In a blog post a week ago I discussed why silver’s Commitments of Traders (COT) situation was nowhere near as bullish as it had been portrayed in numerous articles over the preceding two months. This prompted some criticism that involves a misunderstanding of how I use the COT data. Before I address the criticism, a brief recap is in order.

As stated in last week’s post, the enthusiastically-bullish interpretation of silver’s COT situation fixated on the positioning of large speculators (“NonCommercials”) in Comex silver futures. It was based on the fact that over the past two months the large specs had reduced their collective net-long silver exposure to its lowest level in a very long time, indicating that these traders had become more pessimistic about silver’s prospects than they had been in a very long time. This was clearly a bullish development given the contrary nature of speculative sentiment.

I then explained that two components of silver’s overall COT situation cast doubt on the validity of the bullish interpretation.

The first was that near important bottoms in the silver price the open interest (OI) in silver futures tends to be low, but in early-April of this year the OI hit an all-time high.

The second was that whereas the positioning of large specs in silver futures pointed to depressed sentiment, the positioning of small speculators (“NonReportables”) pointed to extreme optimism. This was evidenced by the fact that over the past two months these traders (the proverbial ‘dumb money’) had, as a group, accumulated their greatest net-long exposure in 9 years. It would be very unusual for a big rally to begin at the time when the ‘dumb money’ was positioned for a big rally.

The latest COT report showed minimal change in the positioning of the small specs. As illustrated by the following chart from goldchartsrus.com, their collective net-long exposure is down from its late-March peak but remains near the top of its 3-year range (and its 10-year range).

The main criticism of last week’s blog post was that the size of the total “NonCommercial” (large-spec) position is about 10-times the size of the total “NonReportable” (small-spec) position and therefore that what the “NonCommercials” are doing is an order of magnitude more important than what the “NonReportables” are doing.

My response is: not if the COT information is being used as a sentiment indicator, which is the only way I use it.

The reason it is useful to know the sentiment of the small traders in any financial market is NOT that these traders are the movers and shakers in the market. They obviously aren’t. If they were they wouldn’t be “small” traders and wouldn’t be classed as “NonReportables” in the COT reports. It is useful to know the sentiment of these minor players because as a group they tend to be wrong when they become extremely bullish or extremely bearish. They are the ‘dumb money’. As I wrote last week and repeated above, it would be very unusual for a big rally to begin at the time when the ‘dumb money’ was positioned for a big rally.

Not surprisingly, then, there was no big rally (or any rally worth trading) in the silver market over the past two months.

During March and April a number of articles appeared at precious-metals-focused web sites describing the silver market’s Commitments of Traders (COT) situation as extremely bullish. However, this unequivocally bullish interpretation overlooked aspects of the COT data that were bearish for silver. Taking all aspects of the data into consideration, my interpretation at the time (as presented in TSI commentaries) was that silver’s COT situation was neutral and that the setup for a large rally was not yet in place.

The enthusiastically-bullish interpretation of silver’s COT situation fixated on the positioning of large speculators in Comex silver futures. As illustrated by the following chart, over the past two months the large specs (called “NonCommercials” on the chart) first went ‘flat’ and then went net-short. This suggested that large specs had become more pessimistic about silver’s prospects than they had been in a very long time, which was clearly a bullish development given the contrary nature of speculative sentiment.

Chart source: http://www.goldchartsrus.com/

However, two components of silver’s overall COT situation cast doubt on the validity of the bullish interpretation.

The first is that near important bottoms in the silver price the open interest (OI) in silver futures tends to be low, but in early-April of this year the OI hit an all-time high.

The second and more significant is that whereas the positioning of large specs in silver futures pointed to depressed sentiment, the positioning of small specs (the proverbial dumb money) pointed to extreme optimism. This is evidenced by the following chart, which shows that over the past two months the small specs (called “NonReportable” on the chart) reached their greatest net-long exposure in 9 years. It would be very unusual for a big rally to begin at the time when the ‘dumb money’ was positioned for a big rally.

Chart source: http://www.goldchartsrus.com/

The upshot is that silver’s COT situation was not price-supportive at any stage over the past two months. This is mainly because the bullish implications of the unusually-low net-long exposure of large specs was counteracted by the bearish implications of the unusually-high net-long exposure of small specs.

[The following is an excerpt from a commentary posted at TSI last week]

The US economic expansion that began in mid-2009 has been much weaker than average, but, as indicated by the chart displayed below, it is also much longer than average. In fact, it is simultaneously the weakest and the second-longest expansion on record. Due to the advanced age of the expansion and the signs of weakness that have appeared over the past three months in economic statistics and the stock market, recession warnings are becoming more common. However, when we take an impartial look at the most reliable leading indicators of recession we arrive at the conclusion that these warnings are premature.

Chart source: http://realinvestmentadvice.com/bull-markets-actually-do-die-of-old-age/

The three leading indicators of US recession that we care about are the ISM New Orders Index (NOI), Real Gross Private Domestic Investment (RGPDI) and the yield curve. Not one of these indicators is close to giving a recession warning, which is why we say that the increasingly-common warnings of recession are premature.

The NOI, for instance, has declined each month since making a 13-year high in December-2017, but it remains far above the level that it would have to drop below (the red line on the following chart) to warn of a recession.

Also, there are not even tentative signs of major trend reversals in either RGPDI or the yield curve. That’s because last month the US yield curve became its flattest in more than 10 years (a recession is signaled by a major shift from flattening to steepening) and because the data published at the end of last week revealed that RGPDI hit a new all-time high in Q1-2018. RGPDI’s trend generally reverses downward at least two quarters prior to the start of a recession.

Note that the vertical red lines on the following chart mark the starting points of the last two recessions.

Based on the latest data, we roughly estimate the recession start-time probabilities as follows:
– Q2-2018: 0%
– Q3-2018: 10%
– Q4-2018: 30%
– Some time in 2019: >80%

The main reason for our high 2019 recession probability estimate is the decline in the G2 (US plus euro-zone) monetary inflation rate illustrated by the following chart. The inflation rate bounced in March, but it’s likely that the preceding decline was large enough to bring the artificial boom to an end.

I update gold’s true fundamentals* every week in commentaries and charts at the TSI web site, but my most recent blog post on the topic was on 20th March. At that time the fundamental backdrop was gold-bearish. What’s the current situation?

The fundamental backdrop (from gold’s perspective) is little changed since 20th March. In fact, it has not changed much since early this year. My Gold True Fundamentals Model (GTFM), a weekly chart of which is displayed below, turned bearish during the first half of January and was still bearish at the end of last week. There have been fluctuations along the way, but at no time over the past 3.5 months has the fundamental backdrop been supportive of the gold price.

It’s possible for a tradable rally in the US$ gold price to get underway at a time when the fundamental backdrop is not gold-bullish, but for this to happen the sentiment situation as indicated by the Commitments of Traders data would have to be very supportive or the US$ would have to be very weak. Currently, the fundamental backdrop is bearish, the sentiment situation is neutral and the Dollar Index has just broken out to the upside. Therefore, as things stand today there is no good reason to expect that a substantial gold rally will get underway in the near future.

Based on how I expect the fundamentals to shift over the weeks ahead my guess is that a substantial gold rally will begin from a May-June low. However, there is more to be lost than gained by ‘jumping the gun’ and buying a short-term trading position now in anticipation of such a rally.

*Note that I use the word “true” to distinguish the actual fundamental drivers of the gold price from the drivers that are regularly cited by gold-market analysts and commentators. According to many pontificators on the gold market, gold’s fundamentals include the volume of metal flowing into the inventories of gold ETFs, China’s gold imports, the volume of gold being transferred out of the Shanghai Futures Exchange inventory, the amount of “registered” gold at the COMEX, India’s monsoon and wedding seasons, jewellery demand, the amount of gold being bought/sold by various central banks, changes in mine production and scrap supply, and wild guesses regarding JP Morgan’s exposure to gold. These aren’t true fundamental price drivers. At best, they are distractions.