Speculative Traders Load Up On Gold - Is Gold Overbought?

by: Hebba Investments

- For eight straight weeks gold longs have increased their positions while gold shorts have decreased their positions.

- Based on historical data, we have never seen eight straight weeks of declining shorts and increasing longs.

- Gold seems short-term overbought, and though we maintain our physical and core positions, we think it's time to take some profits.

- We think at this point silver and palladium offer much better exposure to financial chaos and potential government stimulus than gold.

In the latest Commitment of Traders (COT) report, we saw for the eighth(!) consecutive week gold longs (NYSEARCA:GLD) building up their positions while short speculators abandoned theirs.

Speculative long traders are now at their highest nominal levels since last October, while the ratio between longs and shorts dropped to around 16% - the lowest levels since February 2015.

We will get a little more into this but before that let us give investors a quick overview into the COT report for those who are not familiar with it.

About the COT Report

 The COT report is issued by the CFTC every Friday, to provide market participants a breakdown of each Tuesday's open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. In plain English, this is a report that shows what positions major traders are taking in a number of financial and commodity markets.
Though there is never one report or tool that can give you certainty about where prices are headed in the future, the COT report does allow the small investor a way to see what larger traders are doing and to possibly position himself accordingly. For example, if there is a large managed money short interest in gold, that is often an indicator that a rally may be coming because the market is overly pessimistic and saturated with shorts - so you may want to take a long position.

The big disadvantage to the COT report is that it is issued on Friday but only contains Tuesday's data - so there is a three day lag between the report and the actual positioning of traders. This is an eternity by short-term investing standards, and by the time the new report is issued it has already missed a large amount of trading activity.

There are many different ways to read the COT report, and there are many analysts that focus specifically on this report (we are not one of them) so we won't claim to be the experts on it. What we focus on in this report is the "Managed Money" positions and total open interest as it gives us an idea of how much interest there is in the gold market and how the short-term players are positioned.

This Week's Gold COT Report

This week's report shows speculative traders once again cutting their short positions for the eighth straight week, while speculative longs continue into the gold trade.

Two weeks ago gold longs were entering record territory in terms of consecutive weeks of adding to their positions, we have entered uncharted territory now as both gold longs and shorts move in the same direction for EIGHT consecutive weeks. We have never seen this before in history of the published numbers dating back to 2006 - though we do note that gold longs have increased their positions for eight straight weeks in the midst of the GFC in 2007.

The difference here is that it is both shorts and longs moving in opposite directions consecutively - which suggests quite a bit of group-think.

The prior instance of eight consecutive weeks of speculative long increases resulted in the following:

It is interesting to note that there was no real pullback after the consecutive increases and gold continued to rise another 20% to over $900 per ounce from the mid-$600's. Additionally, the long-short ratio was all the way down to 3-5% which is a significant amount lower than the current ratio of around 16% - again suggesting that gold could continue to move much higher despite the recent rise in speculative longs.

What Does This Mean For Investors?

While historically there are reasons to be bullish based on the COT performance and we are still long-term believers in gold and see no reason to sell physical or core positions, we do feel in the short term that positions are a bit too bullish. Records could continue to be broken, but in this case we believe that it is much more likely for a good pull-back in gold rather than a continued rise.

This opinion of ours is only strengthened by the weakening demand in both the Indian (with record-breaking discounts on gold) and Chinese markets. While gold certainly continued to drop in the past despite strong physical demand in these markets, we don't think it's something we want to continue to bet on.

We want to emphasize that despite our belief that gold is significantly overbought in the short term, we think there are plenty of reasons to be bullish on gold in the long term so this is not a "get outta town" call on gold. In fact we think there's an elevated chance for financial stress and chaos which would trump this overbought status on gold.

That is our dilemma - we believe in gold in the medium/long term so we don't want to abandon positions, but ex-financial chaos or surprise inflation, we think there's some downside here.

Thus what we are doing is selling some of our tradable miners and gold positions and re-allocating many of those positions to silver (NYSEARCA:SIVR) and palladium (NYSEARCA:PALL). We have gone over our reasons to like both of these metals in a previous piece, but in a nutshell the silver-to-gold ratio at 83 is extremely high and if we have a financial chaos type event, we think investors will choose to buy silver instead of gold to higher degree than they have already. Palladium represents a nice play on inflation and reflation as its industrial use allows it to benefit if governments try to stimulate via environmental friendly ways (cutting down on auto emissions) and the market seems to be in structural deficit but is being hit by investor liquidations.

What could go wrong with our short-term call? If something in the system breaks or we see a gold supply shortage issue, then the speculative positioning on the COT report really will mean nothing as the price should rocket. That's why we stress investors should maintain their core and physical gold positions despite the short-term overbought nature of gold. But in the short term assuming none of these events occur, we see gold pulling back a bit as traders lock in gains and shorts re-enter the market.

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