Gold surged dramatically in recent weeks, powering higher to a decisive bull-market breakout. Gold’s first major secular highs in years have really improved sentiment, with bullishness mounting. But gold-futures buying fuel is largely exhausted, after the colossal amount expended to catapult gold back over $1400. That leaves this metal at high risk of suffering a major selloff, a healthy correction in an ongoing bull market.
Even the most-powerful bull markets flow and ebb, taking two steps forward before one step back. Gold is certainly no exception. At best in late June, its current bull extended to modest 35.4 percent gains over 3.5 years. Those weren’t linear, the path to gold’s recent breakout high was quite volatile. It included a 29.9 percent upleg, a 17.3 percent correction, a 20.4 percent upleg, a 13.6 percent correction, and today’s upleg running 21.2 percent at best.
This alternating repeating bull-market pattern is simple, uplegs are inevitably followed by material selloffs often extending into correction territory. Periodic corrections are essential to keep bulls healthy, working off the excessive greed that builds as uplegs peak. That risks sucking in too much capital too soon, prematurely burning out bulls. Corrections rebalance sentiment, bleeding away greed to extend bulls’ longevity.
Even though they are inevitable, normal corrections stress out the majority of traders. The selling taints their psychology and clouds their perspectives of longer-terms trends in play. They fret bulls are dying, and sell out too early and too low. Instead corrections should be embraced, as they offer the greatest opportunities to buy relatively low within ongoing bulls! Entering near correction lows amplifies gains.
While gold’s current bull clocked in at 35.4 percent total in late June, its three major uplegs added up to much-larger 71.5 percent gains. Traders had the potential to more than double gold’s headline gains by attempting to buy relatively low later in corrections and sell relatively high later in uplegs! Although impossible to game bull-market swings’ major lows and highs precisely in real-time, trading near them really boosts capital growth.
The reason gold faces high risk for its next major selloff today is speculators’ current positioning in gold futures. Unfortunately spec gold-futures trading has a wildly-disproportional influence over short-term gold price levels. The dominant reason is the extreme leverage inherent in gold futures, which greatly multiplies that capital’s impact on gold prices. This unfair reality has sorely vexed the gold market for decades.
When a normal investor buys gold outright, $1 of capital exerts $1 of buying pressure on the gold price. That’s the way markets are supposed to work. That can be extended with margin in the stock markets, which has had a hard legal limit of 2.0x since 1974. $1 of capital using maximum margin to buy shares in the leading GLD SPDR Gold Shares gold ETF can exert $2 of buying pressure on gold. That’s still reasonable.
But gold-futures trading is way out in its own extreme realm. Each gold-futures contract controls 100 troy ounces of gold. At this Wednesday’s data cutoff for this essay, gold closed at $1417. So each contract wields gold worth $141,700. An investor would have to put up $141,700 to control that much gold, or $70,850 using stock-market-legal-limit leverage on GLD shares. Futures speculators only need $4,000!
That’s no typo, this week the CME Group only requires traders to have $4,000 cash in their accounts for each gold-futures contract they want to trade. That is absurd, enabling extreme maximum leverage of 35.4x! That means a fully-margined gold-futures speculator can exert $35 of buying or selling pressure on gold with each $1 deployed. That temporarily outguns investors, even though they have vastly more capital.
The Federal Reserve has capped stock-market leverage at 2.0x for 45 years because extreme leverage has extreme risks. At 35.4x, a mere 2.8 percent gold move against speculators’ gold-futures bets would wipe out 100 percent of their capital risked! This constant threat of ruin forces these traders’ focus to an ultra-myopic short-term span, days or weeks at most. All they can do is ride gold’s immediate momentum, piling on.
As if arbitrarily declaring $1 of gold-futures capital should have up to 35x the influence on gold prices as $1 invested outright isn’t ridiculous enough, it gets worse. Unscrupulous traders can wield gold futures’ extreme leverage like a weapon to manipulate gold prices at key technical and sentimental junctures. One way is spoofing, slamming the market with huge gold-futures orders that are canceled before being executed. Related: Amazon Set To Leave Many Of Its Long-Time Vendors
This is not theoretical. In late June the US Department of Justice levied $25m of criminal fines on Merrill Lynch Commodities for this very behavior! And that’s just the tip of the iceberg for gold futures’ extreme leverage being abused to defraud normal investors. This seriously needs to be legally capped at vastly-lower levels. The DoJ’s actual press release did a great job explaining how gold-futures spoofing works.
“...beginning by at least 2008 and continuing through 2014, precious metals traders employed by MLCI schemed to deceive other market participants by injecting materially false and misleading information into the precious metals futures market. They did so by placing fraudulent orders for precious metals futures contracts that, at the time the traders placed the orders, they intended to cancel before execution.”
“In doing so, the traders intended to “spoof” or manipulate the market by creating the false impression of increased supply or demand and, in turn, to fraudulently induce other market participants to buy and to sell futures contracts at quantities, prices and times that they otherwise likely would not have done so. Over the relevant period, the traders placed thousands of fraudulent orders.” These crooks should be in prison!
Compounding gold futures’ gold-price impact, the American gold-futures price is gold’s global reference one. So gold-futures trading moving the gold price heavily influences and sometimes totally controls the entire gold market’s psychology! Investors are motivated to buy and sell gold outright based on what is happening in gold futures. It’s impossible to understand and game gold without closely watching futures.
I had to break my chart into two parts today, lest it get too busy to parse. These superimpose gold’s price through its current bull market over speculators’ gold-futures positioning. Reported weekly by the CFTC in its famous Commitments of Traders reports, specs’ long contracts or upside bets on gold are shown in green while their short contracts or downside bets are rendered in red. They usually dominate gold action.
(Click to enlarge)
The wildly-disproportional influence on gold prices by speculators’ gold-futures trading is critical for all investors to understand. Let’s start with this gold bull itself, the cadence of its uplegs and corrections. Its maiden upleg erupted in mid-December 2015 out of deep 6.1-year secular lows in gold, and ultimately blasted up 29.9 percent in 6.7 months by early July 2016. Major selloffs inevitably follow major uplegs in any bull.
So gold plunged 17.3 percent over 5.3 months into mid-December 2016 in a severe correction. That was way bigger than normal, greatly exacerbated by Trump’s surprise election victory in early November that year. With Republicans controlling the presidency and both chambers of Congress, stock markets soared on hopes for big tax cuts soon. That crushed gold demand, as fully 5/8ths of that correction came after the election!
While ugly, gold remained in a bull market since that massive selloff didn’t cross the -20 percent threshold for a new bear market. Gold quickly rebounded from those deep lows and gradually powered to another nice bull-market upleg, up 20.4 percent over 13.3 months leading into late January 2018. This gold bull’s second major upleg was followed by its second major correction, a 13.6 percent drop over 6.7 months by mid-August 2018.
That birthed today’s third major upleg, which had extended to 21.2 percent at best over 10.3 months by late June. This past month saw gold get exciting again after decisively breaking out of its years-long giant ascending-triangle technical formation to surge to major new bull-market and secular highs. This bull’s pattern has been upleg, correction, upleg, correction, upleg. What comes next in this series is obvious.
Gold is at high risk for another major selloff, potentially a full-blown correction over 10 percent again, because of speculators’ gold-futures positioning. This next chart illuminates what the specs were doing during each of this gold bull’s uplegs and corrections including today’s newest one. These hyper-leveraged traders with their outsized impact on gold prices have effectively exhausted their near-term buying, threatening big selling!
(Click to enlarge)
This gold bull’s initial upleg in largely the first half of 2016 was massive, the biggest in this bull so far at 29.9 percent. That was partially fueled by gold-futures speculators buying a staggering 249.2k long contracts and buying to cover another 82.8k short ones! There are two kinds of buying and two kinds of selling in gold futures, and each set has the same price impact on gold. Thus they can be lumped together for analysis.
Specs can buy new gold-futures contracts to establish long positions, the normal way to buy. But they also buy to cover and close previously-established short positions. The upward pressure on gold from buying longs and covering shorts is identical. On the selling side they can sell their own existing longs, or effectively borrow gold-futures contracts they don’t own to short sell them. Both types hit gold the same way. Related: What To Expect As Driving Season Kicks Off
Speculators’ total gold-futures buying in this gold bull’s first upleg ran a mind-boggling 331.9k contracts! That’s the equivalent of 1032.4 metric tons of gold. For comparison, total global gold investment demand in the first half of 2016 ran 1091.6t per the World Gold Council’s latest fundamental data. That epic spec long buying catapulted their total upside bets to an all-time-record high of 440.4k contracts as that upleg peaked!
Keep these numbers in mind. This gold bull’s greatest upleg soared 29.9 percent higher on 331.9k contracts of total buying by gold-futures speculators. That forced their total longs to their highest levels ever seen of 440.4k contracts. As I’ll discuss shortly, today’s latest gold upleg is skating ever closer to those extreme levels. The ice gets pretty thin in that rarefied air of likely gold-futures buying being essentially exhausted.
This gold bull’s first major correction was largely driven by specs reversing that huge long build in largely the second half of 2016. Note the green spec-longs line above collapsed symmetrically to its massive surge in the preceding upleg. Specs dumped 164.5k long contracts and short sold 25.8k more over that severe correction’s exact span. That adds up to 190.3k contracts of total selling, the equivalent of 592.0t.
During gold-bull uplegs the green spec-longs line rises while the red spec-shorts line falls. Then in following corrections that reverses, the green line falling while the red one rises. Gold-futures buying and selling is heavily driving these major bull-market cycles in gold, and that’s not going to change until regulators wake up and radically curtail gold futures’ extreme inherent leverage. Gold’s second upleg straddled 2017.
That was somewhat peculiar, as the spec gold-futures long buying of 80.6k contracts and short covering of 4.1k only totaled 84.7k. That wasn’t much considering gold’s strong 20.4 percent upleg gains. But realize that gold upleg effectively topped much earlier in early September 2017. Its later upleg peak was marginal. As gold challenged its $1350 bull-market resistance, total spec longs soared as high as 400.1k contracts!
This gold bull’s second correction mostly unfolded during the first half of 2018, and was a textbook-perfect example of heavy spec gold-futures selling. Their green longs line plunged by 98.3k contracts, while their red shorts line rocketed an enormous 128.9k contracts higher. That correction bottomed last August as total spec shorts soared to their own all-time-record high of 256.7k contracts! That portended the next upleg.
Back in early September, I wrote an essay on the “Record Gold/Silver Shorts!”. Published when gold still languished way down at $1196, I concluded then “gold and silver soon soared on short-covering buying following all past episodes of excessive and record short selling. There’s nothing more bullish for gold and silver than extreme shorts! ... Record futures shorts are the best gold and silver buy signals available.”
Speculators’ collective gold-futures positions provide both excellent buy signals near major gold lows and excellent sell signals near major gold highs. Smart contrarians get really bullish on gold when specs are really bearish as evidenced by relatively-low longs and relatively-high shorts. And it is just as prudent to get short-term bearish on gold when specs are excessively bullish with relatively-high longs and -low shorts.
This is exactly the situation we’re in today, and it’s growing ominously extreme. This gold bull’s third upleg powered 21.2 percent higher at best so far as of late June, propelling this metal to a new 6.1-year secular high of $1423. This awesome decisive-bull-breakout upleg was again fueled by enormous gold-futures buying by speculators. They added 99.4k long contracts, while buying to cover a staggering 153.4k short ones!
That adds up to total buying of 252.8k contracts as of gold’s latest peak in late June, or the equivalent of 786.3 metric tons of gold! That’s relevant because it is already 76 percent of the total gold-futures buying that unfolded during this gold bull’s huge maiden upleg in early 2016. Back then popular gold psychology was waxing really bullish, fostering that extreme gold-futures buying. Getting that high again today is a tall order.
The current gold-futures picture is even worse. While gold hit its latest interim high in late June, the gold-futures speculators kept on buying since. The weekly CoT reports are published late Friday afternoons current to the preceding Tuesdays. So the latest data available this week is current to last Tuesday July 2nd. That saw still more big spec buying, they added another 16.5k longs and covered another 10.2k shorts.
That extends this upleg’s total spec long buying to 115.9k contracts and short covering to 163.6k, making for a larger 279.5k total. Thus today’s upleg has already seen speculators buy 84 percent of the gold-futures contracts that they did during early 2016’s massive maiden upleg! That doesn’t leave much room to keep on adding more longs and covering more shorts to propel gold to major news highs in the coming weeks.
As of last Tuesday, total spec longs were already way up in nosebleed territory at 374.0k contracts! Out of the last 1070 CoT weeks since early 1999, only 2.2 percent saw spec longs higher. And that is getting closer to their all-time-record high of 440.4k in early July 2016. While they could conceivably go higher, that’s a hard ceiling until proven otherwise. Gold-futures speculators and their capital are finite, relatively small.
Out of all the world’s traders, only a tiny fraction are willing to run extreme 35x leverage and risk ruin on being slightly wrong on gold’s near-term direction. New gold highs really don’t mint sizable numbers of new gold-futures speculators either, as the risks are so crazy. And this small pool of gold-futures traders really don’t control much capital compared to broader markets. They’d be irrelevant without their extreme leverage.
So at some point gold-futures buying pressure literally exhausts itself. All the specs who want to be long gold have already bought in, expending all their available capital firepower. We can’t know in advance if it will happen at 375k longs, 400k, 425k, or 450k, but odds are it will be somewhere around there. Once the specs are all-in, all they can do is sell to start unwinding their excessively-bullish bets. That will hammer gold.
This relatively-young gold bull has seen three prior episodes where specs liquidated high longs, as seen in the falling green line above. Those were during this bull’s two corrections and a milder pullback in late 2018. Gold fell sharply each time, and this next episode of major spec long selling won’t prove different. At their latest 374.0k levels, spec longs are really high today with little room to buy and tons of room to sell!
The near-term gold risk is compounded by the fact spec shorts are also really low, just 87.2k contracts as of the last CoT report. That’s just a hair over the lowest levels of this entire bull market, 82.5k seen in late March 2018. So spec short-covering buying isn’t likely to go much lower, and in any case has a hard limit as these downside bets get closer to zero. Like spec long buying, spec short covering is largely exhausted.
Total spec gold-futures longs approaching bull-market and all-time-record highs, coupled with total spec gold-futures shorts just over bull-market lows, is very bearish for gold over the near-term! Remember by necessity these guys are short-term momentum followers, their extreme leverage will slaughter them if they are on the wrong side of gold for long. When gold noses over, their selling will intensify and cascade.
It certainly has the potential to snowball forcing another correction-grade gold selloff over 10 percent, which equates to a demoralizing sub-$1281 gold price. We might get lucky, the bullish new-high psychology could retard gold-futures selling. If the normalization of specs’ gold-futures bets is very slow, gold could see a milder pullback largely consolidating high. But we can’t bet on that based on all the bull-market precedent
The greatest hope of gold evading a big selloff on gold-futures selling is investors returning in a big way. They control vastly more capital than the gold-futures speculators, so when they are buying aggressively that can easily absorb and overpower any gold-futures selling. But while new-high psychology has spawned some investment buying, it has only been sporadic so far with euphoric US stock markets near record highs.
Meanwhile traders should prepare for the next major gold selloff, possibly this gold bull’s third correction. That means tightening trailing stop losses on existing long positions in gold and the stocks of its miners. On stoppings, cash should be accumulated and not redeployed. It is simply too risky to add material new long positions in gold and gold stocks until speculators’ extreme gold-futures positioning considerably normalizes.
The bottom line is gold is at high risk for a major selloff today. Speculators’ gold-futures positioning has grown excessively-bullish, leaving their buying firepower largely exhausted. That leaves vast room for big selling to snowball on the right catalyst. This bull’s prior episodes where specs had similar really-high longs and really-low shorts heralded major gold corrections. Extreme bets must eventually be normalized.
Such corrections are normal and healthy within ongoing bull markets, rebalancing sentiment to ensure longer lives with greater ultimate gains. These corrections should be embraced, as they yield the very best opportunities to buy relatively low within powerful bulls. Gold’s current bull is likely to run for years yet, so gird yourself for a major selloff and be ready to buy back in aggressively once it has largely run its course.
By Adam Hamilton
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