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Gold's Dead-Wrong Psychology

Adam Hamilton
Sep 25, 2015

Gold has lapsed deeper into pariahdom this year, becoming the most-hated investment class in all the markets. Traders are avoiding it like the plague, utterly convinced gold is doomed to spiral lower perpetually. But this wildly-bearish psychology is dead wrong. Financial markets are forever cyclical, and gold is no exception to history's ironclad rule. The best time to be heavily long anything is when few others are.

Gold's universal disdain today is the natural result of dismal price action. This precious metal has not seen a new secular high since August 2011, 4.1 years ago. Between that latest bull-market peak and early August 2015, gold fell 42.8% in a brutal secular bear market. With the flagship S&P 500 stock index up 86.8% over that same span, it's easy to understand why many consider gold the worst investment.

But gold wasn't always this way. The greatest mistake investors and speculators make is extrapolating the present out into infinity. They succumb to our innate human tendency to assume the status quo will persist indefinitely. We all do this all the time in our normal lives. When everything is going well, we get euphoric and think good times will last forever. When nothing is working out, we despairingly see a bleak future.

This present-situation-lasting-perpetually outlook is obviously dead wrong, as life moves in cycles. We will all see good times and bad times, with neither extreme persisting for long. The financial markets work the same way. Just when the vast majority of investors and speculators are convinced that an old trend will be the new norm forever, it reverses. The markets shift and massive countertrend moves get underway.

Gold itself is a fantastic example of this. Back in the early 2000s as the stock markets soared, gold was considered dead. Investors despised it, and central banks couldn't dump it fast enough. As the mighty secular stock-market bull peaked in March 2000, gold was around $285. Everyone thought the stock markets were destined to rally forever in a brave new technology-driven era, in which gold was totally obsolete.

But just as the market status quo seemed unassailable, it crumbled. Market extremes are always the result of excessive greed or fear among traders. And since these emotions are finite and inherently self-limiting, they can't last. Once everyone who bought stocks high had already deployed their capital, no one else was left to buy. So the astounding prevailing stock greed in the early 2000s burned itself out.

Meanwhile gold was racked by excessive fear and despair. Everyone who wanted to sell it low had already done so, leaving no one left to sell. So gold's decades-old secular bear shifted to a powerful new secular bull. Between April 2001 and August 2011, gold skyrocketed 638.2% higher while the S&P 500 lost 1.9%! Gold was the world's best-performing asset class by far over an entire decade, creating fortunes.

Like all markets, gold flows and ebbs. It has great secular bull markets followed by long secular bears. As any multi-decade gold chart reveals, gold is highly cyclical. It doesn't move in one direction forever any more than the stock markets do. And gold's innate cyclicality means it is way overdue for a massive trend change out of the recent extreme lows and despair. Today's universal gold bearishness is dead wrong.

Investors and speculators have witnessed gold weakness for so long that they have forgotten what an anomaly it is. Back in August 2011 when gold's gargantuan secular bull crested, this metal was way overbought as I warned at the peak. Gold bullishness was ubiquitous, with greed off the charts. Even major Wall Street firms including Goldman Sachs were publicly forecasting a continuing rally for years to come.

But gold needed to correct hard out of such euphoria, and it did. Over the next 9 months it lost 18.8%, a major correction taking gold to the cusp of bear-market territory. After that gold stabilized, and actually averaged $1669 in 2012 which was 6.1% above peak-year-2011's $1573. The gold market was working normally then, and building a strong base for its next upleg. But then extreme central-bank distortions derailed it.

Back in mid-September 2012, the Federal Reserve launched its third quantitative-easing campaign. The timing was highly irregular and suspect, as a US presidential election was less than two months away. Since 1900, the stock-market behavior in the Septembers and Octobers leading into the November presidential elections has predicted the winner 26 out of 29 times, a truly stunning 90% success rate!

If the Fed hadn't acted right then to goose stock markets, they would have fallen leading into that critical 2012 presidential election. In fully 10 of the 12 times when the stock markets fell in September and October leading into an election, the incumbent party lost. The sharp post-QE3-announcement gains pushed stocks to a final-two-month rally. In 16 out of the 17 times that happened, the incumbent party won.

The Fed is usually very careful not to act leading into an election, because it doesn't want to be seen as political which leads to all kinds of fury from Congress. But Republican lawmakers had been highly critical of the Fed's enormous previous quantitative-easing debt-monetization campaigns, and a new Republican president would have made the Fed's existence a nightmare. So it acted to sway an election!

QE3's timing wasn't the only odd thing, so was its methodology. QE1 and QE2 both had predetermined sizes and end dates when they were initially announced. But the radically-unprecedented QE3 was totally open-ended. The Fed intentionally never disclosed how big it intended QE3 to be and how long it intended QE3 to run. Just 3 months after its birth, QE3's monthly purchases were more than doubled in December 2012.

Stock traders absolutely love central-bank easing, since the deluge of freshly-conjured money works to buoy stock prices. And since QE3 was open-ended, its psychological impact on the stock markets was far greater than the previous QEs'. Whenever the stock markets, which were already overvalued and overextended at QE3's launch, threatened to sell off, Fed officials raced to the microphones to jawbone.

They were constantly alluding to the fact that they stood ready to ramp QE3 if necessary. Stock traders took this as the Fed intended, assuming the US central bank was effectively backstopping the US stock markets! Every dip was quickly bought on the ever-present promise of more Fed QE, spawning a truly extraordinary and unprecedented stock-market levitation. The QE3 era saw stocks do nothing but rally.

And thus began gold's horrendous death march through the sentiment desert. Gold has always been and always will be an alternative investment. It is one of only a handful of assets that generally move counter to the stock markets. So gold investment demand is strong when stock markets are weakening or flat. With stock markets endlessly surging thanks to the Fed, gold investment demand cratered in 2013.

Professional money management is a fiercely-competitive industry, where investors always seek out the best returns. So the fund industry poured its clients' capital into the Fed-goosed stock markets, driving them even higher. The strong stock-market gains were very attractive, seducing capital out of all other markets including gold. So this precious metal utterly collapsed in the first half of 2013 as investors fled.

This extreme selling was concentrated in the flagship GLD SPDR Gold Shares ETF, the premier way for stock traders to get gold portfolio exposure. When they buy GLD shares faster than gold is rallying, this ETF shunts that excess capital directly into physical gold bullion held in trust for its shareholders. GLD's holdings peaked at 1353.3 metric tons just two days before QE3 was expanded back in December 2012.

With the Fed effectively backstopping stock markets, the S&P 500 levitated 12.6% in the first half of 2013. So stock traders sold their GLD shares to chase these big gains, plowing their capital back into general stocks. During that 6-month span, GLD's holdings collapsed a radically-unprecedented 28.2%. Extreme differential selling of GLD shares forced this ETF to jettison 381.3t of gold bullion into the markets!

Such a deluge of marginal gold supply unleashed in such a short period of time was far too much for normal investment demand to absorb. That GLD selling alone equated to 63.6t per month. According to the World Gold Council, during 2012 which was the last normal year for gold, global investment demand averaged 135.5t per month. So the extreme GLD liquidations alone offset nearly half of normal-year demand!

These epic supply headwinds from investment selling caused gold to collapse 26.4% in the first half of 2013. Fully 5/6ths of this gold selling hit in 2013's second quarter, where gold plummeted 22.8% to its worst quarterly loss in an astounding 93 years! A once-in-a-century superstorm of selling spawned by a central bank gone rogue is not a normal or sustainable market event. Everything subsequent is a huge anomaly.

With gold brutally hammered in 2013's first half, American futures speculators rushed into the fray. Of course futures trading is a hyper-leveraged zero-sum game, vastly different from stock trading. Due to this very nature of futures, speculators have no choice but to try and follow trends. So they hopped on the epic-gold-liquidation bandwagon, selling long positions and adding short ones. This amplified gold's drop.

This chart looks at the total positions in long and short gold-futures contracts held by American futures speculators during the Fed's extreme QE3 anomaly. The Commodity Futures Trading Commission's famous Commitments of Traders reports disclose gold-futures speculators' collective bets once a week. And after the extreme GLD-share exodus, they are the other key driver of gold's anomalous QE3-era price action.

Description: Zeal092515A

As gold plunged in the first half of 2013 as the Fed's incessant jawboning about expanding QE3 led to incredible stock-market distortions, American speculators sold gold futures aggressively. They dumped 66.2k long-side contracts while adding 99.6k short-side ones in those fateful 6 months. And with every gold-futures contract controlling 100 ounces of the metal, this unleashed a jaw-dropping amount of gold.

We are talking about the equivalent of another 515.9t of gold sold through the futures markets, a monthly rate of 86.0t! That alone would have offset nearly 2/3rds of the normal monthly gold investment demand in 2012. With this extreme gold-futures selling by speculators on top of that massive GLD-share dump, it's no wonder gold fell off a cliff in the initial 6 months of full-strength QE3. The gold selling was epic!

Gold's entire hyper-bearish psychological environment today remains the product of that superstorm of selling in the first half of 2013. Such an extreme event left such a traumatic imprint on investors and speculators alike that they now assume gold is doomed to spiral lower forever. But in financial markets which are forever cyclical, sentiment based on a perpetual extrapolation of present conditions is dead wrong.

You don't have to take my word for it either, the hard data proves the first 6 months of 2013 have not become the new norm. While the GLD liquidation since has been ongoing as stock traders continued to exit gold, it has slowed dramatically since the middle of 2013. The average monthly liquidation rate of GLD's holdings has collapsed from 63.6t in the first 6 months of 2013 to just 10.9t since. That's a 5/6th reduction!

And the extreme gold-futures selling by speculators has actually reversed. It plummeted from that 86.0t-per-month average in the first half of 2013 to buying of 1.2t per month since! Both the extreme GLD-share and gold-futures selling were already largely exhausted by the middle of 2013. That's why gold didn't keep on plunging since, but has only been gradually grinding lower. And this trend is way overdue to reverse.

While gold psychology has been overwhelmingly bearish since that extreme Fed-fueled anomaly in the first half of 2013, it took a sharp turn for the worse just a couple months ago. In late July, gold plunged in an extreme gold-futures shorting attack exquisitely timed to wreak the maximum havoc on gold prices and long gold-futures stop losses. If you aren't familiar with that event, it is exceedingly important to understand.

Late on a Sunday night when the vast majority of American traders weren't paying attention, a stunning blitz of gold-futures short selling was unleashed. 24k contracts were shorted in one minute, forcing gold to its recent dismal new lows. But the exciting and bullish thing about this is all futures short selling has to soon be fully reversed. Speculators have to buy long contracts to offset and cover their short ones.

In early August just after that brazen shorting attack, American speculators' gold-futures shorts soared to an all-time record high of 202.3k contracts. That is extreme beyond belief! In 2009 to 2012, the last normal years before the Fed's epic QE3 market distortions, speculators' gold-futures shorts averaged just 65.4k contracts. And major support for these positions visited multiple times in the subsequent QE3 era is 75k.

There is zero doubt that speculators will cover their massive short bets back down to 75k, that is a total certainty. And per the latest Commitments of Traders report before this essay was published, American speculators' total gold-futures shorts were back up to 173.9k contracts. This remains incredibly high. In the 141 CoT weeks since early 2013, only 9 saw higher speculator shorting. Today's levels are unsustainable.

In order to buy down their massive short-side bets back to recent years' strong 75k-contract support, speculators need to purchase an incredible 98.9k contracts! That's the equivalent of 307.5t of gold. And as the chart above shows, short covering rallies tend to rapidly unfold over a couple months or so. With gold futures so hyper-leveraged, speculators have to be quick to cover or face catastrophic losses as gold rallies.

So once a small fraction of speculators buy to cover, the rest are forced to follow. And that would create marginal new gold investment demand on the order of 153.7t per month for a couple months! According to the World Gold Council, global investment demand in the first half of 2015 averaged just 75.7t per month. So speculators' gold-futures short covering alone has the potential to temporarily triple investment demand!

And believe me, that happening in today's lopsided sentiment environment where gold is loathed will lead to this metal soaring. Major new uplegs are almost always sparked by futures short covering, as these speculators are the only ones legally and contractually forced to buy low. And once they get the rally ball rolling, the bandwagon speculators and investors hop on to ride the momentum and accelerate the gains.

Between 2009 and 2012, American futures speculators had average long positions in gold of 288.5k contracts. Merely mean reverting back up to those levels would require another 81.7k contracts of buying, equivalent to another 254.0t of gold demand. A conservative estimate for this mean reversion is 6 months or so, adding another 42.3t of gold demand per month. See how that buying will really add up?

But the speculator buying, no matter how large coming out of such extreme short highs and long lows, is just the pre-game show. Gold's real upleg requires investors to return, which they are overdue to do in a major way. As the trivial value of GLD's bullion holdings relative to the overall stock market's market capitalization proves, investors are radically underinvested in gold today. They will start returning as gold rallies.

Gold's hyper-bearish psychology is dead wrong due to this causal chain of self-feeding buying being on the verge of being ignited. First gold-futures speculators are forced to cover, which will drive gold sharply higher. Then the long-side futures speculators will jump on to ride the momentum, further accelerating gold's gains. And once gold rallies far enough to capture investors' attention, they'll take the baton.

With everyone despising gold right now and convinced it is dead, near-record speculator gold-futures shorts wound like a coiled spring, and the stock markets decisively rolling over which will rekindle gold investment demand for prudent portfolio diversification, only a fool would not want to be heavily long gold! History proves the great majority of traders are the most bearish right as major bottoms are being carved.

And contrary to the bearish boogeyman, the upcoming Fed-rate-hike cycle is no threat to gold. I recently did a comprehensive study on how gold performed in every Fed-rate-hike cycle since 1971. Gold not only rallied in 6 of these 11 cycles, but did so dramatically with an average gain of 61.0% in the exact Fed-rate-hike-cycle spans! Gold surged 49.6% in the Fed's last rate-hike cycle between June 2004 to June 2006.

This was despite the Fed more than quintupling its federal-funds rate from 1.00% to 5.25% through 17 separate hikes! And in the other 5 Fed-rate-hike cycles where gold lost ground, every one of them started with gold near major multi-year highs. Today gold is just off that gold-futures-shorting-attack-driven 5.5-year secular low. So the coming Fed-rate-hike cycle is likely to prove exceedingly bullish for it.

How can that be? Gold yields nothing, so higher rates should slaughter it right? Wrong, history proves. Higher rates are very damaging for stocks and bonds, and when stock markets weaken gold investment demand surges since gold prices generally move contrary to stock markets. Fed-rate-hike cycles work to rekindle demand for alternative investments since they wreak so darned much havoc on mainstream ones.

So the prudent bet for investors and speculators to make today is to fight the crowd and be heavily long gold and the derivative plays that rally with it, silver and the precious-metals mining stocks. Physical gold and the GLD ETF are great places to park capital, but the coming gains in the radically-undervalued and left-for-dead gold-mining stocks will dwarf gold's. This sector is trading at fundamentally-absurd price levels!

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The bottom line is today's hyper-bearish gold psychology is dead wrong. Like all financial markets, gold is forever cyclical. It's not going to keep on falling perpetually. The extreme central-bank-spawned gold selling of recent years is exhausted, everyone who wants to sell into secular lows has already done so. That leaves only buyers poised to flood back in as gold decisively rallies to mean revert much higher.

Gold's next mighty upleg will be jumpstarted by American futures speculators covering their near-record shorts back down to reasonable levels. Gold's resulting upside momentum will convince other futures traders to pile in on the long side, further accelerating its gains. And that will ultimately get investors interested in redeploying in gold again. They will have to buy for years on end to regain normal portfolio diversification.


Sep 25, 2015
Adam Hamilton, CPA

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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