Gold Corrects, But Speculators Hold Fast

We recently commented on the commitments of traders in gold, arguing that the data indicated a near term correction in gold was likely. This correction has subsequently happened, and has so far held above the crucial technical level of $1290. Interestingly, speculators have only relinquished a small amount of their net long position in gold futures (less than 10,000 contracts last week), a sign that there were not only speculative sell stops in the market, but also new buy orders at lower levels.

We take this as a good sign, because growing speculative interest is a sine qua non for a strengthening gold market. As noted on several previous occasions, our view of speculator activity in the market is a bit more nuanced than the interpretation one usually comes across. Specifically, while a large and growing speculative net long position certainly increases the risks of a correction, it is not true that it is bearish per se. It can become a potentially bearish datum at extremes, but the current position is still far from extreme. For gold to rally, speculators must become more bullish and increase their net long exposure.

Readers who have followed us for a while will recall that we were worried last year about the growing gross short position held by large speculators in the gold futures market, which we interpreted as a bearish datum. The current large speculator gross short position is still fairly extensive historically at over 57,000 contracts, but it is no longer at the in our opinion far more worrisome 90,000 contracts seen on several occasions in 2013.

After correcting sharply in the course of two trading days (by sheer coincidence in parallel with the Fed chair's testimony, during which gold always seems to correct), gold has apparently established a foothold above the $1300 level. Unfortunately we cannot know the main motives of the buyers. If they are mainly motivated by geopolitical events, then there is a danger that gold will sell off again once those short term triggers disappear.

Note that geopolitical events are not a good reason to buy gold, unless one happens to live in the country where such an event takes place (as one is then able to bribe border guards and has wealth in highly portable form). Only if war triggers an inflationary policy – such as was the case with the Iraq war and the Vietnam war – can one regard negative geopolitical developments as relevant for the gold price. This frequently happens, but the current events seem unlikely to have any effect on US monetary policy.

Gold corrects a bit, but support near the apex of the previous triangle holds – click to enlarge.

Given that we don't regard the geopolitical situation as relevant for gold, what is actually relevant? We believe that there are a number of subtle signs in the markets that indicate investors are becoming more worried about the long term consequences of the central bank policies implemented in recent years. Not only is there growing weakness in many individual stocks and sectors (the stock market's advance seems ever more narrow, with especially small caps showing relative weakness), but credit spreads are now clearly moving in the “wrong” direction as well – as treasury bonds keep rallying and junk bonds have recently begun to weaken.

Below is a chart of the TLT-HYG ratio demonstrating this (we could also have used the TLT-JNK ratio, it looks roughly similar). Well before economic and financial problems become glaringly obvious, there are always signals of this sort evident in the markets. They are as a rule universally ignored. Soemtimes these signals are indeed 'false alarms' based on short term corrective activity, but one would do well to heed them in a market that has reached extremes of sentiment and valuation and is supported by record high leverage.

The gold market in turn is usually extremely sensitive to such changes in perceptions, and often discounts future economic developments (and the monetary policy reaction to them) well in advance. 

The TLT -HYG ratio, a proxy for credit spreads. When this ratio rises, it indicates that credit spreads are widening, a sign of waning economic confidence – click to enlarge.

Waning economic confidence influences both credit spreads and the gold price.

Gold Stocks – Relative Strength Continues

In light of this, it is perhaps no surprise that the character of the action in gold stocks has clearly changed as well. Specifically, their recent relative strength versus gold has continued, in spite of the recent sharp correction in the gold price.

The chart further below shows the HUI as well as the HUI-gold ratio. The latter has just reached a new high for the move. The current action in gold stocks is basically a mirror image of the action near the peaks of gold and silver in 2011.  It is the second time this year that the sector has entered into a phase when it is outperforming gold, but in a sense the current period is even more convincing, as it was preceded by a false support break.

While we have no crystal ball and can never be entirely certain about what will happen in the future, the odds that the gold and silver lows put in place in 2013 will hold have improved considerably (see also our previous comment on the double divergence at the lows). It must be kept in mind that during a transition phase from bear to bull market and vice versa, there will as a rule be an unusual amount of volatility. Often the market will attempt to “buck investors off”. We discussed this phenomenon previously in the context of the initial rally off the 2000 lows. The reason for this is that skepticism is still relatively pronounced in the transition phase (our most recent remarks on how much skepticism there still is can be found here). Traders will be much quicker to pull the trigger in terms of profit taking and will tend to employ very tight stop loss levels.

It is inherently difficult to differentiate between this “transitional volatility” and the return of bearish conditions, so one has to rely to some extent on the evidence gathered along the way. With regard to this, we have documented a growing catalog of both technical and fundamental evidence in recent months that supports the case that the market has bottomed and that at the very least a new cyclical bull market is now underway.

The HUI (daily) and the HUI-gold ratio. The ratio remains in an uptrend, which is usually a bullish sign – click to enlarge.

Conclusion:

How gold stocks react to corrections in the prices of gold and silver usually provides valuable information. While the sector will continue to be volatile and will occasionally throw doubt on the idea that a new uptrend has begun, the action since the lows of last year continues to indicate that a low of some significance has in fact been put in. More and more evidence in support of this idea has emerged in recent months, with the recent widening of credit spreads representing yet another piece of the puzzle.

Charts by: StockCharts, BarCharts