September 29, 2003

COT is an anacronym for Commitment OTraders in the Futures markets. The Exchange analyses the various market participants into 3 categories, Large Commercials/Hedgers, Large Speculators and Small Speculators. Historically the Commercials/Hedgers have been on the correct side of the market movements while the Speculators have been wrong, especially when their open positions have reached extreme levels.

In the gold market, the Commercials/Hedgers have tended to be short while the Speculators have been long. When their respective total positions have reached extremely high levels, the market has often been at a peak. This has given rise to the popularity of the COT indicator. This indicator, it is alleged, has never been wrong. I have not verified this assertion but it may well have been true for the past 20 to 25 years, the period for which data is available.

Bull markets climb a "wall of worry" and the latest worry is that the COT figures have "gone off the page" with the Commercials/Hedgers net short position reaching an all time record high and the Speculators long positions similarly at record levels. Naturally this has raised concerns that the gold market may be on the verge of a big decline if this indicator maintains its record of highlighting market peaks.

The question is whether this will happen or whether we will witness the demise of this indicator, in other words a COT death?

There are sound reasons for believing that things are about to change. The data available over the past 20 years and the signals developed from the resulting market action all occurred during a period when the primary trend of the gold market was DOWN. In other words, the shorts were invested in harmony with the primary bear trend and the longs were invested against the primary trend.

If the gold market is now subject to a primary BULL up trend then all the guidelines and signals developed during the BEAR market may be of no significance whatsoever. There are many indications that gold is in a new bull market - from fundamentals (paper currencies being printed into oblivion), technicals (20 year down trend broken and a new up trend firmly established) and, on my reading, the Elliott Wave Principle (EWP) confirming a new bull market.

The open position in the Comex gold futures at last count exceeded 296,000 contracts. With a contract size of 100 ounces, this means that the respective total long and short positions amounted to 29.6m ounces. With 99.9% of trades on Comex being settled in cash, these huge positions are effectively at a standoff. The longs must eventually sell to close their positions while the bears must eventually buy in what they have already sold.

Most trading on Comex is done on small margins so a $10 down move in the gold price could result in the longs being called upon to produce extra cash of $296m or have their positions forcibly sold at market. Similarly a $10 rise in the gold price would result in the shorts receiving a $296m margin call or be faced with a forced buy-in of their positions. Movements in the physical market produce the price changes that create these pressures for the participants on the wrong side of the market.

During the 20-year gold bear market the primary trend of the physical gold market pushed prices down which caused the long positions to come under increasing pressure. The shorts made a bundle. IF we are in a new gold BULL market, then the physical market will now provide upward impetus to the gold price that will in due course squeeze the short positions.

In a BULL market the shorts, be they large commercials/hedgers or the Queen of England, will eventually be blown away by the huge tidal force of the primary underlying bull trend. In a BULL market the bears get killed and the longs make a killing. The reverse happens in a bear market.

Recently I watched the incoming tide flow up the river Thames in London, England. It was an awesome sight. The strength of this huge surge of water overpowered the out-flowing river and sent a massive body of water upstream threatening to top the riverbank. I watched a small tree being driven upstream as if it were a matchbox.

It occurred to me that someone rowing down the Thames when the tide and the river were both flowing out would cover a mile in a few minutes. The same rower attempting to row against the tide might row for an hour and not even get close to covering a mile. In fact the rower would eventually tire and be swept up the river by the force of the incoming tide.

Anyone drawing conclusions about how far they could row down the Thames would inevitably come to false conclusions if their measurements were only made while the tide was ebbing. Their calculations would be rendered worthless when the tide changed and started to flow upriver in earnest. This is an apt analogy for the COT indicator where all the measurements and signals that were formulated during the bear market when the tide was flowing out are likely to be proved to be worthless when the bull market tide flows in, as it appears to be doing now.

In my recent article on the EWP and gold I suggested that a PM gold fixing above $382 would enhance the probability of a move to about $424 without a serious correction. This past week the PM gold fixing rose to a high of $390.70 on Thursday 25 September before correcting to $382.70 the next day. We thus have a bullish confirmation for the gold market.

When I referred to a "serious correction", I meant a correction of $25-$30, the sort of correction that I anticipate will occur once gold has reached the approximate $424 level.The current correction should not be more than $18 (basis the London PM fixings) from the $390.70 peak giving a probable low of about $373 before embarking on a rise to approximately $424. This is still my expectation. The forecast of a rise to $500 after the $25-30 correction from $424 is still valid. From $500 a more serious correction of about 16% is likely.

There is one remaining EWP potential negative short-term development. It is still possible that the correction that started in February 2003 at $382 is not yet over. There remains the possibility of an EWP "flat" correction, i.e. where the B wave rally slightly exceeds the previous peak before declining in a C wave to near the low of the A wave.

To put some numbers on this, the A wave would be the drop from $382 to $320 from February to April 2003. The B wave would be the rally from $320 to last Thursday's $390, to be followed by a C wave decline to somewhere approaching $320. Thereafter the bull market would resume in earnest. The first indication that this "flat" correction to $320 might be developing would be the current correction exceeding $25, i.e. a PM fixing below $365.

An ongoing rally producing a PM fixing above $390.70, combined with new highs in the Comex futures above $395 should be sufficient to weaken the odds, if not totally eliminate, the possibility of the "flat" correction occurring.

Finally, to complete the EWP analysis, the level at which we would have to abandon the bullish case has now risen from $309 to about $320. A PM fixing below $320 would increase the odds of a further bear market down move of substantial proportions occurring.

Returning to the consideration of the COT position, it is useful to remember that the bears putting out the short positions are as human as we are and subject to the same frailties. It is thus likely that after 20 years of being right and reaping a fortune out of being short the gold bear market, that these people have possibly become over-confident and maybe a touch arrogant. It is unlikely that they will see the problems developing for their short positions that are now arraigned against the primary trend of the market until it is too late.

The bears will do what they have done in the past, put out even more shorts. This is the Nick Leeson syndrome, the technique that brought Baring Brothers bank to its knees a few years ago. Fighting the primary trend of a market is the sure fire road to bankruptcy - and a COT death.

Alf Field

Comments may be sent to the author at: [email protected]

Alf Field was born and raised in South Africa. He is a Chartered Accountant by training. Together with a partner, he started his own funds management business in 1970 in Johannesburg. In August 1971, when the USA stopped converting US dollars for gold at $35, Alf perceived a major opportunity to buy large quantities of gold mining shares personally and for clients. In 1979 he migrated with his wife and four children to Australia. He is currently a self-funded retiree who manages his own portfolio. In 2002 Alf started writing articles on gold related subjects, including monetary history, as well as a series of gold price forecasts using the Elliott Wave technique.

India is perennially the world’s largest gold consumer.

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