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Gold-Futures Buying Yet to Start

Adam Hamilton
Feb 24, 2017

Gold has powered higher in a strong new upleg since the Fed's mid-December rate hike. But the core group of traders who usually fuel early-upleg gains has been missing in action in recent months. The gold-futures speculators have not done any meaningful buying since gold bottomed. This anomaly is a very-bullish omen for gold. Since these traders' buying has yet to start, they need to do lots of catch-up buying.

Since the day after the Fed's second rate hike in 10.5 years in mid-December, gold has surged 10.0% higher at best as of the middle of this week. Naturally these strong gains were really amplified by the gold miners' stocks. The leading GDX VanEck Vectors Gold Miners ETF blasted 34.6% higher over that same short span, trouncing the broad-market S&P 500's mere 1.4% gain! The gold sector is really shining.

But nevertheless it's been a strange gold upleg distorted by the markets' extreme Trumphoria. Normally new gold uplegs see a distinct three-stage buying pattern that fuels their advances. Gold's initial gains off lows are driven by futures speculators buying to cover their shorts. The resulting gold reversal and surge entices in still more futures speculators on the long side, which really accelerates gold's upside.

This early gold-futures buying is essential, single-handedly pushing gold high enough for long enough to reach critical mass psychologically. That finally attracts investors to return, convincing them gold's new upleg is real and sustainable. They command vastly-larger pools of capital than speculators, and fuel most of gold uplegs' gains. Futures speculators jump start the gold-driving engine of investment buying.

This gold-upleg buying sequence has proven the standard for so many years now that it's really hard to imagine it playing out any other way. Speculators and investors have very-different mindsets and risk tolerances, making them uniquely suited to buy at particular times. When gold hits a deep low in extreme bearishness after a major correction, the only buyers are speculators covering shorts to realize profits.

Gold futures actually have a wildly-outsized impact on gold prices, punching way above their weight in capital terms. The main reason is the extreme leverage inherent in futures trading. While the decades-old legal limit for leverage in the stock markets is 2x, it can run as high as 25x in gold-futures trading! So relatively-large amounts of gold can be controlled with relatively-small amounts of capital through futures.

This week, each gold-futures contract of 100 troy ounces only required a small cash margin of $5400 to trade. Yet at $1240 gold, that contract was worth $124,000. Thus fully-margined futures speculators can run leverage as high as 23.0x! Every dollar they bet on gold has up to 23x the impact of another dollar used by investors to buy gold outright. So futures trading can overpower investing to wag the gold-price dog.

On top of the disproportional influence of leveraged capital in gold-futures trading, the gold price derived from it is the world's reference price. So big gold moves driven by hyper-leveraged futures trading can greatly affect gold sentiment universally, leading other traders to follow the lead of futures speculators. Gold-futures trading utterly dominates short-term gold psychology, which is very frustrating for investors.

So to see gold reverse sharply higher since mid-December without any significant gold-futures buying at all is an incredible anomaly. A strong new upleg in gold igniting despite an effective boycott by the futures speculators ought to be impossible based on past precedent. Yet that's exactly what we've seen over the past couple months! These extreme Trumphoria-distorted markets since the election continue to amaze.

Every week speculators' total long and short gold-futures positions are published in the CFTC's famous Commitments of Traders reports. They are released late Friday afternoons, but current to the preceding Tuesday closes. The latest CoT data available prior to this essay's publishing ran to February 14th. And it almost miraculously reveals gold has enjoyed no meaningful gold-futures buying at all by speculators!

This chart is simple, with speculators' total gold-futures long contracts rendered in green and their total short contracts in red. That CoT data is only available at a weekly resolution. Gold is superimposed over the top in blue, along with its key moving averages. For many years, gold-futures buying and selling by speculators has been the dominant driver of short-term gold price action. Until the past couple months' anomaly.

Speculators have four different ways to trade gold futures. They can buy to open new long contracts, or buy to close existing short contracts. Either type of buying has an identical upside price impact on gold. They can sell to close existing long contracts, or sell to open new short contracts. All selling has the same downside gold-price impact. Buying is buying and selling is selling, regardless of current positioning.

So the overall gold-price impact from speculators' gold-futures trading is a combination of what they are doing on both the long and short sides. When they are buying new long contracts as evidenced by a rising green line above, they are bidding gold higher. When they are buying longs to offset, cover, and close existing shorts, as shown by a falling red line, they are also bidding gold higher. Longs and shorts matter.

All the major gold rallies in the past couple years were driven by some mix of speculators adding gold-futures longs and covering shorts. Gold only surged in both bear-market rallies before late 2015 and bull-market uplegs since when spec longs were rising and/or spec shorts were falling. The opposite is also true. Every major gold selloff resulted from some blend of speculators selling longs and adding new shorts.

Throughout most of 2015, gold slumped and plunged to a brutal 6.1-year secular low by mid-December. That terminal 19.3% bear-market drop was partially driven by speculators dumping 90.9k gold-futures long contracts while adding 107.0k short ones. That made for the equivalent of 615.5 metric tons of gold selling in just 10.6 months, an extreme 58.1t-per-month pace. Talk about a roaring deluge of gold selling!

The world's definitive arbiter on global gold supply and demand is the World Gold Council. Once every quarter it publishes fantastic reports detailing gold's fundamental trends. According to the newest data, total worldwide gold investment demand in 2015 ran 918.7t. That works out to 76.6t per month. So the gold-futures speculators hemorrhaging the equivalent of over 3/4ths of that was far too much to absorb.

But gold-futures speculators' capital is finite, and they finally reached selling exhaustion the day after the Fed hiked rates for the first time in 9.5 years in mid-December 2015. A major new bull market was born, which would catapult gold 29.9% higher over the next half-year or so. That was partially driven by speculators adding 249.2k long contracts while buying to cover another 82.8k short ones over just 6.7 months.

That was the equivalent of a staggering 1032.4t of gold buying from this one group of traders alone! At a monthly pace, we are talking about a jaw-dropping 154.7t of ongoing buying! The World Gold Council recently reported global gold investment demand only averaged 130.1t per month in all of 2016. So the extreme gold-futures buying played a big role in gold's powerful new bull market over the first half of last year.

When gold-futures speculators are aggressively dumping contracts, the resulting heavy downside price pressure forces gold dramatically lower as we saw in 2015. But when they later flood back in to buy and reestablish their positions, gold powers far higher as witnessed in the first half of 2016. These traders' outsized dominance over gold's short-term price action extends back many years, it's certainly nothing new.

After digesting a chart like this, it's easy to assume gold-futures trading is all that matters for gold's price levels. But that's not the case, as gold actually has two primary drivers. While the futures speculators command the short term, American stock investors exert massive longer-term influence. Their capital flows into and out of gold via the conduit of that leading GLD gold ETF are gold's other primary driver.

Any gold-futures analysis without considering GLD capital flows is myopic and potentially misleading. If you need to get up to speed on the GLD juggernaut's overpowering influence on gold prices, I recently wrote an essay on it. Gold's price action and prevailing levels result from the interplay between gold-futures speculation and stock-market gold investment via GLD shares. Gold futures don't operate in a vacuum.

Usually speculators' gold-futures trading and investors' GLD-share trading run in tandem, as the same gold sentiment motivates both groups of traders. They are more likely to get greedy and want to buy gold after it has already rallied, as everyone loves chasing a winner. They are more prone to get scared and want to dump gold after it has fallen, succumbing to prevailing fear. Gold futures and GLD rarely oppose for long.

Zooming in this same gold-futures chart to the past year or so, we can get a higher-resolution read on what's been going on in gold since last summer. This perspective is essential to understanding the big gold-futures anomaly today and why it is so darned bullish for gold in the coming months. When this knowledge becomes more widely known, speculators and investors alike will rush to buy gold again.

Gold topped in early July because speculators were so heavily long gold futures that buying exhaustion was hit. They were fully deployed in gold, with no more capital to throw at it. That left a record selling overhang for gold when these guys inevitably started unwinding their excessive longs. Their selling and the resulting downside pressure on gold was mercifully modest until catalyzed by a couple major events.

Gold-futures trading is exceedingly risky and unforgiving due to its extreme inherent leverage. At 20x, a mere 5% adverse move in gold against traders' positions results in 100% losses of their capital risked! So running automatic stop-loss orders is all but mandatory for survival. Last summer traders had a big mass of gold-futures sell stops set near the psychologically-important $1300 level, which held for months.

But as October dawned, gold started drifting near this support and triggering these stops. The resulting mechanical selling quickly cascaded, tripping more stops. This unleashed heavy selling in gold-futures longs bludgeoning gold sharply lower, just like it had in May after FOMC minutes proved more hawkish than expected. That was the first gold-futures mass stopping in the fourth quarter, really damaging gold sentiment.

The second came in the days after Trump's surprise election win. For months, gold had traded higher when Trump rose in the polls and lower when he fell. On Election Day's evening itself, gold futures rocketed 4.8% higher from that afternoon alone when Trump's lead mounted in the biggest battleground state of Florida. All indications were that a Trump win would be bullish for gold and bearish for the stock markets.

So when that universal expectation proved wrong in the subsequent days, speculators and investors alike started fleeing gold. That resulted in more cascading gold-futures selling as stop-loss levels were sequentially hit. Selling begets selling. The faster traders dumped gold futures, the faster gold's price fell spawning even more selling. Gold plunged in the resulting vicious circle of another mass stopping.

Gold kept falling into a third mass stopping last quarter right after the Fed's meeting in mid-December. While its rate hike was universally expected, the FOMC projected three more rate hikes in 2017 instead of the expected two. Gold-futures speculators irrationally fear Fed rate hikes even despite the fact gold has thrived during Fed-rate-hike cycles historically! That's when the gold-futures selling finally started to moderate.

By gold's bottom the day after the Fed, speculators had jettisoned 174.0k long contracts and added 32.2k short ones since early July. That was enormous selling equivalent to 641.3t of gold, or a 116.1t monthly pace that was far too extreme for the markets to absorb. But after such a huge gold-futures liquidation, the speculators' selling was exhausting. So it was only a matter of time until gold-futures buying returned.

That would trigger gold's next major upleg after its brutal 12.7% Q4 plunge, one of its worst quarters ever witnessed. But as these charts reveal, gold-futures speculators weren't ready to buy. With the prospect of the Fed hiking rates three times in 2017, and the US dollar trading near extreme 14.0-year highs on rate-hike hopes, and the stock markets hitting record after record on all the Trumphoria, they didn't want gold.

These traders' serious bearishness on gold in late December was understandable given where gold had come from and the fierce headwinds arrayed against it. So speculators weren't interested in covering their gold-futures shorts, which triggers the initial rally in new gold uplegs. And unlike short covering which is contractually-obligated, long buying is totally voluntary. Speculators didn't want to bet on gold rising.

Yet gold started rallying anyway, rather sharply! While I was expecting a new gold upleg late last quarter after all the gold carnage, I would've never believed it could happen with virtually no participation by the futures speculators. I can't remember a major gold advance, both bear-market rallies and bull-market uplegs, that erupted and grew without speculators buying gold futures. They are the kings of short-term action.

But incredibly, gold bounced and rallied anyway despite speculators boycotting gold-futures buying! This new gold buying didn't come from American stock investors either, since GLD suffered serious draws in December and January showing ongoing capital outflows. But there was a critical clue as to where gold's mysterious buying was coming from. It came in the form of the timing of intraday gold rallies.

While American gold futures trade 23 hours a day, the vast majority of their trading activity comes during the normal US stock-market hours. The same is true of GLD buying. Between late December and late January, gold would often sell off during the US trading day. Most of the gains came overnight when the American traders were sleeping! The gold buying driving this strong new upleg was coming from Asia.

American investors didn't start returning to gold with heavy differential GLD-share buying until the dawn of February. And as of the latest CoT current to mid-February, futures speculators still haven't done any significant buying. That is stunningly bullish, since all their buying fuel remains intact. They have yet to expend any of their capital firepower buying gold, which means they have big catch-up buying to do.

As of that newest CoT when this essay was published, speculators' total gold-futures longs were way down at 252.0k contracts. That is actually considerably lower than where they were when gold bottomed in mid-December! And speculators' total gold-futures shorts are running 124.2k contracts, not far under mid-December levels. This leaves vast room to buy when gold's rally inevitably turns speculators bullish again!

Back when gold peaked in early July, speculators held an all-time-record-high 440.4k long contracts to bet on gold's expected upside. To mean revert back to those levels, speculators have a colossal 188.4k contracts of long buying to do! That's the equivalent of 585.9t of gold, or 3/8ths of full-year-2016's global gold investment demand. They also have 24.1k contracts of short covering to do, for another 74.8t of buying.

And because of the extreme leverage and risks inherent in futures trading, speculators are rapid buyers once they wax bullish on gold again. So we are looking at the equivalent of a potential 660.7 metric tons of gold buying from this group of traders alone unfolding over a few months, six on the outside. That is going to supercharge gold's upleg when it inevitably arrives, greatly accelerating gains and bullishness.

If a full mean reversion back to speculators' early-July gold-futures levels seems too fanciful, you can be very conservative and model a mere half mean reversion. That still equates to 330.3t of gold buying via gold futures over the coming months. Remember global gold investment demand averaged 130.1t per month in all of 2016, so even 50t or 100t per month of gold-futures buying is a massive increase in gold demand!

The fact a strong new gold upleg is underway without speculators buying gold futures is incredible, an extreme anomaly. The Trumphoria stock-market rally, and sky-high US dollar, have greatly distorted market psychology. But once these lofty overvalued stock markets and euphoric topping US dollar inevitably roll over, gold-futures speculators will be shocked from their slumber. Then they will rush to do catch-up buying.

That will really accelerate gold's strong new upleg. While investors can certainly play gold's big coming gains in that leading GLD gold ETF, individual gold stocks will really amplify gold's gains. While gold powered 30% higher in the first half of 2016, the leading gold-stock index nearly tripled with a monster 182% gain! Gold stocks have similar massive upside potential this year, but only smart contrarians will reap it.

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The bottom line is speculators' gold-futures buying hasn't even started yet despite gold's strong new upleg. While these elite traders sat on their hands after gold's mid-December bottoming, Asian buyers usurped their usual early-upleg command. That's left futures speculators greatly under-positioned in gold. So they have massive catch-up buying to do to leverage gold's coming upleg gains, which is very bullish.

Distracted by the extreme Trumphoria market distortions, futures speculators have totally missed this gold boat. They won't stay on the sidelines for long though as gold keeps powering higher. They will rush to get properly positioned for more gold upside, aggressively adding longs and covering shorts. All that coming buying will feed on itself and really accelerate gold's new upleg, catapulting this metal much higher.


Feb 24, 2017
Adam Hamilton, CPA

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