Gold Rally – Too Far, Too Fast

The precious metals markets have picked up steam fueled by negative interest rates and poor stock market performance. We’ve discussed the dislocations governmental policies can create within the markets extensively since the economic collapse and the new era of Economic Engineering at length in the past. Briefly, in a negative rate environment, investors feel more secure owning something that may be worth more in the future, like gold, than owning something with a guaranteed decay, Japanese bonds. This is not the place to argue storage and insurance versus the cost of the negative rate or, currency valuation versus the appreciation of goods owned. The economic theory is sound over the long run. However, we’re here to make money in the short-term and the long-term. Therefore, we see the recent rally in gold as being fueled by those late to the party. Frankly, anyone who bought gold above $1,100 per ounce may be in for some pain if they don’t lock in profits.

There were two key elements that put us on the lookout for the gold rally to begin with. First, we witnessed a large and rapid build in the commercial traders’ gold position between last November and December. Commercial traders purchased more than 160,000 contracts in just a few short weeks, eventually triggering a COT Buy Signal on December 3rd. This was more than $150 lower than the October COT Sell Signal and now, contributes to the resistance between $1,185 and $1,215 per ounce. Secondly, bond spreads began to crumble. The quickly flattening nature of the yield curve led to a deflationary tone in the stock market. Investors began looking for physical goods to own as paper issues like stock and bond certificates began to look worthless.

COT column bannerThis brings us to the current situation. Commercial traders have sold nearly 60,000 contracts since the January 6th high just over $1,113. This was the beginning of the hand off of positions from commercial traders to speculators. We fully expect to see that commercial traders increased their selling dramatically over this past week and wouldn’t be the slightest bit surprised if their net selling totals another 30,000 just for this week. Commercial traders are value players and as long as they can sell the futures profitably above the cash market, they’ll do it. Remember, the cash market isn’t as volatile because it doesn’t have the speculative participation of the futures market. This gives commercial traders a solid value line to trade around. Clearly, $1,200 gold in the futures market is more than they can get for it out of the ground.

Gold's recent rally has been heavily sold by commercial gold miners as the recent future's rally has offered them better prices than the global cash markets.
Gold’s recent rally has been heavily sold by commercial gold miners as the recent future’s rally has offered them better prices than the global cash markets.

We’re not sure if the gold rally is over but, we’re looking to short it once our momentum trigger shows us it has changed direction. We feel pretty comfortable with this move as gold futures face heavy technical resistance with the long-term (90&120 week) averages now at $1,185 and $1,215, respectively. Couple this with the trend line resistance shown on the chart above and an equity rally supported by whatever the next version of global Quantitative Easing turns out to be and we believe the markets will return to at least to their recent mid-levels while the rest is sorted out. This would represent more than a $50 decline in gold futures, March Bonds in the 152 area and the S&P 500 back up around 1,950. That should be more than enough room to capitalize on this commercial traders’ mean reversion strategy.

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