Gold’s technical breakdown suffered in its recent capitulation selloff naturally unleashed a flood of bearish sentiment. Traders are totally convinced gold’s woes are just starting, that the worst is yet to come. This pessimistic worldview is largely universal, even among futures traders. But their collective bets are actually a strong contrarian indicator. Their bearishness peaks right before major rallies erupt.
Futures speculators are generally considered the most sophisticated of traders. With futures’ inherent high leverage, margin requirements, limited lifespans, and zero-sum nature, they are far more risky and challenging to trade than stocks. Thus the average futures trader is much better informed and better capitalized than the average stock trader. Unforgiving futures trading soon weeds out mediocre traders.
But nevertheless the surviving futures traders are still human. They struggle with the same dangerous emotions of greed and fear that plague stock traders. As a herd, futures traders grow too euphoric and greedy after a price has surged too far too fast. So they flood into longs near highs. And they get too despondent and fearful after a price has plunged too far too fast. So they pile into shorts near lows.
And the latter has certainly happened recently thanks to gold’s capitulation. As an unfortunate chain of news and sentiment fed on itself as analyzed in depth in our latest monthly newsletter, futures traders grew exceptionally bearish. So they made big bets that gold’s price would keep on falling, which in the futures world means taking the short side of contracts. And these shorts reached incredible extremes.
US futures trading is regulated by the Commodity Futures Trading Commission, an arm of the US government. While the CFTC can be a real pain sometimes like all regulators, one good thing it does is publish a weekly report called the Commitments of Traders. Released late Friday afternoons, it shows what positions several classes of futures traders happened to be holding as of the preceding Tuesday.
Futures are a zero-sum game, every contract has one trader betting a price will move one way against an opposing trader betting that price will move the other way. So every dollar won in futures is a direct dollar loss from the counterparty on the other side of the contract. Thus the total number of longs and shorts in any commodity, including gold, are always perfectly equal. Shorts can’t exist without offsetting longs.
While total gold shorts always equal longs, the CFTC divides futures traders into three different classes. These are commercial traders, non-commercial traders, and nonreportable traders. These are generally translated as hedgers directly using a physical underlying commodity for business purposes, large speculators, and small speculators. The aggregate positions held by each class can vary considerably.
The way it nearly always works in the gold world is commercial hedgers mostly take the short side of gold contracts. They are dominated by miners locking in future selling prices. And then speculators, both large and small, take the offsetting long side of these trades. When the total longs and total shorts for each class are added up, the result is a net-long or net-short position. This effectively reveals sentiment.
The more net-long the speculators are, the more bullish they are on gold. They won’t make these risky leveraged bets on this metal unless they are convinced it is likely to continue surging. This tends to happen near major toppings after big uplegs. The less net-long speculators are, the more bearish they are on gold. They won’t bet heavily on gold upside after this metal has long languished in corrections.
This first chart looks at these aggregate class positions in gold futures over time. The always net-short commercial hedgers’ positions are shown in yellow. Without them, gold futures trading wouldn’t exist. The offsetting net-long large and small speculators are rendered in orange and red. When the gold price is overlaid on these collective positions, it becomes readily apparent they are a strong contrarian indicator.
Even though commercials are always net-short and speculators always net-long during a secular bull, the degree of these bets is very revealing. As speculators get exceptionally bullish or bearish on gold, their net-long exposure rises and falls accordingly. And amazingly given futures’ traders well-deserved reputation as sophisticated players, they nearly always make the wrong bets near gold-price extremes!
We’ll focus on the bearish side of this equation, low net-long positions, since that is what is happening in gold today. In this weekly chart running back to 2005, I highlighted major lows in speculator net-long positions in blue. Futures traders as a herd were the most bearish on gold at these junctures, not willing to make big upside bets because they were so convinced the metal was doomed to keep spiraling lower.
The great value in this CoT gold-futures position data is unlocked when directly compared to prevailing gold prices at the time. Note above that every single time speculators’ net-long gold-futures positions fell to major new lows, gold happened to be near a major low itself. Speculators were the least bullish, and therefore most bearish, right after gold had already suffered through a major correction or consolidation.
Obviously the core mission in the markets is to buy low and sell high, it is the only way to make money. If the gold-futures speculators were living this truth as a group, their net-long positions would be the highest near major gold lows and the lowest near major gold highs. But they are doing the opposite, succumbing to the irrational fear near major gold lows and the exuberant hype near major gold highs.
Right after every major low in gold-futures speculators’ net-long positions in this entire secular gold bull, gold soon started surging in a major new rally or upleg! Collectively they haven’t mastered their own greed and fear, just like stock traders. So the smart bet to make near extremes is to do the exact opposite of what the specs are doing. When their net longs are the lowest, gold is the most likely to start surging.
Gold’s recent capitulation selloff that spawned their excessive bearishness gradually began sliding on February 11th. It steadily snowballed over the following week, climaxing on the 20th when the Federal Reserve released its latest FOMC minutes. If you want to understand exactly what news fed into this capitulation, our monthly newsletter analyzes the chronology in depth. It was a 7-trading-day event.
About 6/10ths of that total gold selloff occurred in the first 6 trading days, with the final 4/10ths mushrooming on the 20th as the capitulation climaxed. That was a Wednesday. But the weekly CoT position report includes data as of each Tuesday, so the 19th was the closest we have to the selloff’s peak bearishness. And the positions gold-futures speculators held that day already revealed staggering levels of fear.
Large speculators held the long side of 196k contracts, and the short side of 92k. This led to a net-long position of less than 104k contracts, a staggering 50-month low! Gold-futures speculators had not been that bearish since December 2008 just after that once-in-a-century stock panic. You may recall that gold got sucked into that maelstrom of general-stock selling, failing to fulfill its expected safe-haven surge.
So gold bearishness was extreme in late 2008, with the gold price languishing at $776. Gold not only couldn’t even catch a bid during the biggest and craziest fear spike we’ll ever see in our lifetimes, it actually plunged 27.2% in just under 4 months! Nearly everyone, including sophisticated futures traders, believed this meant gold’s secular bull was dead. So their net-long bullish bets plunged to dismal lows.
Was their groupthink conventional wisdom correct? Was their extreme bearishness justified? Heck no! That net-long low happened just as gold was ready to start surging dramatically. Between that very day and August 2011, gold’s secular bull would power 144% higher. Peak bearishness in gold futures occurred at the worst possible time, a major unsustainable low just before a major new upleg was born.
While that panic is the most extreme example of this bull, we see this phenomenon at every major low in gold-futures speculators’ net-long positions. They are the most bearish when gold is the most bullish, at the best times to buy low. So it is very telling to see large specs’ net longs at their worst level since the stock panic on February 19th, 2013. Small specs’ net longs were just shy of a 49-month low of their own.
Throughout gold’s entire secular bull, one of the surest bets to make was being the most bullish on gold when futures speculators were the most bearish. And since gold’s bullish fundamentals are as strong as ever today in terms of global supply and demand, smart contrarians are betting against the futures speculators today. The recent gold capitulation may prove to be the best buying op since the stock panic!
In addition to this net method of analyzing the weekly Commitments of Traders report on gold-futures positions, there is another way to slice the data. And it shows the same thing, that collectively futures speculators are a powerful contrarian indicator. It adds up the total long-side and short-side contracts held by both classes of speculators, large and small. This method reveals an equally extraordinary buying op.
Both classes of speculators’ total long and short positions in gold futures are shown in green and red. In some ways this is an even purer window into their collective sentiment, since the extremes aren’t masked as in the aggregated net method. On the buy side, this contrarian indicator combines two facets. When highs in total short positions coincide with lows in longs, a major gold low is being carved before a rally.
Again I highlighted these episodes in blue, for easy comparison with the gold-price data that reveals what happened next after futures speculators became so bearish. Of course gold surged dramatically, with major new uplegs being born soon after peak futures-trader discouragement. The most extreme example was once again during 2008’s insane stock panic. But amazingly last month far exceeded it on the short side!
In the four weeks leading up to the eve of February 2013’s gold-capitulation climax, the total short positions held by large and small gold-futures speculators soared nearly 90%! This happened to be the biggest surge in shorts, the most extreme flaring of bearishness, in 113 months. It was the largest ballooning of speculator short positions in nearly a decade, since way back in September 2003.
Large and small speculators’ total short contracts surged over 125k on February 19th. After seeing this chart, I was of course curious about how long it’s been since we’ve witnessed anything like that. It turns out it was a 163-month high. Speculators hadn’t been more heavily short gold futures since July 1999, at the tail end of this metal’s multi-decade secular bear! February’s short peak was unparalleled in this secular bull.
And back then gold was only trading near $253, a far cry from mid-February’s $1605 level as of that CoT report. So the amount of capital exposed in shorting gold futures last month was almost certainly a record, just staggering. We have never seen futures bearishness flare faster to more extreme levels in this entire secular gold bull, despite weathering many selloffs much sharper than February’s capitulation.
If gold’s near-future outlook is a direct inverse function of futures speculators’ bearishness, which the historical data from this bull clearly shows, then we’ve never seen this metal look more bullish than it did in late February. That is truly amazing, considering gold has been powering higher on balance since April 2001. Extreme bearishness is a powerful contrarian indicator, the exact time to be the most bullish.
Having been trading this secular gold bull since those early days, I’m perplexed that February’s events could have spawned such extreme bearishness. Gold demand remains near record highs globally, while mine production and recycling supplies are shrinking. Central banks are buying. And despite the scare last month, the Fed’s hands are tied. It can’t stop QE3 without sparking an economic catastrophe.
All this is also explained in depth in our new March newsletter. The chain of events that drove February’s 7-trading-day gold capitulation was really pretty mild compared to other big gold selloffs earlier in its secular bull. This makes gold-futures speculators’ reaction look even more irrational and emotional. They simply lost their nerve and freaked out, despite no fundamental threats to gold emerging.
If gold demand was consistently falling over time, if gold supplies were surging, then I would totally understand the desire to be bearish. But since that isn’t happening, and since global investors remain woefully underinvested in gold considering the extreme central-bank money creation globally, the wise bet to make is the contrarian one. Gold-futures traders have always been wrong at peak bearishness.
The markets abhor sentiment extremes. Excessive fear and excessive greed never last, the great sentiment pendulum soon starts swinging in the opposite direction. Excessive fear only flares up near major lows, just before major new uplegs start powering higher. This is because that fear frightens all traders susceptible to it into selling right away, leaving only buyers. The balance of power shifts to them.
So with gold-futures speculators’ net-long positions just at their lowest since 2008’s stock panic, which preceded the biggest upleg of gold’s secular bull, smart contrarians are betting against them. And with the specs’ total short positions at extremes never before seen in this bull, peak bearishness has to be past us. The rational thing to do in light of these strong contrarian indicators is to buy gold aggressively.
And despite the gold bearishness spiking to silly levels in recent weeks, that seen in gold stocks utterly dwarfs it. Just this week the flagship HUI gold-stock index sunk to levels last seen 43 months ago in August 2009! Gold and silver were trading at $933 and $14 that day, a far cry from this week’s $1575 and $29. This gross fundamental disconnect from reality won’t last, gold stocks are an über-contrarian play.
At Zeal we are battle-hardened veterans of this secular gold bull, having traded its entire 12-year span to great success. All 637 stock trades recommended in our newsletters since 2001 have averaged stellar annualized realized gains of +33.9%! We achieved this and greatly multiplied our subscribers’ wealth by being contrarians. We are brave when others are afraid, buying low when futures traders freak out.
Last month’s irrational gold capitulation was analyzed in depth in our acclaimed weekly and monthly subscription newsletters. They are written for speculators and investors who are tired of being scared into selling low then seduced into buying high. They will help you master your own emotions and trade smarter, which will ultimately help you greatly multiply your wealth. Subscribe today and start thriving!
The bottom line is gold-futures speculators’ aggregate bets are a powerful contrarian indicator. Despite their reputation of being sophisticated, they struggle with the same greed and fear we all do. So they wax the most bearish on gold right after major lows just before major uplegs. This secular gold bull’s record of aggregate speculator gold-futures positions as revealed in the weekly CoT reports make this crystal-clear.
Thus prudent contrarians watch what the gold-futures speculators are doing and make the opposite bets near CoT extremes. The more bearish these specs get, the more bullish the outlook for gold actually becomes. Succumbing to groupthink in the markets always leads to big losses. Transcending it to think like a contrarian is the only way to consistently buy low and sell high. Fight the herd and grow rich!
Adam Hamilton, CPA
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