Below is an extract from a commentary originally posted at www.speculative-investor.com on 30th September 2007.
A Commitments of Traders (COT) extreme to be reckoned with
The Commercial net-short position in COMEX gold futures was 208K contracts as at Tuesday 25th September (the cut-off date for the latest COT report), which roughly matches the all-time high reached in early October of 2005. This Commercial net-short position is, of course, balanced by an equally large speculative net-long position.
Although it reveals unbridled optimism on the part of speculators in gold futures, the current COT situation is not a reason, in and of itself, to expect anything more than a routine pullback in the gold price. That this is the case becomes evident when we look at the following chart showing the performances of gold and gold stocks (as represented by the HUI) during the second half of 2005. Note, in particular, that after the Commercial net-short position peaked in early October of 2005 the gold market began to work its way back towards its 50-day moving average. Following a test of this moving average in early November, another strong rally got underway. Also note, though, that the HUI peaked almost two weeks prior to gold bullion and experienced a more substantial correction. Specifically, a 5% correction in gold was accompanied by a 14% correction in the HUI.
With reference to the following daily chart, the 50-day moving average for the December gold futures contract is currently at $695. However, it is rising and four weeks from now will probably be around $710. A 5% pullback to around $710 over the next few weeks would therefore be consistent with what happened the only other time the COT situation was roughly the same as it is today.
If the HUI also mimicked its performance following the Oct-2005 COT extreme then it would drop back to the mid-340s over the coming few weeks. Furthermore, a 5% pullback in gold combined with a 14% pullback in the HUI would satisfy the requirement, discussed over the past week, for the HUI/gold ratio to trade at least a few percent below its 40-day moving average in order to create a short-term bottom.
The main risk for gold isn't the COT; it's the dollar
One of the big differences between the current situation and the situation in early October of 2005 is that in October of 2005 the US$ had been trending upward for 9 months and was close to an intermediate-term peak, whereas the US$ is currently (in our opinion) at the tail-end of an intermediate-term decline. Putting it another way, the US$ has considerably more upside potential now than it had in October of 2005. In fact, we think the US dollar can currently be likened to a beach-ball that is getting pushed further and further underwater. The pressure being applied by speculative selling may continue to force it lower in the very short-term, but at some point in the not-too-distant future it will catapult upward.
We therefore continue to perceive significant downside risk for gold and substantial downside risk for gold stocks associated with a US$ recovery.
The downside risk for gold stocks is much greater than the downside risk for gold bullion, for two reasons. First, the gold-stock indices recently became extremely 'overbought' relative to gold bullion. Second, US$ weakness has been one of the propellants of the global stock market rally, so the initial phase of the US dollar's next upward trend will probably be associated with parallel declines in the gold market and the broad stock market. This could result in gold stocks being simultaneously hit from two directions.
Outlook
Gold bullion ended last week at a new multi-decade high while the HUI finished the week about 2% below its 11th May-2006 and 21st September-2007 peaks. This is a bearish divergence because the stocks typically lead the metal at important turning points, although it clearly wouldn't take much additional strength from here in the gold-stock indices to eliminate the divergence.
Regardless of whether the HUI is in the process of completing a major double top or is immersed in an intermediate-term upward trend that will take it much higher over the coming months, a sizeable pullback is likely to occur over the next few weeks. As previously advised, history tells us to expect the HUI/gold ratio to trade at least a few percent below its 40-day moving average prior to the next short-term bottom. If this happens over the next few weeks and gold concurrently pulls back by around 5% then the HUI will drop to the 340s.
The sort of pullback described above is the most likely short-term outcome even if the overall upward trend is going to remain intact.
The risk is that a top of longer-term significance is currently being put in place. This possibility doesn't mesh with the current fundamental backdrop and is therefore not the most likely intermediate-term outcome, but the fundamentals could change and therefore need to be continually re-assessed. Just to quickly recap, the main fundamental drivers of the gold price are credit/yield spreads, nominal interest rates, inflation expectations (the expected rate of purchasing-power loss), and currency exchange rates.
