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Gold's Artificial Lows 2

Adam Hamilton
Dec 04, 2015

Gold's latest slide to new secular lows has amplified the hyper-bearish sentiment long plaguing it. More than ever, traders are universally convinced gold is doomed to drift lower indefinitely. But these extreme gold lows are not fundamentally righteous, they resulted from extreme record gold-futures shorting. As these risky leveraged bets must soon be covered, prices driven by them are artificial and unsustainable.

One of the greatest mistakes made in the markets is the common assumption that prevailing price levels are justified by fundamentals. Nothing could be farther from the truth. While prices do indeed gravitate towards levels supported by supply and demand over the long term, herd emotions drag them away in the short term. Popular greed and fear have vastly more influence on current prices than fundamentals.

While this psychology-fueled price distortion always exists, it becomes most evident at extremes. An example from the most extreme emotional event of our lifetimes, 2008's once-in-a-century stock panic, helps illustrate this. In mid-November 2008 during that epic fear maelstrom, gold plunged to $711 an ounce. Even though it had averaged $905 in the first 8 months of 2008, traders assumed panic lows were righteous.

But instead of reflecting global supply and demand, they were the result of extreme unsustainable fear that would soon dissipate as always. Traders caught up in that powerful herd emotion foolishly sold right into those major secular lows. In 2009 as that radically-unbalanced sentiment normalized, gold rallied powerfully to average $974 that year. Artificial lows driven by extreme psychology never last for long.

Gold history is rhyming with that panic episode again today. The extreme herd bearishness has duped traders into believing gold in the $1050s is justified by normal global supply and demand. But that's just not true. Gold's fundamentally-righteous price levels have been temporarily subverted by record short selling by American gold-futures speculators. When they are soon forced to cover, gold will rebound far higher.

Before we get into the extreme shorting driving gold's artificial lows today, consider the latest definitive read on gold's fundamentals recently released by the World Gold Council. That was during this year's third quarter. Remember late July witnessed that extreme gold-futures shorting attack exquisitely timed to brazenly manipulate gold's price lower to run stops. This bashed gold to a major new 5.5-year secular low.

Gold hit $1084 in early August, right in the very heart of Q3. If that was fundamentally justified, a sharp deterioration of gold's fundamentals would have been evident that quarter. Since gold's average price plunged 12.2% year-over-year to $1125 in Q3'15 from $1281 in Q3'14, gold's supply and demand must have taken a major turn for the worse right? That's certainly the popular story traders universally believe.

But the world's best fundamental gold data from the WGC showed overall global gold demand rose by a robust 7.6% YoY in Q3'15. This was led by a gigantic 27.1% surge in world investment demand! And jewelry demand, about 4/7ths of overall demand, also grew by a healthy 6.4%. This jewelry demand was the strongest of any third quarter since 2008! So if gold fundamentals collapsed in Q3, it wasn't the demand side.

Thus if Q3's secular gold lows were fundamentally justified, supply had to be the culprit since demand was so darned strong. But the WGC reported third-quarter gold supply only edged up a trivial 0.7% YoY, and actual mine production which constitutes 3/4ths of that total actually retreated 1.0%. Now you don't need a doctorate in economics to realize 8% demand growth on 1% supply growth doesn't fuel secular lows.

So what the heck is happening to gold? It has suffered from excessive supply growth in a sense, but virtually instead of physically. American gold-futures speculators have been selling these contracts at truly staggering rates, and unfortunately gold's price in the US futures market is the benchmark the world looks to. So this one group of traders now commands a wildly-disproportionate impact on gold's price.

There are two reasons, investors missing in action and extreme leverage. Back in early 2013, the Fed launched its wildly-unprecedented open-ended third quantitative-easing campaign. Fed officials deftly used the ambiguity of these bond monetizations to jawbone stock markets higher, resulting in recent years' extraordinary levitation. This seduced capital away from everything else, investors abandoned gold.

And the extreme leverage inherent in futures trading greatly amplifies the price-moving firepower of speculators' capital in gold. Since 1974, the legal limit of leverage in the stock markets has been 2x. But in gold-futures trading, the minimum maintenance margin for each contract controlling 100 ounces of gold is only $3750 today. With each contract worth $105,000 at $1050 gold, that's extreme 28x leverage!

At 28x leverage, each speculators' dollar deployed in gold futures has 28x the price impact of a normal dollar from investors! And even if the majority of gold-futures traders aren't foolishly running maximum leverage, where a mere 3.6% adverse price move would wipe out 100% of the capital they risked, their gold-price impact is still an order of magnitude or two higher than investors'. Their trading dictates gold's price.

And that's exactly what's happened since 2013 when the Fed started grossly distorting world financial markets. Gold's woes are not the result of normal global supply-and-demand weakness as everyone assumes, but excessive virtual supply from American futures speculators. This chart documents that and proves gold's newest secular lows are totally artificial and not sustainable, heralding a major upleg.

Every week, the US Commodity Futures Trading Commission publishes its famous Commitments of Traders report. This CoT details the total futures positions held by specific groups of traders including speculators. Speculators trade gold futures solely to game the gold price, as they neither produce nor consume physical gold. Their extreme trading has turned gold into a house of mirrors greatly distorting reality.

This chart reveals speculators' total long and short positions in gold futures in every CoT week since 2013 in green and red respectively. The total deviation of these positions from normal years' levels is shown in yellow. Finally the gold price is superimposed over this gold-futures data in blue, along with key moving averages. Extreme gold-futures selling is the whole story of gold in recent years and weeks!

Before the Fed decided to actively manipulate market psychology by intentionally convincing traders it was backstopping stock markets, gold averaged $1669 in 2012. That was the last time its price reflected underlying global supply-and-demand fundamentals. The dominant force driving gold ever since has been the short selling by American futures speculators, the vultures preying on gold in the Fed's wasteland.

The gold price has had a powerful, ironclad inverse correlation with the total gold-futures shorts held by these traders. When they are aggressively short selling as evidenced by a fast-rising red line, the gold price falls sharply. Then right when any particular short-selling episode peaks, gold bottoms. And then it rallies sharply over the subsequent weeks as speculators reduce these leveraged downside bets by covering.

As ridiculous as it sounds, this CoT data inarguably proves that speculators' leveraged gold-futures short selling in recent years has drowned out every other gold-price driver. That includes worldwide physical supply and demand, gold's ultimate fundamental drivers. I've written extensively about this extreme anomaly in recent years, doing everything I could to lift the scales from investors' eyes to reveal this gold truth.

American speculators' gold-futures shorting has generally meandered in a total-positions trading range between 75k-contract lower support and 150k-contract upper resistance in these recent Fed-distorted years. They generally stop short selling when they have over 150k short contracts outstanding, and generally stop covering near 75k. It's the excessive-shorting exceptions to this rule that force secular gold lows.

Despite record speculator gold-futures shorting, gold enjoyed strong support in the first two-and-a-half years of the Fed's stock-market levitation. This ran between $1150 and $1200, and its durability resulted in many long-side stop losses being set near this support. Bearish speculators intentionally tried to shatter it in mid-July. One lazy Sunday night, they short sold an astounding 24k contracts in a single minute!

This extreme gold-futures shorting attack I've discussed in great depth indeed broke gold to that major new secular low in early August. But it required speculators to ramp their gold-futures shorts to an all-time-record high of 202.3k contracts then. Our CoT data extends back to early 1999, so all the extreme gold-futures shenanigans in recent years eclipse all that history and are certainly new all-time records.

Since it was speculators' gold-futures short selling that spawned those late-summer secular gold lows, they weren't sustainable as rare contrarians like me argued at the time. Indeed, the speculators would soon have to cover their excessive shorts. And that resulted in gold rallying 9.6% over the next 10 weeks even while sentiment remained utterly rotten. It's critical to understand why excessive shorting is so bullish.

By definition, shorting is selling something that traders don't own and therefore have no means to sell. So they borrow whatever they are shorting from other traders. They believe the price is going to keep on falling, so they reverse the usual buy-low-then-sell-high trading strategy to sell high then buy low. As they have to buy back and return what they borrowed from other traders, they turn a profit if the price falls.

Speculators selling short gold futures are under a legal contractual obligation to return the gold-futures contracts they borrowed to sell. This means all gold-futures shorting is guaranteed near-future buying. Each short contract is covered mechanically by buying an offsetting long contract, and the upside gold-price impact of this short covering is identical to buying new longs. This covering is proportional to the shorting.

And the extreme leverage inherent in gold-futures trading greatly amplifies the legal imperative to cover shorts. Again at maximum 28x leverage, a mere 3.6% gold rally would wipe out 100% of the capital that these traders risked shorting. As gold continued rallying, they would face ruinous margin calls forcing them to contribute far more capital to maintain those positions. So there's a visceral incentive to quickly cover.

This makes short covering inherently self-feeding. If even a tiny fraction of speculators buy gold-futures contracts to offset and cover their shorts, the gold price rises. This puts serious pressure on the rest of the speculators to cover their own leveraged shorts, accelerating gold's rally. The more shorts covered, the faster gold rallies. The faster gold rallies, the more speculators have to cover. It's a powerful virtuous circle.

The frenzied covering following early August's record extreme shorting event created a strong new gold uptrend in the subsequent months. This gold rally was poised to continue, and start enticing investors back in to take the buying baton from speculators covering shorts. But then the Fed surprised in late October with a hawkish FOMC statement warning the first rate hike in nearly a decade was likely in December.

There is nothing gold-futures speculators fear more than Fed rate hikes. They believe higher rates are gold's ultimate nemesis, since gold yields nothing. As higher rates lift general yields, they are sure that gold investment will collapse as investors migrate away. While this certainly sounds logical, the problem is history proves just the opposite. Gold actually tends to thrive during Fed-rate-hike cycles, powering higher.

It turns out there have been 11 Fed-rate-hike cycles since 1971. In the majority 6 of them, gold actually rallied an average of 61.0% higher during the exact Fed-rate-hike cycle spans! During the last one that ran between June 2004 and June 2006, the Fed made 17 consecutive hikes more than quintupling its federal-funds rate to 5.25%. Yet gold still surged 49.6% higher over that exact span! How can this be?

Higher rates are far more damaging to overvalued stocks and bonds, and gold is the classic alternative investment that moves contrary to stock markets. So gold investment demand for prudently diversifying portfolios soars when the Fed is hiking rates! Gold only fell an average of just 13.9% in the other 5 Fed-rate-hike cycles because they began when it was already overbought way up near major secular highs.

But with the extreme leverage inherent in gold-futures trading, these speculators can't afford the luxury of thinking beyond the next hour. So when they see gold fall as their peers sell even on a historically-false premise, they pile on. And that piling on of extreme gold-futures shorting since the FOMC's late-October meeting with that hawkish surprise has reached record extremes. That's why gold hit new lows.

There have been 4 full CoT weeks since that October 28th FOMC meeting. And since the recent years' extreme gold anomaly courtesy of the Fed has forced me to become a gold-futures-trading expert, I have been watching the records fall in this past month with sheer amazement. Overall in that span, American futures speculators have dumped 66.7k long contracts while also adding 87.2k short ones. That is truly epic!

On a few words in an FOMC statement from a Fed that has consistently lied about the duration of its zero-interest-rate policy continuously since its stock-panic birth in December 2008, this single group of traders liquidated 1/4th of their longs and catapulted their shorts 7/8ths higher! That 153.9k contracts of gold futures speculators dumped was the equivalent of 478.6 metric tons of gold, an impossible amount to absorb.

That equates to 119.6t of virtual supply per week, dwarfing the WGC-reported weekly gold investment demand year-to-date as of the end of Q3 of 17.5t! That 153.9k contracts of selling over 4 CoT weeks was easily a dominant new all-time record. The previous one before this past month was just 121.4k, seen in May 2004. And out of 878 CoT weeks before that since early 1999, only 4 had seen 100k+ contract 4-week dumps.

And the records keep on coming, particularly in the third CoT week of the last 4 that ended on November 17th. Total spec gold-futures shorting in the 2 CoT weeks leading into that ran 74.9k contracts, an epic 53% greater than the previous 2-CoT-week record of 48.7k in March 2015. The shorting in that recent late-November CoT week alone, 41.1k contracts, was the most ever witnessed in any single CoT week by far.

It was fully 1/3rd higher than the previous record. So the drastic gold-futures shorting ramp by the American speculators following that late-October hawkish FOMC surprise has been the most extreme ever seen on multiple fronts by huge margins! Given such radical record gold-futures shorting, it should be no surprise that gold was artificially forced down to marginal new 6.1-year secular lows this past week.

With such an astounding onslaught of record extreme gold-futures selling, the fact gold only fell 7.8% over that crazy 4-CoT-week span is an incredible testament to its fundamental resiliency. There remain lots of investors interested in buying gold low out there, and they were voraciously snapping up gold at the artificial lows the American speculators temporarily wrought. And their shorting is reaching exhaustion.

After epic single-CoT-week gold-futures short selling of 33.8k and 41.1k contracts in the second and third CoT weeks of the last four, this momentum collapsed in the latest CoT week ending November 24th at mere 2.8k-contract growth. That strongly implies that all the speculators foolhardy enough to sell gold near major secular lows with extreme leverage have already done so. That means short covering nears.

All excessive gold-futures shorting is proportional guaranteed near-future buying. After past episodes of extreme shorting in recent years, speculators' self-feeding covering buying propelled gold an average of 16.2% higher in 10 weeks. A similar merely-average short-covering rally today from this week's secular gold low would blast gold up near $1225. That alone would likely entice investors to start returning in mass.

But I suspect this next short-covering frenzy is going to be much larger than average. Not only was the recent speculator shorting at off-the-charts record levels, it helped push speculators' total gold-futures bets on both the long and short side to a record deviation from their normal-years average. The last time gold traded normally was from 2009 to 2012, after 2008's stock panic but before 2013's gross Fed distortions.

As of this latest CoT week, speculators' total gold-futures bets are a combined 211.1k contracts away from these normal-years norms! That's a new record high even exceeding early August's levels. Just to mean revert to this normal baseline on both the long and short side, not even overshoot, speculators are going to have to buy 211.1k gold-futures contracts. That alone would fuel an incredibly powerful gold upleg.

On top of this, gold sentiment is ridiculously bearish now thanks to these artificial gold lows courtesy of this extreme speculator gold-futures shorting. So as the great sentiment pendulum inevitably starts to swing in the opposite direction again, investment capital is going to start to return too. Investors remain radically underinvested in gold even by recent years' standards, and their buying will accelerate gold's gains.

The markets are perpetually symmetrical, so record extreme selling is almost always followed by proportional buying. This portends an imminent major gold upleg, initially sparked by mandatory speculator short covering, extended by voluntary speculator gold-futures long buying to re-establish positions, and finally handed off to investors and their vastly larger pools of capital. Gold looks epically bullish going forward!

Smart contrarian investors tough enough to fight the groupthink herd emotions can certainly ride this mean reversion higher the usual ways, with physical gold bullion or the flagship GLD SPDR Gold Shares gold ETF. But gold's gains will be radically dwarfed by those from the best of its beaten-down gold miners' stocks, which are now trading at fundamentally-absurd levels relative to their existing profits.

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The bottom line is gold's new secular lows are totally artificial and unsustainable. They are the result of record extreme gold-futures short selling by American speculators, in stark contrast to gold's strong physical fundamentals. This epic shorting arose from these traders' historically-proven-false belief that Fed rate hikes devastate gold investment demand. And their radical short selling is running out of steam.

This means the symmetrical guaranteed gold-futures buying is imminent as those excessive shorts are covered. As usual that will propel gold sharply higher, erasing these fake new secular lows that were never fundamentally righteous. Speculators' massive short covering following such extreme shorting will be amplified by long futures buying and investment capital returning, unleashing a mighty gold upleg.


Dec 04, 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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