Adam Hamilton: Gold's Curious Sentiment

Gold is faring quite well today technically, though you sure wouldn't know it from the rampant bearish sentiment. Gold's price is in a strong uptrend over a year old, high in both its current upleg and young bull market. Gold isn't far from breaking out to its best levels since September 2013, a really big deal. The stock markets even finally sold off after years of unnatural calm. Yet traders are still down on gold.

Across all markets price action drives psychology. When something's price is rising, traders get excited and bullish on it. So they increasingly buy to ride that upside momentum, amplifying it. Of course the opposite is true when a price is falling, which breeds bearishness and capital flight. Given gold's great technical picture today, investors and speculators alike should be growing enthusiastic about its upside potential.

But they really aren't, which is certainly curious. Gold's current upleg was born right before the Fed's last rate hike in mid-December. Everyone thinks Fed rate hikes are very bearish for gold, but history proves the opposite as I argued near gold's recent interim lows. In the 2.4 months since, gold has rallied 6.6% as of the middle of this week. That trounces the leading benchmark S&P 500 stock index's mere 1.6%.

Gold's rate of ascent since mid-December annualizes out to a 33% pace, which is pretty darned exciting! Yet gold's two primary sentiment proxies, silver and the stocks of gold miners, show enthusiasm for gold is nonexistent. Over that same current-gold-upleg span, silver is only up 5.0% while the HUI gold-stock index clocked in with a dismal 1.8% gain. Normally silver and the gold stocks leverage gold upside by 2x to 3x!

As I discussed about a month ago, gold is on the verge of a major breakout that would greatly shift psychology back to bullish. Gold's bull-to-date peak was carved in early-July 2016 at a $1365 close. For a variety of reasons gold stalled at best since. Just a month ago gold surged to $1358 though, and only a week ago it hit $1353. It wouldn't take much of a rally to boost gold to new bull-market highs to catch the limelight.

Generally upside breakouts have to be decisive to really attract traders' attention. I define that as 1% beyond the old level, so $1379 in gold's bull-high case. That's only a handful of good up days away, not far at all. And that's close to $1383, which is gold's best level in a whopping 4.5 years. Start pushing $1400 again, and even oblivious traders who've long forgotten about gold will realize something big is changing.

On top of these key technical upside-breakout levels so close, the sharp stock-market selloff is fantastic news for gold investment demand. The S&P 500 plunged 10.2% in just 9 trading days! That ended an all-time-record 405-trading-day span without a mere 5% pullback, and is the first stock-market correction in 2.0 years. Stock selloffs are very bullish for gold, as investors remember the wisdom of diversifying portfolios.

So gold's popularity should really be mounting now given its strong price action. Yet that certainly hasn't happened yet, gold's sentiment is really curious. The prevailing psychology remains quite bearish, which feels much more like a major bottoming. The fear, anxiety, and apathy somehow still plaguing gold is the polar opposite of the greed and excitement near major highs. Gold is still overlooked, ignored, and shunned.

This weird sentiment anomaly totally disconnected from technical realities can and will turn fast, likely as gold decisively breaks out to new bull highs. That could happen anytime in the coming weeks or maybe months, it is nearing. But for now, it's useful to understand why gold oddly remains so out of favor. The answer lies in the psychology of gold's two primary driving forces, futures speculators and stock investors.

Gold-futures speculators exert inordinate influence on daily gold price action. This is primarily due to the extreme leverage inherent in futures trading. This week a single gold-futures contract that controls 100 ounces of gold has a maintenance-margin requirement of just $3500. That's all the capital traders need to buy or sell a contract. But at this Wednesday's $1323 gold, each contract controls gold worth $132,300.

That equates to extreme maximum leverage of 37.8x, death-defyingly high! For comparison, the legal limit in stock markets for decades has been 2.0x. At 35x leverage, each dollar speculators deploy in gold futures has 35x the gold-price impact of another dollar used to invest in gold outright. Such ridiculous leverage allows futures speculators to collectively punch far above their weights, dominating gold-price action.

As if that's not unfair enough to normal investors, gold futures' extreme leverage necessitates an ultra-short-term focus. Again at 35x leverage, a mere 2.9% adverse price move in gold would wipe out 100% of the capital speculators risked! So these guys are forced to think in terms of minutes, hours, days, or sometimes weeks for their trading time horizons. The months and years of investors may as well be eternities.

That incredibly-myopic view on gold creates all kinds of problems because data is far too sparse to justify ultra-short-term trading. The best fundamental data available on gold is only published once each quarter by the World Gold Council. Some other localized peripheral data is released monthly. So with insane leverage compressing down speculators' gold outlooks into days or less, they have nothing to trade on.

Instead of backing way off on their leverage and taking rational longer-term trading spans, they fabricate their own gold-trading cues. The two they've collectively decided on are the price action in competing US Dollar Index futures and the closely-related Fed-rate-hike outlook. Developments there motivating gold-futures speculators to act are half of the explanation surrounding gold's curious sentiment these days.

Nearly a month ago futures speculators bid gold up to $1358. They were watching USDX futures, as that leading US dollar benchmark was grinding inexorably lower. On February's first trading day, the USDX slumped to a major 3.1-year secular low. That weak dollar is what drove gold tantalizingly close to a major bull-market breakout. But futures speculators were perplexed if not angry this was actually happening.

These elite traders hold tight to certain core beliefs with tenacity that puts religious zealots to shame. The main one is that Fed rate hikes are bullish for the US dollar and therefore bearish for gold. The idea is simple, higher rates boost dollar yields making it relatively more attractive than other currencies. So foreign investors rush to buy, bidding the dollar higher. Futures speculators know this is how the world works.

That logic appears sound, but what if their deeply-held thesis simply isn't true? The Fed's current rate-hike cycle began in December 2015 after 9.5 years with no rate increases, and 7.0 continuous years of a zero-interest-rate policy. The 5 hikes since coming off a near-zero base should've been wildly bullish for the USDX, right? Futures speculators bet heavily long the dollar and short gold heading into that initial hike.

Yet since the day before the Fed started its current rate-hike cycle, the USDX is down 8.3% and gold is up 24.7% as of the middle of this week! Clearly Fed rate hikes aren't as bullish for the US dollar or as bearish for gold as futures speculators thought. You'd think they'd be smart enough to form their trading strategies based on hard data instead of mere conceptual arguments. But they steadfastly refuse to budge.

Gold started to sell off on Friday February 2nd in the wake of the latest monthly jobs report. It saw wage growth climb at its fastest annual pace since June 2009, stoking inflation fears. Higher inflation implies the Fed will have to hike rates faster. So the oversold USDX surged 0.7% higher that day, making for its biggest up day since late October. Gold-futures speculators saw that and fled, hammering gold 1.4% lower.

The S&P 500 happened to plunge 2.1% that day on those same inflation fears, its own worst down day since early September 2016 before Trump won the election kicking off the extreme taxphoria rally. That sharp stock-market drop shattering the unnatural calm was the dominant news that day. That led investors to assume gold fell because the stock markets sold off, but the real reason was that big dollar bounce.

That's happened before. Back in late 2008 during that first stock panic in a century the USDX rocketed 22.6% higher in just 4.2 months, its biggest and fastest rally ever! That was in response to safe-haven buying as the S&P 500 plummeted 38.1% in that short span. But that epic dollar strength hammered gold a proportional 23.7% lower. Investors wrongly figured weak stock markets hurt gold, but it was the hot dollar.

When stock markets fall sharply, cash suddenly becomes much more attractive than stocks. So dollar demand surges as stocks plunge. Gold-futures speculators see that and dump gold, driving it lower. This dynamic fully explains gold's weakness in recent weeks. Every single gold down day was the direct result of a parallel USDX rally! That was true in early-February's S&P 500 selloff and then again this week.

Since the dollar's action and the Fed-rate-hike outlook is the extent of gold-futures speculators' entire trading worldview, they've been really bearish on gold as the dollar bounced twice this month. Thus they have greatly pared their long gold-futures positions. This chart superimposes gold over the total gold-futures long and short contracts held by speculators, published weekly in the Commitments of Traders reports.

CoT data is released late each Friday afternoon current to the preceding Tuesday close. So the latest-available data on speculators' collective gold-futures trading when this essay was published is as of February 13th. In just the 3 CoT weeks since gold hit $1358, these guys dumped a massive 59.8k long contracts! That's equivalent to 185.9 metric tons of gold, a huge amount. No wonder gold couldn't rally during that.

But interestingly all that frenzied gold-futures long selling on modest US-dollar strength drove specs' total longs back down to their gold-bull support line rendered above in green. Other than a brief break below leading into the Fed's last rate hike, strong buying has soon followed earlier support approaches. That has fueled sharp gold rallies once spec longs hit support. That will likely prove true again in coming weeks.

Despite the extreme leverage they wield, gold-futures speculators' capital is finite. They only have so much they can deploy on both the long and way-smaller short sides of the trade. So looking at where specs' total longs and shorts are relative to their own past-year trading ranges offers an excellent approximation of how much buying or selling firepower these guys have left. That greatly affects gold's outlook.

As of last Tuesday the 13th, their total longs were only running 35% up into their past-year trading range. That means these elite traders still had room to do nearly 2/3rds of their likely near-term buying! That's very bullish. The short side was far-less bullish, with speculators' total gold-futures shorting running just 14% up into their past-year trading range. That means 6/7ths of likely short-covering buying was already done.

The gold-price impact of buying new long contracts or buying to cover existing shorts is identical. If these total long and short trading ranges are combined, speculators' effective total upside bets on gold were at 55%. That implies 45% of probable near-term buying remains! That's exceptionally bullish with gold still up near major breakout highs. Normally near highs 80% to 90% of buying power has already been expended.

So once the USDX inevitably turns lower again, there's lots of room for speculators to buy gold futures and push gold higher. The dollar weakness will likely reemerge on ballooning US deficits and debt. The Republican lawmakers are keeping the extreme out-of-control government spending of the Obama era intact, while simultaneously cutting taxes. Rising rates are also catapulting US interest expenses much higher.

And more Fed rate hikes aren't likely to ride to the dollar's rescue. The USDX entered the last Fed-rate-hike cycle between June 2004 to June 2006 relatively low, perfect conditions for a rally. Then the FOMC hiked 17 times in a row, more than quintupling its federal-funds rate to 5.25%. Yet the USDX still slipped 3.8% over that exact span, while gold powered 49.6% higher! Fed rate hikes haven't proven great for the dollar.

The second driving force behind gold's curious sentiment is little investor interest. Investors control vastly more capital than futures speculators. So when investment capital is moving into or out of gold in any significant way, it overpowers and drowns out all the daily gold-futures noise. Stock selloffs greatly boost gold investment demand, but not immediately. Investors first get distracted by the dollar-driven futures action.

The S&P 500 plunged 8.5% in just 5 trading day ending February 8th, a precipitous tumble. Yet instead of surging on that stock weakness, gold dropped 2.4%. Investors assume that was in sympathy with the stock markets. But it was really the result of the USDX surging a similar 2.0% over that span on safe-haven buying. The dollar surging on heavy demand in the hearts of stock-market selloffs delays gold's reaction.

So investors weren't yet flocking back to gold earlier this month. The world's dominant gold ETF publishes its physical-gold-bullion holdings held in trust for shareholders daily. The GLD SPDR Gold Shares showed no holdings builds as stock markets recently plunged, indicating stock-market capital wasn't yet flowing into gold. There were actually sizable draws over that span as stock investors dumped GLD shares.

When stock markets fall sharply, investors freak out. Fear flares so fast that people have to act instead of think. So they sell everything they can to raise cash, including gold. Weaker gold prices driven by futures selling in response to the surging USDX exacerbate any gold selling. In the heat of the moment investors think gold gets sucked into stock-market selloffs, that it really doesn't move counter to stocks.

But once the biggest-fear days in stock-market selloffs pass, investors come to realize they are taking on too much risk with their stock-dominated portfolios. So they start rebuilding depleted gold positions in the wake of major stock-market selloffs. We're indeed already seeing modest GLD builds return over the past week or so. And this same dynamic was actually what birthed today's gold bull back in early 2016.

Heading into that first Fed rate hike in 9.5 years in December 2015, gold slumped to a brutal 6.1-year secular low. Because futures speculators are totally convinced Fed rate hikes are kryptonite for gold, history be damned. The S&P 500 had gone a near-record 3.6 years without a single 10%+ correction, so complacency was extreme. Investors believed stocks did nothing but rally, so they could hold them forever.

Finally back-to-back S&P 500 corrections arrived in mid-2015 into early 2016. This benchmark stock index fell 12.4% in 3.2 months, bounced most of the way back, and then dropped another 13.3% over 3.3 months into mid-February 2016. That first SPX correction only spurred limited gold investment buying. Stock investors weren't very worried the lofty stock markets would head much lower again, so they procrastinated.

Yet after that second correction arrived shortly after, differential GLD-share demand exploded! Investors flocked back to gold to prudently diversify their stock-heavy portfolios. That heavy investment buying catapulted gold 29.9% higher in just 6.7 months, birthing today's bull market. Gold kept rallying rather relentlessly until the stock markets finally made new highs which totally dispelled weaker-stock worries.

The same thing happened during and after 2008's epic stock panic. Gold was hammered by the skyrocketing USDX during that extreme stock-market selloff. But in the following months gold investment demand blasted higher as investors realized they needed counter-moving gold allocations in their portfolios. That heavy gold investment demand persisted for years after the stock panic, driving gold to record highs.

History has shown over and over that gold investment demand is weak when stock markets are high and euphoric. Why buy gold when stocks apparently do nothing but rally indefinitely? But once corrections or new bear markets emerge to rebalance sentiment and knock back overvalued, overbought stocks, gold soon returns to favor. That doesn't happen instantly, as safe-haven dollar buying temporarily forces gold lower.

But after major selloffs when investors start to realize that stock markets can fall too, they start thinking about gold again. It's the ultimate portfolio diversifier. That post-selloff gold-investment process is very gradual, it takes months or years to rebuild significant gold positions relative to stock portfolios. Odds are a similar outcome will play out again following this latest sharp S&P 500 selloff, which likely isn't over yet.

Given the radical gold underinvestment following this extreme stock bull, investors will likely have to do big gold buying for years to reestablish normal portfolio allocations. That will continue to fuel this young gold bull born in late 2015 in the previous stock-market correction. At best gold was only up 29.9% so far as of mid-2016, nothing yet. The last gold bull powered 638.2% higher over 10.4 years ending August 2011!

While investors can ride gold's ongoing bull in GLD shares, far better gains will be won in the stocks of its leading miners. They tend to amplify underlying gold gains by 2x to 3x due to their profits leverage to gold. With gold so out of favor, the gold stocks are deeply undervalued today. That gives them huge upside as gold mean reverts higher, dwarfing everything else in all the stock markets. Fortunes will be won.

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The bottom line is gold's curious sentiment today results from an interplay of factors. Safe-haven dollar buying erupted as usual during the stock markets' first real selloff in a couple years. That led the gold-futures speculators to sell aggressively, driving gold lower. Investors saw gold falling with stocks and wrongly assumed stock selloffs aren't bullish for gold. And their confidence in stocks remains very high.

But as stocks head lower again after their post-correction bounce, psychology will really shift. Investors will increasingly worry that stock weakness could persist for some time. They will remember gold is the ultimate portfolio diversifier, and start shifting capital back into it. The resulting investment buying will persist for months or even years, drowning out whatever the hyper-leveraged gold-futures speculators are up to.

Adam Hamilton, CPA

February 23, 2018

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