This article got first published by Adam Hamilton, CPA on zealllc.com
Gold and Silver
The miserable summer for precious metals grinds on, with both gold and silver limping along near major lows. Such dismal price action has exacerbated the extreme bearishness long plaguing this sector, sparking even more capitulation. But this incredible weakness will be short-lived, as it was driven by American futures speculators’ record short selling. That will soon reverse into guaranteed, proportional buying.
In all markets including precious metals, price is rightfully considered the most- important fundamental signal. Prevailing price levels are set by free-market buying and selling until supply and demand meet. And gold and silver prices are exceptionally weak, with these despised precious metals slumping down to challenge major new 5.2-year and 5.4-year lows this week. So their fundamentals must be bearish, right? The only fundamental factors that can drive prices near major secular lows are too much supply, too little demand, or some combination of the two. And if the gold and silver markets are as oversupplied as their prices indicate, they’re likely to keep drifting lower indefinitely. This popular bearish thesis is universally believed today, with virtually no dissent. There aren’t many contrarians left to combat this overpowering groupthink.
But what if the withering selling pressure devastating gold and silver this summer is artificial? What if the traders dumping the precious metals don’t actually own them in order to sell them? What if 2015’s apparent glut of gold and silver has been mostly borrowed first and then sold? And what if these short sellers used extreme leverage to dump these metals? This scenario radically changes precious metals’ outlook.
When traders who actually own gold and silver sell it, they never have an obligation to buy it back. And that’s the kind of potentially-permanent selling the bearish consensus assumes is happening today. But short selling is vastly different, as traders who don’t own gold and silver have to borrow them first before selling. And these debts must soon be repaid contractually and legally, making all short selling temporary. Short selling is artificial and short-lived because every single ounce borrowed and sold will be rebought in the open markets in the near future. Since all short selling guarantees proportional buying as those shorts are covered, price levels driven by shorting are a transitory illusion that is not fundamentally righteous.
And that’s exactly what’s happening in both gold and silver today, a short-selling-fueled fantasy. American speculators have just mushroomed their short positions in gold futures and silver futures to all-time record highs! They have never had bigger leveraged downside bets on the precious metals, and thus have never had more near-term buying to do. When this inevitable short covering begins, gold and silver prices are going to surge dramatically higher. And then they will finally reflect actual global fundamentals.
Unfortunately most investors don’t follow gold and silver shorting, which is why they’ve succumbed to the bearish hype today. It is overwhelmingly centered in the American futures markets. Once a week, the US Commodity Futures Trading Commission publishes reports detailing futures positions called the Commitments of Traders. But these are large, complex, and esoteric, certainly not easy to understand.
But since American futures speculators have utterly dominated gold and silver trading in recent years as investors fled, digging into the CoTs is essential for serious investors. They fully explain why gold and silver have been so weak, and why current price levels don’t reflect global fundamentals. Our charts this week look at American speculators’ total long and short positions in gold and silver futures, now at records.
The CFTC releases its CoT reports late every Friday afternoon, current to the preceding Tuesday close. So this data is the latest available when this essay was published. And it shows stoundingly bullish conditions in both gold and silver, with American speculators legally on the hook to soon buy truly vast amounts of both precious metals to close their extreme positions! A record short-covering frenzy is imminent.
As of the last CoT week, American speculators had borrowed to sell short an unbelievable 179.0k gold-futures contracts! This was the highest level seen in at least 16.5 years since early 1999, the extent of our CoT data, and almost certainly ever. This latest record narrowly eclipsed the previous record of 178.9k contracts shorted in early July 2013. And that earlier event illustrates why excessive shorts are so bullish.
Back in early 2013, the US Federal Reserve’s wildly unprecedented open-ended third quantitative-easing campaign ramped up to full steam. Unlike QE1 and QE2, QE3 had no predetermined size or end date. Fed officials used this to their advantage to actively manipulate stock-market psychology. They were constantly jawboning about ramping QE3 if necessary to arrest any material stock-market selloff.
The Fed-fostered notion that it was effectively backstopping stock markets radically distorted the whole world’s financial markets. Traders started to perceive stocks as riskless, and soon forgot that markets are forever cyclical.
They shunned prudent portfolio diversification and sunk all their capital into levitating stock markets, quickly buying every dip. And they dumped everything else, including gold and silver.
This incredibly unprecedented shift of capital away from precious metals into the Fed-levitated stock markets was catastrophic. It led to epically-extreme gold-ETF selling in 2013’s second quarter, leading to gold plummeting 22.8% then!
That proved to be a hundred-year storm, gold’s worst quarter in 93 years! So everyone including American futures speculators figured gold was doomed to keep spiraling lower indefinitely.
Thus they aggressively borrowed all the gold futures they could and sold them, ballooning their shorts to that last record in early July 2013. Since gold had just plunged so drastically, there’s no doubt that the popular fear and bearishness then was far greater than it is today. Betting on gold falling farther looked like an easy sure bet. But it was anything but since futures short selling layed such a big role in that drop.
Every gold-futures contract controls 100 ounces of the yellow metal, which was worth $120k at $1200 gold levels back then. But the futures regulators only required traders to keep just over $5k of capital in their accounts to borrow and sell each $120k contract! That represented maximum leverage of 29 to 1, insanely risky compared to the decades-old legal limit in stock markets of 2 to 1. Such positions aren’t durable. If gold merely rallied 3.5% out of those extreme summer-2013 lows, fully-leveraged futures speculators would lose 100% of their capital risked. Anything beyond 3.5%, and they would have to throw additional capital in to maintain the required margin. So once gold inevitably started rallying again from the most extreme levels of despair we’ll see in our lifetimes, these leveraged futures speculators quickly rushed to cover.
The way short positions are closed in futures markets is by buying offsetting long contracts. The upside price impact from buying a long contract to close a short or buying a new long is identical. Over the next 16 weeks, American futures speculators bought 95.3k long contracts to cover their shorts. Despite one of its worst sentiment environments ever, gold still powered 18.2% higher in under 9 weeks on this short covering alone!
Short selling is very different from normal long selling since it must all soon reverse into guaranteed and proportional long buying. So a major price low in any market driven by extreme short selling is always short-lived. This has played out multiple times in gold in recent years, as this chart reveals. Speculators will borrow and sell gold futures, driving it down to a major low. But then they will rush to cover, and gold surges.
Gold has rarely faced a tougher scenario than the past couple years. The Fed-levitated stock markets destroyed the demand for critical portfolio-diversifying alternative investments, led by gold. The resulting extreme gold weakness devastated gold psychology, leaving it overwhelmingly bearish. On top of that, the US dollar rocketed parabolic since last summer, another product of the Fed’s epic market distortions.
Yet even facing such howling headwinds with everything stacked against it, gold still saw sharp short-covering rallies after American futures speculators’ shorts grew too excessive. This created a trading range of these positions in recent years as you can see in this chart, running from about 75k-contract support up to 150k-contract resistance. Speculators’ shorts returned to support multiple times in recent years.
And right after episodes when these leveraged downside bets on gold exceeded 150k contracts like they are at today’s record, major short covering soon ensued. This led to sharp gold rallies blasting 16.2% higher in 10 weeks on average. These are big gains anytime, let alone when everyone is hyper-bearish on gold.
And since speculators’ gold-futures shorts are so epic today, the next short-covering rally will likely be huge.
Even since 2013 in these surreal Fed-distorted markets, speculators have bought to cover their total shorts down to 75k contracts several times. The last short-covering spree ended in early February 2015 at 70.4k contracts, a buying frenzy that catapulted gold 14.2% higher in just over 10 weeks. So it is very conservative to expect speculators to once again buy down their short positions to return back to 75k support.
From their current record extreme of 179.0k, it will require a staggering 104.0k of long-contract buying to return to 75k. And since each contract controls 100 ounces of gold, this collectively represents 323.5 metric tons of buying on short covering alone by this single group of traders! That is a colossal amount of gold buying in a short period of time, several months on the outside. Short covering soon feeds on itself.
Today at $1150 gold, each futures contract is worth $115,000. Yet the minimum maintenance margin per contract is now only $3750. So futures speculators can run leverage up near 31x, astoundingly risky. At such levels, a mere 3.3% gold rally would wipe out 100% of the capital they risked! So once gold starts moving, these speculators have to rapidly cover to avoid catastrophic losses. So they buy aggressively. And their very short covering accelerates gold’s gains, putting pressure on the rest of the speculators who are not running minimum margin and maximum leverage. So they are soon forced to buy to cover too, putting even more upside pressure on the gold price. So once even a minor gold rally ignites a serious bout of short covering, it rarely stops until it has fully run its course. And today we are in for a massive one!
That 104k contracts of short covering necessary to return to recent years’ support of 75k again is the equivalent of 323.5 tonnes of gold. And it will all hit over several months or so. Let’s call it 3, since the average duration of short-covering frenzies in recent years is 10 weeks. That is 107.8t of additional gold demand monthly that doesn’t exist now. And according to the World Gold Council, that is wildly bullish.
The WGC’s latest figures showed average global investment demand in gold of 92.9t per month in the first quarter of 2015. So for the several months it takes to unfold, American futures speculators’ short covering alone will increase worldwide gold investment demand by an amazing 116%! This will fuel a sharp gold rally as always. At the recent-year average of 16.2%, gold would surge to $1335 in 10 weeks.
But I strongly suspect that gold’s imminent short-covering rally will be significantly larger coming from such extreme record levels of short selling. The bigger the short positions, the more buying is naturally required to unwind them back to reasonable levels. So instead of gold looking utterly hopeless today as everyone believes, it has an exceedingly-bullish setup. Major lows fueled by shorting are artificial and short-lived.
There are a couple more key observations from this gold chart before we move on to silver. Note that the gold price has had an incredibly-strong inverse correlation with American speculators’ total level of gold-futures shorts in recent years. When this short selling is temporarily adding futures supply, gold falls.
And when it reverses into buying, gold rallies. Speculators’ shorting is literally the whole story on gold recently!
With investors still missing in action thanks to the Fed’s gross market distortions, speculators are ruling the roost. But provocatively, gold has been relatively resilient despite their extreme shorting this year. Even in the midst of its worst time of the year fundamentally in terms of seasonal demand spikes, the gold price hasn’t fallen below its early-November-2014 lows despite speculators’ futures shorting being much higher.
That means there are buyers out there absorbing this excessive gold-futures selling. Imagine how much this latent demand will explode once gold rallies enough to convince these hardcore contrarians that things are finally changing. Gold is poised for a massive short-covering rally, almost certainly the largest one in recent years given the record extremes of shorts that have to be bought back. This is super-bullish!
And amazingly, the situation is even more extreme in silver futures. Speculators also just ramped their leveraged downside silver bets to their highest levels since at least 1999, and almost certainly ever. And unlike gold which barely edged out record shorting, today’s silver-futures shorting is far higher than the last record. So silver too is on the verge of a massive-if-not-record short-covering frenzy running parallel with gold’s.
In this latest CoT week, American futures speculators’ total short bets on silver soared to 81.6k contracts! This is astoundingly high, levels that defy all reason.
In recent years, these positions have returned to 27k-contract support no fewer than 5 times. Mean reverting to that same level from today’s extremes will require 54.6k contracts of short-covering buying. And at 5000 ounces per contract, that is a vast amount of silver.
We are talking about 273.0m ounces of silver that will be bought in the futures markets within several months or less. Assuming 3 months, this equates to marginal new buying that doesn’t exist today of 91.0m ounces per month!
According to the Silver Institute, average global silver investment demand in 2014 ran just 16.5m ounces a month. So this short covering alone would temporarily boost that demand by 552%!
Short-covering episodes in recent years have fueled silver gains of up to 32.6% in just over 8 weeks. And while silver prices also have a strong inverse correlation with speculators’ futures shorting, this relationship has moderated in the last year or so. I suspect the reason is sentiment plays a far-greater role in silver’s price levels than in gold’s. And silver’s sentiment is totally dependent on gold’s fortunes.
So silver is essentially slaved to gold, with traders always looking to gold’s price action for their silver trading cues. Silver can’t enjoy major uplegs unless gold is rallying and traders expect it to keep on climbing into the future. Obviously with gold sentiment so hyper-bearish in recent years, this necessary prerequisite to strong silver uplegs hasn’t existed. But sentiment is forever cyclical, bullishness will return.
A secondary reason silver’s short-covering upside price action has been muted in the past year is its lower leverage. At $15 silver each futures contract controls $75,000 of this metal, but the minimum margin is still $7,000 per contract. That works out to maximum leverage under 11x, far lower than the 31x in gold futures. Lower leverage means lower risk, which makes short covering somewhat less frantic.
But with speculators’ total silver-futures short positions so mind-bogglingly high, odds are the coming silver short-covering frenzy will really surprise to the upside. Of course investors and speculators can bet on these coming mean reversions of excessive futures shorting in physical gold and silver and their leading ETFs, the GLD SPDR Gold Shares and SLV iShares Silver Trust. But they will only pace the metals’ gains.
Radically-greater upside exists in the beaten-down gold and silver miners! Just this week, their leading index slumped to an astounding 12.1-year low. The last time gold and silver stocks were trading at these dismal price levels, gold and silver were trading near $350 and $5! These miners are truly priced at fundamentally-absurd levels today with gold and silver 3.3x and 3.0x higher. They will greatly leverage the metals’ gains.
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The bottom line is American futures speculators’ gold and silver shorts just surged to record levels. It was almost exclusively this marginal supply that recently forced the precious metals down near major secular lows. But borrowed futures are temporary artificial supply that must soon reverse into guaranteed proportional buying as they are covered. Thus excessive shorting is an exceedingly-bullish omen.
Even in recent years with gold and silver facing howling headwinds from the Fed-distorted stock and currency markets, the futures-short-covering episodes fueled large double-digit gains unfolding over a few months or less. And given today’s record levels of shorts, the next short-covering frenzy is likely to drive considerably-larger rallies. They will greatly improve sentiment, getting even investors interested again.
Adam Hamilton, CPA.