold lower. The main reason that gold stalled since early September is speculators had exhausted their buying firepower on both sides of the trade.
Their total long contracts hit 433.0k and 431.0k in late August and early September, and bounced slightly higher in late September to 433.9k. These are extreme levels by any measure, the 2nd, 3rd, and 4th highest seen out off all 1085 CoT weeks since early 1999 in gold’s modern era! They were only eclipsed by early July 2016’s all-time-record high 440.4k, which again preceded a monster 17.3% gold correction.
In this chart it is crystal-clear that gold stalled out exactly when specs stopped buying gold-futures longs. With their positioning so excessively-bullish and extreme, that left a massive gold-futures-selling overhang threatening gold. Gold hasn’t corrected hard yet, only drifting modestly sideways to lower, because these guys haven’t been scared into selling en masse. But that could still happen anytime with the right catalyst hitting.
In this latest CoT week, total spec longs remained way up in the 97th percentile of all CoT weeks. There is far more likely to be major selling than big buying from here. Anything over 350k contracts is worrying, and that happens to coincide with about the 94th percentile. For 17 CoT weeks in a row now, total spec longs have been above 350k. They averaged a lofty 396.6k over that recent span, or the 98th percentile!
These recent persistent extreme spec-long levels are eerily reminiscent of mid-2016. This gold bull’s maiden upleg peaked then after rocketed 29.9% higher in just 6.7 months. Spec gold-futures longs remained above 350k continuously for 17 CoT weeks, averaging 409.8k or almost the 99th percentile of all modern CoT weeks. Spec longs can remain excessively-high for some time, but eventually they must normalize.
And that was seriously painful for traders ignoring the gold-futures situation, as gold again plunged 17.3% over the next 5.3 months. The major gold miners’ stocks amplified that downside by 2x to 3x like usual, with the leading GDX VanEck Vectors Gold Miners ETF plummeting 39.4% in roughly that same span! It doesn’t pay to buy gold and gold stocks high once speculators’ gold-futures buying nears exhaustion levels.
Compounding gold’s near-term downside risks, total spec shorts are near major lows. Back in late August they sunk to a deep 4.5-year low, and extended that slightly to a 4.6-year one just 3 CoT weeks ago. In this latest CoT week they were trading just 8% up into their gold-bull-market trading range since mid-December 2015. That compares to spec longs running 77% up into their own, after hitting 97% in late September.
As is apparent in this chart, spec shorts have an effective floor. No matter what gold does, there are always traders betting it will fall lower. Today’s spec shorts remain right near those bull-market lows, so there is little room left to buy to cover additional shorts. Instead there is vast room to add new shorts to pile on to gold’s downside momentum driven by specs dumping longs when the right catalyst inevitably arrives.
Considered from this bull’s extremes, in this latest CoT week speculators had room to add 57.9k longs and buy to cover another 14.5k shorts. That adds up to 72.5k contracts of potential buying. But they had room to sell 195.7k longs and short sell another 162.6k. That makes for 358.2k contracts of potential near-term selling. With room for selling outweighing room for buying by 4.9x, it’s hard to be bullish on gold.
Gold stalled out because these gold-dominating traders exhausted their buying in early September. And gold is going to struggle until those excessively-bullish bets are normalized by selling longs and adding shorts. Gold will remain saddled with serious downside risks until spec longs and shorts mean revert. I don’t like it either, and am eager for gold’s next upleg. But with this spec positioning, we have to stay wary.
The secondary reason gold has stalled out is identifiable investment inflows have disappeared as gold’s futures-fueled upleg peaked and started drifting lower. This next chart looks at this gold bull compared to the physical gold bullion held in trust by the world’s leading and dominant GLD SPDR Gold Shares gold ETF. It publishes its holdings daily, making them the best high-resolution proxy for gold investment demand.
While successful investment requires buying low then later selling high, gold investors love to buy high. They get most excited about gold when it is surging, succumbing to greed to pile in to ride that upside momentum. Differential buying of GLD shares during gold’s recent 32.4% upleg forced this ETF to add 122.5 metric tons to its holdings. That was less than 1/8th of spec gold-futures buying during that span!
New-high psychology is a powerful motivating force for investors to buy, and fueled a massive 131.8t GLD build in the 2.5 months between gold’s decisive bull-market breakout in late June and its early-September peak! That was actually bigger than GLD’s build over this entire upleg, since this ETF’s holdings slumped even lower in June than when gold’s upleg was born. American stock investors were buying big.
But once gold’s new highs ceased as gold-futures speculators’ buying firepower exhausted, so did the outsized gold investment demand soon after. With US stock markets hovering near all-time-record highs, investors feel little need to prudently diversify their stock-heavy portfolios. They aren’t worried about any material stock-market selloffs, so the only reason they flooded into gold recently was to ride the momentum.
That’s why this recent gold-investment-demand surge is quite fragile. As long as US stock markets don’t plunge, gold investors will flee when gold rolls over on the inevitable spec gold-futures selling coming. American stock investors in particular will dump GLD shares faster than gold is being sold, forcing this ETF’s managers to sell gold bullion exacerbating gold’s selloff. Gold’s momentum-dependent demand isn’t durable.
Again mid-2016’s precedent is ominous. Investors poured into gold early that year as this gold bull’s strong maiden upleg soared higher. And investors were mostly content to remain in gold as long as its price stayed near highs. But once gold turned south materially on gold-futures selling, investors rushed for the exits as evident in GLD’s holdings. The result was that miserable 17.3% gold correction in late 2016.
Every day I get e-mails from subscribers wondering why I’m not buying gold stocks right now. And my answer is simple. Why buy now if odds heavily favor materially-lower gold prices in the near future? The major gold stocks leverage gold corrections by 2x to 3x, so if gold corrects 10% GDX is going to fall 20% to 30%. At worst so far in late September, gold had merely retreated 5.2% from its early-September peak.
Successful trading isn’t about doing what you want to do, but what you ought to do. While you won’t win every time, the goal is to only trade big when the odds are most in your favor. A poker player who bets big holding a hand with just two pairs isn’t brave, but a fool. The smart ones won’t throw all-in unless they are holding something strong like a full house or four-of-a-kind. Probabilities need to offer high chances of success.
And the current still-overbought gold-price levels, still-excessively-bullish speculator positioning in gold futures, and momentum-driven gold investment make for high odds gold’s correction is not over. Few are taking it seriously so far because it has looked like a benign high consolidation. But until specs’ lopsided gold-futures bets mean revert to more-normal levels, it is highly likely gold faces more sizable selling soon.
Gold’s powerful upleg stalled out a couple months ago for major reasons, so as long as they persist there is no reason to expect this bull’s next upleg to start marching. We can’t change the markets, so it is futile to fight them and counterproductive to worry about what they are doing. When corrections are likely, the best course is to patiently wait them out in cash to preserve capital and boost buying power at their bottoms.
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The bottom line is gold’s strong summer advance stalled out for good reasons. Gold surged to super-overbought levels, sucking in all available near-term buying. Gold-futures speculators’ bets became so excessively-bullish that they exhausted all their capital firepower. And once gold’s advance flagged, the momentum-driven gold investment demand withered too. Gold won’t rally materially until all this is rectified.
Speculators’ collective gold-futures bets can stay extreme for some time, but sooner or later a catalyst hits forcing them to start normalizing. The radical leverage inherent in that market makes selloffs self-feeding. Gold, silver, and the stocks of their miners are going to remain precarious with serious downside risks until that necessary gold-futures selling comes to pass. Jumping the gun on buying will be punished.
Adam Hamilton, CPA