Gold Buying Precarious / Commodities / Gold & Silver 2020

Gold dramatically surgedto major new secular highs this past week, fueled by stunning geopolitical news.  The US assassinated Iran’s top general, so Iranfired ballistic missiles at military bases in Iraq used by the US.  That naturally ramped gold bullishness,spawning all kinds of predictions for much-higher prices.  But geopolitically-driven gold spikes neverlast long, and the gold buying behind this surge is very precarious.

Geopolitics are fascinating,the modern intersection of centuries of history, politics, religion, andmilitary actions.  Growing up,geopolitics were my second passion after the markets.  I read everything I could on that broadtopic, both nonfiction and fiction.  Tom Clancy’smasterful novels were my favorites, and I love that whole technothriller genreto this day.  For decades I’ve eagerly followedand devoured geopolitical news.

And being a lifelong stockspeculator, I’ve always had a special interest in how geopolitical developmentsaffect markets.  So this past week’s wildly-unexpectedevents were amazing to observe, and had major impacts on gold prices.  Last Thursday January 2nd, gold closed at$1528.  That was its best level sincelate September, but unremarkable with gold well under its last upleg’s peak of$1554 in early September.

Then overnight a US Reaperdrone fired missiles at cars carrying Iran’s top general Qasem Soleimaniat Baghdad International Airport in Iraq! He commanded all of Iran’s extraterritorial military and clandestineoperations, which were often carried out by proxy foreign militias that Iran armedand supported.  This targeted assassinationwas authorized by Trump because Soleimani was reportedly plotting to killAmericans.

Gold shot as high as$1550 on that shocking game-changing event, which risked snowballing into a full-blownwar between the US and Iran.  Last Fridaythe 3rd it closed up 1.4% to $1549, the highest it had been since that lastupleg peak.  Iran would have to retaliateover the killing of who was described as its second-highest official after itspresident.  Over the weekend speculation ofwhat that would look like ran rampant.

When US gold-futurestrading opened up Sunday evening New York time, gold rocketed from $1552 to$1585 virtually instantly.  It wasable to hold some of those gains this Monday, rallying 1.0% to $1565.  That was not only a new upleg high, but amajor secular one as gold’s highest close in 6.7 years!  Gold excitement was really building, leadingto countless forecasts that a major surge higher was just starting.

Gold climbed another0.4% to $1572 on Tuesday, with mounting anticipation for Iran’s revenge.  I warned about gold being veryoverextended in our weeklynewsletter that day, writing “Geopolitical rallies are seldom sustainableanyway.  The initial fears from eventsalways prove worse than realities.  Andonce the geopolitical news fades from prominence in a matter of days, thatgold-futures buying reverses to selling.”

At Tuesday’s US close Iconcluded that, “Given the extreme spec gold-futures positioning and a lack ofinvestment-buying support, gold’s near-term outlook is for a sharp selloff.”  That contrarian view sure wasn’t popular,like usual when greed is swelling with gold at major highs.  Before I share the analyses that fed intothat call, geopolitically-motivated gold rallies are always suspect since they neverlast for long.

After big geopolitical newsflares, the airwaves are flooded with military experts commenting on what isgoing on.  Without fail, they spin dire worst-casescenarios of what could happen next.  Whilethese are often plausible, history has proven they almost never play out.  I first learned this lesson in high school asI tried to trade around the Gulf War from mid-1990 to early 1991, when the USinvaded Iraq to liberate Kuwait.

Iraq invaded and annexedKuwait in August 1990.  Iraq’s military,considered the best in the region by far then, dug in and heavily fortifiedpositions for months.  As the US started shippingin an invasion force, pundits warned attacking Iraq’s army would take months resultingin thousands of American soldiers dying. But instead of fighting to the death, Iraqi soldiers mostly fled.  The ground battle was largely over within days!

The retreating Iraqimilitary had a scorched-earth policy, setting fire to around 700 oilwells.  Experts filled the media warningit would take years to extinguish those raging fires, and the entire planet facedcooling and crop failures as oil-fire smoke reflected too much sunlight.  Yet most of those were extinguished in afew months, and all were put out within that same year!  Geopolitical worst-case scenarios are alwayswrong.

More recently lastSeptember, a drone and cruise-missile attack took down one of the world’s largestoil-processing facilities in Saudi Arabia. Abqaiq removes hydrogen sulfide from 7m bpd of Saudi crude oil, makingit safe to be shipped in tankers.  About5% of global oil capacity was taken offline, and experts warned repairs wouldtake months!  Yet that massive facilitywas back up to full capacity in a couple weeks.

In my decades studyingthe markets and trading, I can’t recall a single major geopolitical event thatproved worse than initial assessments. Gloom and doom drives viewers and thus advertising revenue, so the medialooks for worst-case-type experts.  Whenthe aftermath of geopolitical events doesn’t prove as bad as first feared, thegold and oil spikes quickly reverse into proportional selling.  This is all sentiment-driven.

Back to this week, onTuesday evening US time Iran retaliated for Soleimani’s assassination.  It launched at least 15 ballistic missilestargeting military bases in Iraq used by American forces.  Fear exploded, with all kinds of talk about WorldWar 3 getting underway!  Goldrocketed from $1574 to $1610 within a couple hours, its highest levels sinceMarch 2013.  Again excitement mounted fora major upleg getting underway.

While the headlinesthat night seemed scary, again the perceptions were far worse than thereality.  As the dust cleared the nextday, Iran declared it “took & concluded proportionate measures”.  Then midday Wednesday Trump reported therewere no American casualties so the US was also standing down.  The Iranian missiles looked to bedeliberately targeted at aircraft hangars and equipment instead of barracks.

Gold had alreadystarted retreating overnight way before that, back near $1573 when Wednesday’sUS trading began.  It quickly plungedfrom about $1570 to $1556 after Trump gave an address indicating there would beno further US military strikes unless provoked. So one of the biggest geopolitical shocks seen in decades ended with awhimper instead of a bang.  Thankfully theUS wasn’t going to war with Iran!

Gold had rocketed from$1528 before that assassination to $1610 at the perceived peak of the crisis, thenhad plunged back down to $1555 on Wednesday’s close.  That geopolitical-event spike-failure patternis typical.  But regardless of what was happeningin the Middle East, the gold buying was precarious and not likely tolast.  I explained most of the followingto our newsletter subscribers last week before Soleimani’s killing.

Gold prices are drivenby capital flows, which come from both speculators and investors.  When they are buying, gold rallies higher.  Heading into this latest stunninggeopolitical event, speculators were tapped out and investors weren’t buying.  That meant gold had little chance of seeing amajor new upleg power higher, despite the endless groupthink momentum-followingcommentaries eagerly claiming otherwise.

Speculators’ gold-futurestrading dominates gold’s short-term price action for two reasons.  This market allows mind-boggling extremeleverage exceeding 30x!  Thatgreatly amplifies gold-futures trading’s price impact on gold.  At 30x, every dollar deployed in gold futuresliterally has 30x the gold-price influence as a dollar invested outright.  Thus this small group of traders’ capitalfirepower is greatly magnified to move gold.

Further upping theiroutsized influence, the resulting gold-futures price is gold’s world referenceone.  So the gold-futures-driven goldprice action heavily affects investors’ psychology, indirectly driving far-largerinvestment capital flows into and out of gold. If you aren’t up to speed on why gold-futures trading is so darned importantif not overpowering for gold’s fortunes, I explained it more deeply backin mid-September.

This chart shows specs’total gold-futures longs and shorts during this secular gold bull over the past4 years or so.  Reported weekly, longsare rendered in green and shorts in red. Gold is superimposed over the top of that.  Spec gold-futures positioning was literally atrecord extremes before that US Reaper took out Soleimani!  The latest-released data is current toTuesday December 31st, days before that strike.

In this data series’ last-reportedweek ending New Year’s Eve, gold continued rallying after its Christmas Eve correction-downtrendbreakout rally.  I discussed that in depth in last week’s essay, whereI again took the contrarian side arguing the recent gold-stock surge was ahead-fake rally.  Since gold sellingwas far more likely than sustainable buying, the surging gold stocks actually “facemajor near-term downside”.

When traders are excitedthat any sector is high, they hate hearing that stocks both rise and fall.  So I got a lot of flak for that call too.  Yet it too is proving right so far.  In the 4 trading days from just before thatUS drone strike to this Wednesday, the leading GDX gold-stock ETF fell3.4%.  That was far from what most greed-blindedgold-stock traders expected with gold surging to those geopolitically-drivenmajor secular highs!

Heading into this wildpast week, speculators’ total gold-futures longs and shorts ran 442.6k and 76.1kcontracts.  Each contract controls 100troy ounces of gold worth $155,000 at $1550, but only requires that traderskeep $4,500 margin in their accounts. That equates to crazy maximum leverage up to 34.4x!  At such extremes, a mere 2.9% adverse goldmove would wipe out 100% of the capital risked betting on it.

Those spec longs even beforethis past week’s US-Iran shooting started were already at a new all-time-recordhigh!  The hyper-leveragedgold-futures traders had never been more bullish on gold as evidenced by theiraggregate bets.  The problem is they are alwayswrong at extremes, when herd psychology just runs rampant.  The previous spec-longs record eclipsed onNew Year’s Eve was 440.4k from early July 2016.

That didn’t work out sowell for gold, heralding a brutal 17.3% correction over 5.3 months!  Note above that this entire secular gold bull has closely tracked spec gold-futures longs.  Gold powers higher strongly in major uplegswhen they are being aggressively bought. But once specs run out of capital firepower to keep buying, gold soonrolls over and corrects.  They were totallytapped out before geopolitics just flared up.

Extreme gold-futuresbuying inevitably soon leads to proportional selling.  Gold futures are not only super-leveraged,but have expiration dates.  Traders whobuy longs are legally required to sell them sometime before they expire.  Once spec longs climb to historic extremes, thesetraders’ finite buying is mostly exhausted. That makes imminent selling far more likely than material new buying,which is bearish for gold.

Gold futures are azero-sum game, with each contract having a long and short side.  So speculators also sell short to game golddownside.  In that latest-available data,total spec shorts had sunk to an extreme 4.9-year secular low!  That meant there was likely little room leftto buy to cover and close existing shorts. The gold-futures buying necessary to push gold higher lookedcompletely exhausted before this past week.

In terms of theirgold-bull trading ranges, total spec longs and shorts were running 100% and 0%up into them!  That’s the most-bearish-possible near-term setup for gold, since there’s virtually no room to keep buying butvast room to sell.  If spec positioningdidn’t grow even more extreme than this bull’s already record-extreme tradingranges, they had room to buy 0k contracts but room to sell a staggering 436.5k!

Still they did domore buying, as that’s the only explanation for gold’s sharp overnightsurges driven by this past week’s shocking geopolitical news.  That almost certainly leaves theirpositioning even more extreme today.  Thenext weekly read on their positioning current to this Tuesday’s close, hours beforeIran’s missile attack, will be published late Friday afternoon.  That data could prove even more bearish forgold.

I’ve carefully analyzedall gold’s uplegs and corrections since 1999 relative to spec gold-futureslongs and shorts.  Had the US-Iran thingnot happened, that would’ve been this week’s essay topic.  But gold hasn’t climbed in uplegs unlessgold-futures specs are buying, either adding new longs or covering to closeexisting shorts.  And when they areselling, either closing existing longs or adding new shorts, gold sells off.

Since gold-futuresspeculators are at their limits of potential buying on both sides of thetrade, they aren’t able to keep pouring capital into gold to drive it highereven if they want to.  Far worse, theirexcessively-bullish bets are very precarious. When gold falls materially, gold-futures selling rapidly snowballs.  These traders are forced to sell or they facequick ruin from their extreme leverage. That amplifies gold’s downside.

With the gold-futuresspeculators’ buying firepower more than fully expended, investment buying is gold’s only hope for powering higher still from here.  Unfortunately global gold investment data isonly available at a quarterly resolution. But the physical-gold-bullion holdings of the leading GLD SPDR GoldShares gold ETF offer a fantastic daily proxy of investment-demand trends.  This proves true for a couple reasons.

Gold ETFs act like conduitsfor the vast pools of stock-market capital to slosh into and out of gold.  Their mechanics necessary to track goldprices reveal capital inflows and outflows, showing what investors arecollectively doing.  And GLD is the world’smost-important gold ETF by far, commanding nearly a third of all the world’sgold held in ETFs.  GLD’s holdings alsomirror and drive major uplegs and corrections in gold.

When they are rising, Americanstock-market capital is flowing into gold. As investors bid up GLD share prices faster than gold itself is beingbought, this ETF threatens to decouple to the upside and fail its gold-trackingmission.  So GLD’s managers have to offsetand absorb that excess share demand. They do this by issuing sufficient new GLD shares, and then theresulting proceeds are used to buy more physical bullion.

As this chart of GLD’s holdingsover gold’s secular bull shows, gold’s recent upleg that initially peaked inearly September was also driven by strong investment buying.  GLD’s holdings surged with gold, showing big investment-capitalinflows.  But ominously investors aren’tbuying gold’s latest sharp rally to new upleg highs.  Geopolitical spikes are always driven nearlyexclusively by gold-futures buying, not investment demand.

Gold’s latest upleg wasthe most powerful of this secular bull, clocking in at 32.4% gains in 12.6months as of early September.  And thispast week’s geopolitical spike has further stretched that to the current 33.9%gain over 16.7 months.  Had the US-Iransituation not flared, odds are these newest gold highs wouldn’t havehappened.  They are a temporary anomalyfrom sentiment driving gold-futures extremes.

This chart shows stronggold investment demand for most of gold’s original upleg that peaked back inearly September.  Over that exact 32.4%-rallyspan, GLD’s holdings climbed 15.8% or 122.5 metric tons.  Of particular interest is thepost-gold-breakout phase of this upleg. That came after late June’s first new gold-bull highs seen inseveral years.  GLD’s holdings wererunning 764.1t before that enticed investors back.

Investment buying ismuch-slower-moving than gold-futures buying, tending to lag gold’s major swingsa bit.  So GLD’s holdings peaked in lateSeptember a few weeks after gold crested. They soared 21.0% or 160.8t higher in just 3.2 months!  That’s what a righteous gold upleg looks like, investors joining their vast pools of capital with specgold-futures buying to drive gold higher for months on end with big weeks seen.

For example in lateAugust and late September, GLD enjoyed two separate 5-trading-day spans whereits holdings blasted 3.6% or 30.5t and 4.7% or 41.3t higher!  Massive gold investment demand at that scalecan overpower whatever the gold-futures specs are doing.  In order for gold’s recent breakout rally tonew upleg highs to be sustainable, investors have to join in.  Especially with spec gold-futures buying exhausted.

In mid-December whengold was still very much in correction mode, GLD’s holdings slumped to880.7t.  That was down 4.8% or 44.3t fromtheir late-September peak.  Then thisleading gold ETF started to see some slight differential buying pressure.  Over the next several weeks into this one,GLD enjoyed fully 7 holdings-build days showing American stock-market capitalflowing into gold.  But they were all small.

Note in this chart howtiny the growth in GLD’s holdings was surrounding gold’s breakout surge, ithas barely registered!  At best over 12 tradingdays ending this Monday, after Soleimani’s assassination but before Iran’s retaliatorymissile strike, GLD’s holdings grew just 1.8% or 15.5t.  That’s virtually nothing in context of gold’ssurge.  And this Wednesday after Iran’sattack on those US-used bases, much of that reversed.

GLD suffered a major1.0% holdings draw that day as investors fled on gold’s geopolitical spike collapsingagain.  That unwound over 60% ofthe entire investment buying in recent weeks! So at this point GLD’s total build over the last several weeks is just0.7% or 6.2t.  That is trivial, arounding error.  Investors are not materiallybuying gold, and are unlikely to with Fed-conjured stock-marketeuphoria stunting gold demand.

So today’s gold pricenear 6.8-year secular highs exciting traders is actually reallyprecarious.  The gold-futures speculatorshave stretched to record extremes of buying, leaving their bets excessively-bullish.  They are very unlikely to have much capitalfirepower left to buy materially more. With their buying all but exhausted, they can’t buy more gold futures.  The risk of a cascading selloff from suchextremes is very high.

Meanwhile investorshave shown they likely won’t buy more gold.  Despite gold rocketing almost $100 higher injust several weeks to its best levels since early 2013, investors haven’t beenmotivated to buy much.  Gold is the ultimateportfolio diversifier, and is rarely in favor when stock markets are nearrecord highs and euphoria runs rampant. Investors are much more likely to continue recent months’ net selling.

All this leaves gold ina precarious place today.  Gold needscontinuing capital inflows to keep pushing it higher still.  Gold-futures speculators and/or American stockinvestors have to keep buying.  If theydon’t, gold will stall out and roll over. And that will likely ignite the vast pent-up selling from this ominousrecord gold-futures-selling overhang. If gold’s correction resumes like itought to, gold stocks will get hammered lower.

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The bottom line is therecent gold buying driving secular highs looks really precarious.  Gold broke out to new upleg highs in ageopolitical spike.  But historicallythese soon reverse into proportional selling, as the initial event-driven fearsalways prove overblown.  Spec gold-futurespositioning was already way up at record extremes even before the US and Iranstarted shooting, so traders’ buying firepower is exhausted.

At the same time gold-futuresspeculators can’t buy materially more, gold investors aren’t interested in buying.  GLD’s holdings, the leading daily proxy of goldinvestment demand, have barely budged even as gold blasted higher in recentweeks.  Record-high euphoric stockmarkets leave gold out of favor for diversifying portfolios.  Without material capital inflows from speculatorsor investors, gold can’t keep climbing.

Adam Hamilton, CPA

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