Hesitant Longs, Fearful Shorts, And What Friday's Move Means For The Gold Market

by: Hebba Investments

- The latest COT report showed speculative gold longs selling while shorts slightly increased their own positions.

- Friday's move should remind gold investors that algorithms are firmly entrenched in the gold markets.

- While we like the long-term fundamentals of gold, we still expect a major pullback in the gold price to below $1,300.

In the latest COT report, we saw a decline in the gold long speculative positions and a rise in short positions in both gold and silver. Interestingly enough, gold commercials closed a significant number of short contracts for the week, which in the past has been a more bullish indicator. Looking back over the past few weeks, this was the fourth week out of the past five weeks where we saw a significant decline in speculative gold longs which may suggest a little bit of steam has been taken out of the market. While shorts have not taken advantage of this to boost their own positions by significant amounts, it is something to be wary of.
We will give our view and will get a little more into some of these details, 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 investors a way to see what larger traders are doing and to possibly position their positions 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 showed speculative gold longs reversing last week's rise and declining for the fourth week out of the past five weeks with a 9,934 contract decline. While shorts slightly increased their own speculative positions, they have had very little courage over the past few months, and this week was no different as they increased their positions by a mere 1,582 contracts despite the larger decline in longs. That's a far cry from the 10-20 thousand increase in short contracts we used to see in 2015.
While that can be interpreted as a positive by the gold bulls as shorts have little in the way of conviction, we think it is something to be wary of as it also means many shorts that we have seen in the past are currently sidelined and there's plenty of dry powder left to jump in. That, paired with declining longs, could lead to a significant down week for gold similar to what we saw in May (specifically the week of 5/24) - and that was at net levels less extreme in terms of their bullishness than what we see now.

Moving on, the net position of all gold traders can be seen below:
The red line represents the net speculative gold positions of money managers (the biggest category of speculative trader), and as investors can see, speculative traders have slightly pulled back from all-time high positions and are now only net long by around 256,000 contracts.
Interestingly enough for the gold bulls, producer/merchant positions increased to a slightly more bullish level for the week as they covered short positions, but we are still a far cry from what we would term "bullish commercial positions".
As for silver, the week's action looked like the following:
The red line, which represents the net speculative positions of money managers, saw a slight pullback as shorts increased their positions by a little more than 2,500 contracts while longs decreased their own positions by a little over 750 contracts. Not much interesting action here as silver pretty much followed the trajectory of gold for the week.
Our Take and What This Means for Investors
We would not be doing our jobs properly if we didn't mention Friday's up and down session in gold as it rose significantly only to fall back after the European close.
While some blogs are throwing out the conspiracy theory card, we think that this is simply an example of how traders play in the gold market and take advantage of opportune times to cause massive spikes or drops in the gold and "run the stops". Right or wrong that's simply the nature of markets in 2016 so investors shouldn't be surprised to see these kinds of moves, especially considering most of this trading is done by HFTs and not fundamental based traders.

Which brings us to an important point and why investors should be really cautious in these precious metals markets. We know that there are algorithmic traders out there with massive amounts of cash just looking for an opportunity to move markets to the point where it causes short-covering or longs jumping ship - which gives these algorithmic traders an opportunity to cash in on the move by buying/selling to these panicked shorts/longs.
Based on the latest COT reports, we are still extremely overbought in the gold and silver markets and this makes us concerned that we could see a big spike downwards as these algorithmic traders take advantage of where the most opportunity is to panic position holders.

In this case, we believe it's the longs that are most exposed and ready to panic as they are significantly above historical norms and still very close to record-breaking levels.
The thing that can prevent something like this is if we saw fundamental based buyers step in and take advantage of price drops. In this case, that would be physical buyers, who have been mostly absent from the gold market over the past few months and investment funds pushed the price of gold higher and higher. In fact, physical demand is extremely week and recently Bloomberg highlighted that gold demand in places like the Middle East is the lowest on record.
Thus, the "path of panic" for algorithmic traders to cause the most havoc (and personal profits) is down and, with weak physical demand, any unloading of gold by gold ETFs may be met with little interest in the physical market - driving the price down further. Thus, we maintain our position that we expect a significant sub-$1,300 pullback in the gold market and think investors should wait to purchase gold positions in ETFs such as the SPDR Gold Trust ETF (NYSEARCA:GLD), the ETFS Physical Swiss Gold Trust ETF (NYSEARCA:SGOL), and miners such as Randgold (GOLD) and Barrick Gold (NYSE:ABX).

We want to emphasize, though, that we think that drop will be a very good buying opportunity as we believe a new paradigm in economic policy is about to take hold of markets.

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