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If
you’re waiting for capitulation in the gold market, don’t hold your breath –
An argument for why the bottom in gold will come with a whimper, not a bang and
why the mainstream media might be looking for capitulation in the wrong
place.
ca·pit·u·la·tion noun
\kə-ˌpi-chə-ˈlā-shən\
When investors
give up any previous gains in stock price by selling equities in an effort to
get out of the market and into less risky investments. True capitulation
involves extremely high volume and sharp declines. It usually is indicated by
panic selling.
Having
just finished reading the umpteenth article on gold going to $700 an ounce on
a wave of panic selling reminiscent of the 1987 stock market crash, with
‘complete despair with even the most ardent of gold bugs’, I found myself
again shaking my head in disbelief. This is what you get, I suppose,
when you have a CNBC stock shill analyst covering the gold market.
"More Pain Ahead for Gold Bugs”, was another headline.
The assault against gold has…wait for it…reached mania levels, with
price predictions that border on outrageous finding their way into financial
headlines daily. Does this sound familiar? It does to me.
The last time this happened was when gold was charging past $1800 in a swirl
of a US credit downgrade and full throttle QE. Calls for $2500, $3000,
$5000 and more in the gold price littered the mainstream press. The
consensus was that the gold bull market would top out in a blaze of parabolic
glory. Everybody loves a good bandwagon (especially, I’m learning, the
mainstream financial press – see current position on gold), and even the most
ardent of gold bears were on board. But as it turned out, gold came off
its highs at $1920, and traded within about a 15% band of that high for the
next 16 months. Hardly a parabolic blaze of glory, and a top, that
while obvious in retrospect, was rather subtle at the time.
Back to the
present. The almost painfully redundant prediction I keep seeing
regarding the gold price is that ‘when gold bottoms, you’ll know it, and its
going to be painful.’ In other words, complete and total capitulation.
But is capitulation a realistic future for the gold market, or is the notion
nothing more than the latest buzzword of a biased, shortsighted mainstream
financial media?
My answer, as you’d
likely expect, is the latter.
As the definition
cited at the beginning of this article notes, capitulation is marked by complete
abandonment of an asset class to the point of panic selling, causing massive
downward volatility in the price. But that characterization fails
entirely to factor in the mentality of the physical gold owner, and the
mentality of countries like China and India, where the role of physical gold
ownership is innately understood, not questioned.
The average gold
owner isn’t going to bother going to his safe deposit box to pull out his
physical gold to sell because the price is dropping. To him, gold is
insurance. Despite new stock market highs and steady stream of ‘all’s
well’ news, in his estimation, the world hasn’t changed enough to warrant
selling his monetary insurance. If anything, to the asset preservation
minded investor, dropping prices seem like a good opportunity to supplement
his or her holdings – in fact as the price dropped just recently, mints
around the world reported an explosion in gold and silver bullion coin sales
(see US mint figures here).
Health
insurance - Wealth insurance
Here is a little
story to put this into context:
A guy walks into
his doctor’s office for a physical exam. After all the tests come back,
the doctor sits him down and tells him, “Congratulations, you’re in excellent
health. Keep a healthy diet and continue to exercise and you’ll likely
stay that way.” The patient remarks, “That’s great!” and proceeds to
pull out his cell phone and immediately dial away. The doctor, trying
not to appear irritated inquires, “Can’t this wait?” The patient
replies, “No, this is great. You just said I’m in perfect health,
right? Well there’s not a moment to lose. I’m canceling all of my
health insurance immediately! This is going to save me a fortune!”
Nobody would do
this. Why? Because you own insurance to protect against the
things you cannot plan for - for the things that do not show up in the
tests. Similarly, gold is wealth insurance. To say that the
average believer in gold will one day capitulate because of a falling price
is akin to saying the average person would cancel his or her health insurance
after a successful well visit to the doctor.
The more I read,
the more I realize that those reporting in the mainstream financial media
have basically no understanding of the mentality of the gold owner (either as
private individuals or as nation-states). They live in a fairytale
world where P/E ratios and cash flow models are infallible value metrics, and
anything that can’t be valued through these methods must surely be worthless.
They try to pigeonhole gold as a risk asset, and predict its performance
accordingly. So in a way, I can’t blame them for calling for a
capitulation in gold. To them, it is logical. But I have a
question for these opinion makers: Do you even know why stock owners
‘capitulate’? Because when the bottom starts to fall out, their scared
out of their minds that their pieces of paper are going to be 100% worthless!!!
– A fear, mind you, that is rooted in historical reality.
By contrast, the
average gold owner owns gold specifically because he knows that it will NEVER
go to zero!
China shares the
same sentiment toward gold, begging the question: Why in the world would a country
that has been steadily acquiring metal over the past decade suddenly
capitulate and drain their gold holdings because of a falling price?
They wouldn’t, unless of course Gordon Brown was their prime minister.
If anything, they’d acquire more, and you can bet China is licking its chops
at the prospect of any such ‘capitulation’. Whether or not they can
find any metal to buy if this happens is another story altogether.
Speaking to that
point: Did you also know that if gold does go to $700, it will be
approximately $500 below mining production costs, and almost $700 below
all-in costs for the major producers? Did you also know that with the
falling price and the already committed assets and manpower, mines are now
mining their highest-grade ore just to stay profitable? Many mining
analysts believe that we are right smack dab in the middle of peak production
for gold mines, right now. It doesn’t take a PhD in Economics to
see that $700 an ounce is not the kind of price that can sustain a stable supply/demand
paradigm.
Capitulation
more likely with the paper gold market shorts than physical metal owners
Moreover, if there
ever were to be a capitulation in the gold market, it would come in the paper
market, where traders of the metal treat gold as a number on a screen rather
than a wealth preservation asset. BUT THERE’S ONE HUGE PROBLEM WITH
THIS! The traders (especially at the institutional level) are
overwhelmingly SHORT! Not to mention that many would argue these short
positions - and their inherently limitless supply - are actually one of the
primary catalysts when gold declines in the first place. So simply put,
how can there be capitulation amongst the speculators when the vast majority
of the speculating volume is on the short side of the market to begin
with?! If anything, when the downside proves resistant, your
capitulation is going to come at the exhaustion of the shorts, not the
longs.
Don’t believe
me: Check out these graphs/commentary on current futures positions in
the market. Charts
courtesy of the CME group.
 
Graph
Commentary:
The above graph shows the net long/short positions of the
producer/merchant/processor market participants. A
producer/merchant/processor/user is an entity that predominantly engages in
the production, processing, packing or handling of a physical commodity and
uses the futures markets to manage or hedge risks associated with those
activities. While this segment of the market is always for more short than it
is long, it is worth noting the increase in the gap between the shorts and
longs from the beginning of the year to present. Moreover, the
aggregate number of longs is about half of what it was at the beginning of
the year.
Graph
Commentary:
The above graph shows the net long/short positions of the Managed Money
positions in the market. A "money manager," for the purpose
of this report, is a registered commodity trading advisor (CTA); a registered
commodity pool operator (CPO); or an unregistered fund identified by CFTC.
These traders are engaged in managing and conducting organized futures
trading on behalf of clients. Put simply, this is the best
representation of ‘the public’.
While still
slightly more long than short, it is worth noting that the short positions
are over triple where they were at the beginning of the year, or even as
recently as the beginning of August. Put another way, the managed money
market is three times as short as it was 12 weeks ago! Also very telling is
the rapid increase in shorts at the beginning of September, coinciding
perfectly with the near top seen in gold in the mid $1320’s and the decline
we’ve experienced ever since. "
Graph
Commentary:
The above graph represents the Swap Dealer net positions within the market. A
"swap dealer" is an entity that deals primarily in swaps for a
commodity and uses the futures markets to manage or hedge the risk associated
with those swaps transactions. The swap dealer's counter parties may be
speculative traders, like hedge funds, or traditional commercial clients that
are managing risk arising from their dealings in the physical
commodity. In other
words, we’re talking about the big boys.
Again, always short
more than they are long, especially near the interim top in gold back in
July, I was actually taken aback by the trend differences here when compared
to the Managed Money market. Clearly, the gap between short and long at
the swap dealer level has closed considerably from where it was over the
summer. In fact, as of November 4th, Swap Dealers are representing
more long contracts and fewer short contracts than they have had at any point
this year. November 4th also happens to be the day that
gold bottomed (for the time being) at $1140.00.
Makes you
wonder, who has it right?
When adding the
data from all three of the market segments together, the futures market is
about 4.5 million ounces more short than it is long. To give that some
context, that is akin to being short 140 tonnes of gold, or just over 5
billion dollars worth of the yellow stuff – paper yellow stuff that
is. As recently as a month ago, the gap was closer to 200 tonnes
and $7.5 billion dollars.
When we talk of
capitulation, I reiterate a thought I posed earlier. It appears in
these reports, especially when focusing on the Managed Money positions, that
the herd money is on the short side, not the long. Look no further than
the obvious spike in retail short positions in just the last three
months. It seem to me that these shorts are actually the weakest
positions in the market, and the ones most likely to ‘capitulate’ when the
trade doesn’t go their way. You might even say, that is what’s
happening right now. As I put the finishing touches on this
article, gold has stormed back $30+ intraday, and is pushing back toward the
$1200 level.
All told, I can’t
say if this is the bottom in gold or not, but I’m inclined to think that a
massive panicked wave of selling is as outrageous at the $700/ounce
predictions associated with it.
Here’s my
call:
Whether its already
behind us, or it comes next week, next month or next year, the gold market
will bottom with a whimper, not a bang, and every one of these financial
pundits will miss it. The one thing they always seem to overlook is
that the herd can, and will, run in either direction, and when that occurs,
these same pundits will find themselves ironically returning to square one
with their predictions.
Jonathan
Kosares, USAGOLD Executive Vice President of Sales & Marketing, graduated
cum laude from the University of Notre Dame with a dual major in Finance and
Computer Applications. He has been with the firm since 2002.. He is the
moderator of the USAGOLD RoundTable series, has authored numerous articles on
the gold market and manages client activity for the high net worth division
as well as the USAGOLD Trading and Storage Program.
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