For Gold Bugs, the Fun May Soon Be Over

All good things must come to an end. For the gold bugs, the fun might soon be over.

After trading in a relatively tight trading range for years, the gold futures market breakout was met with buy stop-loss running. Specifically, the election of buy stop orders to exit positions for those short the market and to enter fresh long positions. Buy stop orders are, and clearly where, also used by sidelined traders looking to get into long gold positions on a break above resistance.

Similarly, gold prices were boosted by the short-covering of traders who have likely enjoyed selling the rips in gold for years without too much trouble. Gold futures also benefited from the FOMO (fear of missing out) trade as investors who had given up on the metal months ago scrambled to gain exposure once again.

Finally, the precious metals rally has been sparked by a relentless barrage of concerning headlines and tweets, but there is a probable chance that most of the bad news is behind us. If so, the gold rally will fizzle as buyers become scarce.

Source: Barchart

The COT report (Commitment of Traders) issued by the CFTC (Commodity Futures Trading Commission) revealed the excessive nature of last week's gold rally.

According to the stats that were released Friday, but measured on Tuesday of last week, there are roughly 290,000 net long positions in gold futures held by large speculators. Our guess is the reality is even higher given the fact that gold settled near the weekly highs on Friday. Thus, it is conceivable to assume the net long position is at, or near, 300,000.

The all-time high, which occurred in mid-2016, was in the 310,000 ballpark and we all know how that ended. Gold eventually fell from $1,380 to $1,120 as the overcrowded trade unwound itself.

To put these figures into perspective, during the 2011 metals bubble large speculators were holding somewhere between 230,000 and 240,000 net long contracts, so we are already well beyond that level of bullishness.

Knowing this and being aware of the historical price action that has occurred on previous occasions of overzealous gold buying, we must believe the buyers are probably running out of ammo. In short, if all the bulls are already in the market positioned long, eventually, there isn't anybody else to buy. Naturally, the lack of buyers creates a vacuum in which prices tend to collapse.

Source: QST

Gold and the Dollar

The negative relationship between gold futures and the U.S. dollar index is one that most people accept as a given. However, occasionally the relationship alters to reflect abnormal market conditions. In this case, the interest-rate differential and economic prowess of the U.S. economy relative to nearly all other areas of the globe have resulted in a mass influx of investor dollars into the U.S. currency. Those funds are then being allocated to risk assets such as gold, Treasuries, and stocks. As a result, gold and the greenback have been traveling in the same direction, as opposed to the usual opposite direction.

While this relationship can occur in the short run, it is unlikely that it can remain in the long run. Accordingly, it seems reasonable to assume either gold or the dollar will need to soften to get back to some semblance of normalcy.

Source: QST

The RSI, Relative Strength Index, oscillator applied to a weekly chart tells a story of an overheated rally in desperate need of a pullback. In fact, the RSI is above 70 for the first time since the 2011 peak. While the reversal could be messy, we do believe the bears have an edge overall.

Markets, in general, can rarely survive an RSI reading over 70 without significant corrective trade. Also, we see trendline resistance near $1,530ish in December gold. The market did poke above it last week but quickly retreated.

For the gold rally to continue, we would need a consistent stream of bearish economic news. Further, the market's expectations of multiple rate cuts from the Fed will need to become a reality for the market to hold gains, and we doubt the Fed will deliver as aggressively as the markets are pricing in.

Bottom Line

If you are long gold or thinking of getting long, beware of the potential for a sharp reversal and protect profits. If you are short the market, patience could be a virtue but make sure your risk is reasonable -- gold is a market that shows little mercy to those on the wrong side.

At the time of publication, Garner was short October gold $1,575 call option and long September $1,575 call option.

*There is a substantial risk of loss in trading commodity futures, options, ETFs. Seasonal tendencies are already priced into market values.