Detailing the Necessity of Speculative Interest in Gold Price Advances

A common refrain that we often read nowadays comes from "analysts" who seem to believe that they are able to correctly forecast tops in the gold, and/or silver markets from peering into the Commitment of Traders reports.

The thinking generally goes along this line - "speculators are holding their largest net long position since such and such time and therefore gold is undoubtedly ready to top out. "

One sometimes gets the distinct impression from reading their comments that having a large amount of speculators in a market is some sort of curse that plagues a market and is to be avoided at all costs.

Here's a news flash - markets cannot move higher WITHOUT speculative interest and they cannot mount strong sustained up moves without significant speculative interest in buying them. In other words, speculators drive our commodity markets. It is their buying or their selling which push markets up or down.

Yes, there are instances in which we get what is termed a "commercial signal failure" which is generally the result of some event or occurence which significantly unbalances the fundamental supply/demand equation. Such events, which I might add are not all that frequent, will then find commercials, end users or producers, etc, being forced into huge amounts of short covering or fresh buying or fresh selling, depending on the market and the event occurence, which then become the main drivers of that market for a period of time.

Think mad cow scare some years ago in Canada or the outbreak of what was stupidly termed, "swine flu' (H1N1 virus) or a crop freeze or drought.

Generally speaking, however, it is speculators who move the markets.

As you look at the following chart, please note that there is a comparison made of the gold price and the total number of net long positions being held by Managed Money accounts. Note that I have not included the general public or the CTA's or other large reportables merely for the sake of simplicity.

Look at the areas within the two ellipses. Back in July of last year, gold began a stunning advance that took it from near $1150 all the way to $1375 in the matter of just 3 months' time. If you note the navy blue line which details the net long position of managed money, you can see that it increased sharply also, moving from just above 150,000 to nearly 230,000 or so. It was that buying by this category of speculators that drove the gold price up over $225/ounce.

Now note the second ellipse and you can see where the gold price declined from over $1420 down towards $1310.  As you can see by examining the decline of the managed money interest in the long side of the market, the price went south right alongside their heavy exodus from the market. We are using approximates here but the decline was from near 175,000 in late December/early January to about 130,000 in late January. Another way of saying this is that managed money selling out of longs took the gold price lower.

Now note the area between the two ellipses (Oct 2010 - early Jan 2011)showing the point where the managed money net long position began declining in earnest and the price of gold which somehow continued rising.

What has going on in the market during that time frame was that the smaller, undercapitalized public were jumping on the gold bandwagon alongside some of the CTA' and other large traders and ended up buying the top of the market. There were also Swap Dealers who were covering or buying back existing short positions during this same time frame. The Managed Money was selling out while the general public was buying in alongside of the short covering mentioned by the Swap Dealers.

As you can see from the subsequent price action in gold, that buying was enough to take it higher but it was not what I would consider "quality buying". Once the managed money guys lost interest in the market, the biggest gains were already pretty much over. The buying from the other categories mentioned above was good for another $55 dollars or so before it ran out of steam.

Now look at the third or final ellipse drawn in red. YOu can see that as Managed MOney began rebuilding longs in this market, the price of the metal moved higher again and well as stopped moving lower. Once they were done selling out of their longs, there was insufficient firepower on the short side to take the market any lower.

The point in this is simple - Managed Money holds the key to the paper gold market. If they rebuild their longs - price will rise higher and sharply higher depending on the size of that build. If they were to begin liquidating again for any reason, price will head lower at the Comex.

For gold to therefore take out the first resistance level above $1370, which comes in  near $1380 - $1385, and then ultimately make another run towards $1,400, the hedge funds are going to have to get reinterested in gold.

Some of the pressure in gold right now is tied to the fact that a fair amount of the money at the disposal of these funds is moving into the equity markets attempting to catch the wave higher in stocks coming off the Fed's funny money scheme euphemistically termed, "Quantitative Easing". The "improving economy" theme (How many more of these terms do we have to deal with - remember "Green Shoots") has drawn off some speculative interest away from gold in favor of equities for the time being.

Gold will need a trigger or something on the monetary front such as further fears involving European Sovereign Debt woes, spreading instability across the mid-East, lousy employment numbers necessitating further and more extended QE, a sharper fall in the Dollar, another fresh surge higher across the commodity complex, etc. to rattle the cages of the "improving economy" crowd to entice the hedge funds back into a more aggressive stance in gold. So far we have decent buying coming in at the lower levels - a lot of which I might add is tied directly to the very things I just recited - which has shored up a floor of support near the $1320 level which is a definite positive. We do need however to see the type of aggressive build in managed money net longs once again to see this market kick into a higher gear.