The elation the gold bugs felt in the bull market spanning from 2002 through 2011 is long gone. Since the "U.S. credit rating downgrade peak," holding gold in an investment portfolio has been as pleasant as sleeping on hot coals. As an asset class, gold has fallen largely out of favor and after last week's precipitous plunge below obvious support levels, it feels like even the die-hard bulls are throwing in the towel. Nevertheless, that is exactly what is so intriguing about this market!
The large specs have liquidated
Large speculators are holding the smallest net short (bearish) position we've seen in well over a decade. Some look at this as a potential bearish development, but in light of the fact that this group of well-funded speculators have almost always been long gold, we look at it as a positive. After all, with most of their money sidelined, large speculators will have plenty of buying power to employ once prices finally turn the corner -- and we believe they will.
On the last occasion in which the "smart money" had such a meager net long gold position (2001), prices eventually rallied from $300 per ounce to $1,900. Obviously, the latter part of the move was done under extenuating circumstances (financial crisis), but the initial rally spanned several years and several hundred dollars per ounce on its own merit.
For those of you unfamiliar with the futures market delivery process, the exchange declares a date at which holders of open futures contracts are agreeing to enter into the futures delivery process. Accordingly, those futures traders intending to simply speculate (98% of market participants) on price changes rather than making or taking delivery of the underlying commodity, must exit their open positions to avoid the obligation. In this particular case, those gold traders that are long or short the futures contract expiring in August must offset the trade prior to Friday, July 31.
When one futures contract is expiring, futures traders have the option to move into the next viable contract month, December in this case, or they can opt to sit on the sidelines. We've noticed when markets are trading near price extremes, speculators tend to liquidate the current contract month but fail to enter the next contract month. As a result, the expiration of the front month futures contract (or at least the date at which speculators must exit) often marks the high or low of a move.
In this case, we believe previously bullish speculators in gold have sold their August contracts, but are not yet willing to buy into the December contract. The result, is weaker gold prices now, but once we get beyond first notice day those sidelined traders might opt to get back in (by buying the December gold futures contract). If so, there should be upward pressure in pricing.
Seasonal strength in gold could soon kick in
According to MRCI (Moore Research Center Inc.), data taken of December gold in the previous five years has seen a sharp price increase beginning in early August. The seasonally bullish pattern diminishes slightly when the data is expanded to 15 years, and weakens a little more if taken for a 30-year sample period. Nevertheless, it is clear that gold prices have a relatively high probability of firming up from what are normally annual lows in the June/July time frame.
The gold chart
The July 27 plunge in gold did some technical damage, but all is not lost. Trend reversals in gold are usually very messy; they typically take place over several trading sessions and offer traders plenty of sleepless nights and head fakes. Nonetheless, there are still some compelling technical analysis arguments for a potential gold recovery.
On a daily chart of gold, as well as the weekly, the relative strength index (RSI) is hovering below 30. Historically, this is a relatively rare event, but when it does occur it has frequently been followed by a sharp rally. Also, despite breaches of well-known support levels, gold prices have managed to close at respectable levels.
We suspect the lows in gold are either here, or very near, but if we are wrong about the current levels holding, we cannot rule out one more flush action that would bring prices toward $1,040. If such levels are seen, we believe it would be a rare opportunity for the bulls.
Remember, gold is treacherous, so be sure to talk to your broker prior to implementing a strategy.