Suddenly, gold and silver are good again. In two short months, they've
morphed from targets of derision to shiny new toys on the financial
playground.
Not surprisingly, questions have been pouring in from people who kind-of
sort-of know the precious metals story and are wondering if they should jump
in with both feet. A reasonable response: "If your time frame is the
coming decade, sure, go for it. But if you're thinking in terms of months
rather than years, you should be considering entry points and accumulation
strategy."
Which brings us to the Commitment of Traders (COT) report. Most new
precious metals investors have never heard of it. And since it seems to be a
pretty good indicator of those metals' short-term price fluctuations, this
might be a useful time to define and explain it. So here goes:
Gold and silver prices are set in the "paper" market where big
players trade futures contracts that enable them to buy (or require them to
deliver) large amounts of metal at some point in the future. There are two
main groups in this market: The fabricators who buy metal and turn it into
coins or jewelry or whatever, and the speculators (hedge funds and other institutional
gamblers) who use futures contracts to bet on the metals' price movements.
Over and over again, the fabricators trick the speculators into piling in
or out at exactly the wrong time, thus moving prices in ways that benefit the
former. They might, for instance, sell a few contracts into the market when
most traders are at lunch or home for the night, pushing the price down and
activating hedge fund stop-loss orders. Those sales push prices down further,
activating technical signals that cause momentum traders to short the market,
producing yet another sharp drop. Then the fabricators step in and buy very
cheaply -- raising prices a bit and leading speculators to go long, pushing
prices back up to where the game began. As observers like to say, "wash,
rinse, repeat."
The COT report quantifies who's long and who's short and by how much,
which makes it a snapshot of how the above game is going.
Here, for instance, is a chart showing what the speculators are up to.
When the blue line depicting their long positions and the red line depicting
their shorts diverge, that means hedge funds and other traders have been
suckered into betting on a gold price surge. When the lines converge,
speculators have been fooled into betting aggressively on a decline. The thin
gray line is the price of gold. As you can see it tends to do the opposite of
what the speculators expect.
What is this chart saying now? Well, the lines have diverged, indicating
that speculators are extremely bullish. History says they are now sheep
lining up for slaughter, in the form of a gold price correction which forces
them to cover at a loss. So -- again, based on history -- a better entry
point for incoming gold investors might be a few months off.
However -- and this is a very big caveat -- indicators work until they
don't. Someday the paper markets will be overwhelmed by a tsunami of demand
for physical metal. The commodities exchanges on which futures trade will run
out of inventory and default when too many holders of long contracts demand
delivery, and gold and silver will rocket higher. On that day everyone who
isn't fully invested in precious metals will be out of luck.
And some claim that day is at hand. In a recent King
World News interview, metals trader Andrew Maguire noted: "Now
that we are entering a negative rate world, I am seeing a lot of very
large-sized institutional money looking for a home. Some of this money is
flowing into gold, and this is confusing technical traders who are battling
what looks like a technically overbought gold market..."
So for new precious metals buyers, is it better to get in gradually, using
the COT report and other indicators to help define entry points? Or should
they ignore the squiggles, stop being cute and just fully commit on the
assumption that whatever price they pay today will be dwarfed by what
prevails when the system finally breaks down?
There isn't, alas, a one-size-fits-all answer to such a question. So why
bother discussing it? Because it's interesting. And more information is
always better than less.
