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With gold
awakening from its usual summer slumber, traders are getting more excited
about its prospects. Presumably this shifting sentiment will even grow to
encompass futures traders, who’ve been incredibly bearish on the yellow
metal for months now. While traders hold futures guys in high esteem, they
are just as susceptible to groupthink as everyone else. They are actually a
powerful contrary indicator for gold.
Just a month
ago, it seemed like you couldn’t even give gold away. Bearishness
abounded, and commentary and analysis were overwhelmingly pessimistic and
calling for major new lows soon. Go back and skim the stuff published on gold
in mid-July, and you’ll quickly see what I mean. Because it had
languished in a correction since August 2011, shedding 18.8%, everyone was
very negative on it.
Unfortunately
this is typical in the markets, as traders tend to mentally extrapolate
short-term trends out into infinity. When a price has been rallying for
months, they assume it will continue powering higher indefinitely. And when a
price has been falling, they convince themselves it will keep on grinding
lower. These false assumptions blind
traders, rendering them incapable of buying low and selling high.
Peer pressure
feeds in as well, as traders feel very uncomfortable being bullish when
everyone else is bearish and vice versa. There is comfort in the
crowd’s warm embrace, running with the herd to ensure acceptance.
Succumbing to this groupthink is the main reason the great majority of
traders lose money. They don’t buy until everyone is bullish, which
only happens after prices have
already run high.
And after
buying high, a fool’s errand, they get frightened into selling when
everyone is bearish. Of course that only happens after prices have already seriously sold off. Buying
high and selling low is not the recipe for building a fortune, but for
financial ruin. And amazingly even the large majority of futures traders,
with all their alleged sophistication, stumble into this deadly trading trap.
They run with the herd.
Contrarianism
is the only remedy for groupthink, being brave when everyone else is afraid
and vice versa. The best time to buy low is when no one else wants to buy,
and the best time to sell high is when everyone else wants to buy. This is
simple in concept, but incredibly difficult psychologically in execution. It
takes many years of trading experience, and an iron will, to actively fight
the herd.
I know how
brutally hard contrarianism is because I’ve painfully forged myself
into one over decades. Back in mid-July when the trading world was so darned
bearish on gold, I was bullish. I wrote an essay then explaining that the summer doldrums leading to
major seasonal lows that time of year were par for the course for this entire
secular gold bull. These lows soon yield to gold’s major autumn rally,
which is indeed now underway.
As a group,
futures traders didn’t expect this upside move even though gold does it
almost every year like clockwork. There are as few contrarians per capita in
the futures world as there are in any other pool of traders. How can I dare
make such a heretical assertion? Futures traders’ biases are laid bare
in the Commodity Futures Trading Commission’s giant Commitments of
Traders report, published weekly.
If you are not
up to speed on the CoT, I wrote an essay explaining how
bullish it was for gold a month ago when pessimism still dominated. In gold
and many other futures markets, the CoT reveals how many futures contracts
are open at any given time, which group of traders holds them, and whether
these groups are taking the long side or short side of the trade. This last
datastream reveals futures traders’ sentiment.
The only time
traders will make long-side bets on something is when they expect its price
to rise. So playing the long side indicates bullishness. And it is only
rational to sell futures short when traders expect their underlying price to
fall. So shorts show bearishness. And incredibly in the entire history of
gold’s spectacular secular bull over the past decade or so, futures
traders are the least long right
before major uplegs get underway!
Of course
futures are a zero-sum game, every single contract has a trader on its long
side with a different trader taking the opposite short side. The only way to
make money in futures is if your counterparty loses it. Capital merely
changes hands, it isn’t created or destroyed like in the stock markets.
But while longs and shorts are always perfectly balanced, they flow and ebb
among the major categories of
traders.
The CFTC
essentially divides futures traders into two categories, hedgers and
speculators. Hedgers are formally known as commercials in the CoT, and are large traders who are actively
involved in either physically producing or consuming the underlying
commodity. In the gold world, this includes miners on the production end and
jewelers on the consumption end. Hedging is why futures markets exist in the
first place.
But hedgers
can only hedge because speculators are willing to take on the risks the
hedgers want to offload in order to smooth their operating cashflows. The
CFTC farther divides speculators into two sub-categories, large speculators
and small speculators. These are formally known as non-commercials and non-reportables
in the CoT reports. And it is these speculators, large and small alike, that
are contrary indicators for gold.
In my usual CoT analysis thread, I
look at net long and short
positions held by each category of traders. That is the most logical
strategic approach in a zero-sum game where total longs and total shorts are
always perfectly equal. But this week we’re digging deeper, looking at
the total long-side gold futures
contracts held by both large and small speculators. These vaunted traders are
victims of some serious groupthink.
Our charts
superimpose gold over the weekly CoT data of total spec longs (green) and
total spec shorts (red). As you’ll see, the futures traders are always wrong near major lows in
gold before massive uplegs. Since the great majority of them aren’t
contrarians, they give up on gold after corrections or long consolidations.
But that is exactly when gold is the cheapest and ready to start surging
higher again.
Trading is all
about buying low and selling high, so if gold futures traders were prudent
contrarians you’d expect them to be the most bullish right before major uplegs. But this
hasn’t been the case. For gold’s entire secular bull, a
gargantuan 638% run higher over a decade, futures traders as a group
haven’t been able to get this right. As this chart shows, speculator
longs in gold futures hit major lows
near gold lows just before major uplegs.
The green line
shows the total long positions held by large and small speculators per the
CoT reports. I highlighted major lows in this series over the years with
light-blue columns. Before today, there were 8 major lows in
speculators’ total longs. Look at gold’s performance after each
of them. Every single time the
metal soon started rallying, usually enjoying one of this bull’s
super-profitable massive uplegs.
While total
longs coincide with low gold prices before major surges, notice where the
light-blue columns hit the red total-shorts series. Speculators’ short
positions in this metal tend to be at highs, near highs, or at least on the
high side of their secular trading range every time gold is cheap and poised
for a major advance. Futures traders are truly not contrarians, so the smart
thing to do is make the opposite bet
from what they are making!
For my entire
trading life, over a quarter of a century,
I’ve constantly heard variations on the theme that futures traders are
smart while stock traders are dumb. And though I’m certainly biased on
this question as a lifelong stock trader, this oft-voiced aphorism simply
isn’t correct. True contrarians, battle-hardened traders who walk the
walk in fighting the crowd, are as rare in the futures world as they are in
the stock markets.
When
speculators’ total long positions in gold futures collapse to major
lows, there has literally been a 100% chance throughout this entire secular
bull that gold is right on the verge of surging higher. You’d be
hard-pressed to find a better strategic contrarian indicator than the biases
of gold futures traders. And this brings us to the reason why I wrote this
essay this week, a major new low in total spec longs today.
Before
gold’s recent major correction, it topped just under $1900 in August 2011.
As an actual contrarian, I wrote an essay one
trading day before this top warning that gold was very overbought so a sharp
correction was imminent. Believe me, it is never easy fighting the crowd.
Whenever I make a contrary call like that, getting bearish while everyone
else is euphoric, I get raked over
the coals with scorn.
But in the
timeless words of a 1990s alt-rock song, “[bleep] the naysayers cause
they don’t mean a thing”. In the markets capital flows away from
the mainstreamers who get greedy at highs and scared at lows to contrarians. We grow rich while
those who can’t fight groupthink slowly bleed away their fortunes. The
subsequent gold correction carved a decisive low in mid-May, during a
full-blown capitulation.
Around that
week gold bottomed, total spec longs fell to 216.0k contracts. In late May
they slumped again to 217.3k. Then after recovering a bit as gold bounced in
early June, they fell to 220.1k at gold’s major seasonal low in late
July. In early August’s CoT, they retreated again to 218.2k. But
amazingly in the most recent CoT as of this writing, with August 14th data,
total spec longs in gold futures fell to a
new low of 215.5k!
To put this
into perspective, gold spec longs haven’t been this low since April
2009 just after the stock panic’s secondary low. Gold was trading near
$880 that week! How did it do since? Pretty freaking awesome, as you can see
on the charts. Futures speculators, as evidenced by their lack of longs in
the latest CoT, are as bearish on gold today as they were just before it more than doubled in a massive
multi-year run!
They’ve
been wrong as a group before every other major upleg in this entire secular
gold bull, and I’m betting big money that they are wrong again today.
Traders who are not contrarians, who get afraid when everyone else is scared,
are going to fail. Succumbing to popular fear always leads to both selling
low and failing to buy low. And
futures traders are as bearish on gold now as they’ve been in several
years.
This next
chart zooms in a bit to examine the huge drop off in
futures-speculator enthusiasm for gold when this metal is consolidating or
correcting. The same major long lows highlighted above are highlighted here
as well. I was interested in the total drops in spec longs from the preceding
highs before these lows. They are shown in green, with the corresponding
spec-short drop in red, along with how long these declines took.
Since futures
speculators aren’t contrarians, their long bets rise during gold uplegs
and contract during gold consolidations and corrections. I suspect that the
magnitude of these contractions reflects the degree that sentiment shifts
among these traders. So the bigger the drop off, the more pessimism exists on
gold and therefore the higher it is likely to run. The greatest example of
this was 2008’s stock panic.
While gold
fared better than pretty much everything else but the safe-haven US dollar, it still took
a major hit. Between July 2008 and November 2008 in the panic’s dark
heart, gold plunged 27%. Gold futures speculators naturally freaked out with
such an epic selling event driven by a once-in-a-century fear superstorm.
In just over 9 months, the total long-side contracts held by large and small
specs plummeted 54%!
If the futures
traders were right, gold would have continued plunging. But instead it
started surging. Over the next 33 months, gold would blast an astounding 167%
higher. For comparison, the benchmark S&P 500 stock index only gained 32%
over this span. When futures traders were the most bearish, had the fewest
upside bets on gold, was exactly the right time to buy aggressively into the
yellow metal.
And now as of
the latest CoT read in mid-August, spec longs have fallen 42% over 22 months
to a major multi-year low. Even though gold remains high in a secular sense,
nicely weathering a correction and high consolidation, futures traders have
largely given up on it. This is by far the biggest decline in spec longs
since the stock panic. And considering how bullish that long low was, this
one ought to be too.
With longs
this low, with futures traders as a group as bearish on gold as they are
today, there is a very high probability that we are on the verge of a major new upleg in gold. Worst case,
this metal is likely to at least power higher during its strong season between
now and May. Odds are new all-time record gold highs will be seen well before
then. And this new gold upleg may even continue rallying higher after that.
Also note that
spec shorts are fairly high today as well. They’ve generally run in a
trading range between 50k and 100k contracts. They’ve recently been
almost as high as they were during the stock panic, an incredible opportunity
to be long not short. And the only time they’ve been higher was in 2011
as gold surged to new record highs while climbing the wall of worry. This
setup today is amazingly bullish all around.
At Zeal we are
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There is still time to buy low before this new gold upleg accelerates.
The bottom
line is futures speculators as a whole are no more contrarian than stock
speculators. They wrongly get greedy when prices are high and scared when
prices are low. And since their positions are so carefully documented by the
CFTC, they are a fantastic contrarian indicator. When gold futures
speculators wax the most bearish is right before major new uplegs in gold
start getting underway.
And today the
gold futures long positions of both large and small speculators just hit a
major multi-year low. These traders haven’t been this bearish on gold
since soon after the stock panic’s secondary lows, just before gold
more than doubled over the subsequent years. So if you are mentally tough
enough to fight the crowd and buy low, today’s opportunities in gold
and its beaten-down miners’ stocks are vast.
Adam Hamilton, CPA
August 24, 2012
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visit www.zealllc.com/adam.htm
for more information.
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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