Gold or Not to Gold – Part 2

Updated: Dec 6, 2019


Gold or Not to Gold – Part 2

In the last part we discussed what affected the gold demand, supply and price since financial crisis of 2008. In this part we shall discuss what to expect from the market and how to use it as an investor. We shall be looking more at technical analysis and price action before forming a bias on gold.

Below is the Gold Futures continuous contract (/GC) chart for past few years. Between 2008 and 2009, gold made several attempts to break above $1000 level- a significant psychological barrier. After breaking above $1000 mark in 2009, gold continued to rally to $1900. Whatever were the fundamental reasons that we discussed in Part 1, the core argument is that from economics 101 – significantly more demand than supply for the yellow metal.

Fig. 1: NYMEX Gold Futures continuous contract price, weekly chart (Source: ThinkorSwim charting)

In April 2013, after gold broke down below $1600 level, it has been trading in a contracting descending triangle, as seen in the figure above. The downward trend is intact, as it is posting lower highs followed by lower lows.

However the length of upswing and downswing is decreasing as gold gets closer to $1000 demand area. It is also an indication that there are more sellers, but their strength is reducing. At the same time, there is significant unsatisfied demand that is waiting at the price band $900-$1000 which is waiting for the price to get there. For gold to continue in downtrend, fresh supply has to get into the market to satisfy this demand. Unless that happens, we can expect the trend to reverse, with a breakout above this triangle.

To get better idea who is trading gold, we look at the following chart – a near term view of gold price action with commitment of traders (COT) for past three years.

Fig. 2: Gold futures and Commitment of Traders (COT)

For those unfamiliar with COT[i] – The Commitment of Traders (COT) is a report published by U.S. Commodity Futures Trading Commission (CFTC) every Tuesday where they report breakdown of open interest held by various types of traders. These types include[ii]

  • 1. Commercial traders consisting of Producer/Merchant/Processor/User and Swap Dealers (Red Line)

  • 2. Non-Commercials traders(or Large Speculators) consisting of Managed Money and Other Reportables (Green Line)

  • 3. Small Speculators (Blue Line)

We pay more attention to the hedgers. These are the traders who usually deliver or receive physical gold. They are the ones who really move the markets.

In the above chart (Fig. 2) take a closer look at the gold price action inside the descending narrowing channel (or descending triangle). You will notice that net commercial holding is usually negative suggesting that they are short on gold futures (because the producers hedge their physical holding with futures). Whenever commercials’ position gets closer to zero, a new rally starts with increase in their short position. See the highlighted parts in the chart. Not surprisingly, these the close-to-zero holding happens at a time when price trades at the bottom of the channel (or close to that). This is very repeatable behavior over past few years.

More importantly –commercials whose net position was close to zero for past few weeks during Dec’15 have just started to increase short position. This is when the gold price was at the bottom of the channel. We shall see one or two such rallies in near future until the price slides to $1000 demand zone. However the real rally will start sometimes thereafter.

Think of this technical analysis in context of the global macroeconomic picture. Though we had rally in stock markets for some time, we are seeing signs of slowdown everywhere. Most of the energy and commodity prices are on downslide. China, the second largest economy has slowed down like never before. There is fear of another real estate bubble burst in many countries — such as China, India, Canada, Australia and many emerging markets. Europe, which has unending debt problems fears disintegration. Rising Fed rates may scare investors as they have done in the past, prompting them to take money out from financial markets. All this negativity has already started showing its effect on financial markets with rising bond yields and dropping equity markets.

And specifically for gold – the supply of fresh gold is expected to shrink as many of the largest producers are expected to slow down in coming years. We discussed this in part 1. A confluence of all these supply-demand factors happens around a time when gold price gets close to historically important number of $1000, watched by all the market. No surprise if we see gold rising again in coming months.

And this would bring cautious investors back to gold again, at a time when gold gets close to $1000 magic number. Our outlook is – a smart investor should reduce exposure on equities, keep an eye on gold as it enters the demand zone, and build position slowly. ETFs such as GLD (gold), GDX (gold mining) or gold futures would be a good place to start if you do not wish to put money in less liquid physical gold.

References

[i]The Commitment of Traders Report (http://www.cftc.gov/MARKETREPORTS/COMMITMENTSOFTRADERS/INDEX.HTM)

[ii] The Commitment of Traders Reports explanation on barchart.com (http://www.barchart.com/futures/cot.php)

#GOLD

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