Gold Selloff Risk High

Gold surged dramatically in recent weeks, powering higher to a decisive bull-market breakout. Gold’s first major secular highs in years have really improved sentiment, with bullishness mounting. But gold-futures buying fuel is largely exhausted, after the colossal amount expended to catapult gold back over $1400. That leaves this metal at high risk of suffering a major selloff, a healthy correction in an ongoing bull market.

Even the most-powerful bull markets flow and ebb, taking two steps forward before one step back. Gold is certainly no exception. At best in late June, its current bull extended to modest 35.4% gains over 3.5 years. Those weren’t linear, the path to gold’s recent breakout high was quite volatile. It included a 29.9% upleg, a 17.3% correction, a 20.4% upleg, a 13.6% correction, and today’s upleg running 21.2% at best.

This alternating repeating bull-market pattern is simple, uplegs are inevitably followed by material selloffs often extending into correction territory. Periodic corrections are essential to keep bulls healthy, working off the excessive greed that builds as uplegs peak. That risks sucking in too much capital too soon, prematurely burning out bulls. Corrections rebalance sentiment, bleeding away greed to extend bulls’ longevity.

Even though they are inevitable, normal corrections stress out the majority of traders. The selling taints their psychology and clouds their perspectives of longer-terms trends in play. They fret bulls are dying, and sell out too early and too low. Instead, corrections should be embraced, as they offer the greatest opportunities to buy relatively low within ongoing bulls! Entering near correction lows amplifies gains.

While gold’s current bull clocked in at 35.4% total in late June, its three major uplegs added up to much-larger 71.5% gains. Traders had the potential to more than double gold’s headline gains by attempting to buy relatively low later in corrections and sell relatively high later in uplegs! Although impossible to game bull-market swings’ major lows and highs precisely in real-time, trading near them really boosts capital growth.

The reason gold faces high risk for its next major selloff today is speculators’ current positioning in gold futures. Unfortunately, spec gold-futures trading has a wildly-disproportional influence over short-term gold price levels. The dominant reason is the extreme leverage inherent in gold futures, which greatly multiplies that capital’s impact on gold prices. This unfair reality has sorely vexed the gold market for decades.

When a normal investor buys gold outright, $1 of capital exerts $1 of buying pressure on the gold price. That’s the way markets are supposed to work. That can be extended with margin in the stock markets, which has had a hard legal limit of 2.0x since 1974. $1 of capital using maximum margin to buy shares in the leading GLD SPDR Gold Shares gold ETF can exert $2 of buying pressure on gold. That’s still reasonable.

But gold-futures trading is way out in its own extreme realm. Each gold-futures contract controls 100 troy ounces of gold. At this Wednesday’s data cutoff for this essay, gold closed at $1417. So each contract wields gold worth $141,700. An investor would have to put up $141,700 to control that much gold, or $70,850 using stock-market-legal-limit leverage on GLD shares. Futures speculators only need $4,000!

That’s no typo, this week the CME Group only requires traders to have $4,000 cash in their accounts for each gold-futures contract they want to trade. That is absurd, enabling extreme maximum leverage of 35.4x! That means a fully-margined gold-futures speculator can exert $35 of buying or selling pressure on gold with each $1 deployed. That temporarily outguns investors, even though they have vastly more capital.

The Federal Reserve has capped stock-market leverage at 2.0x for 45 years because extreme leverage has extreme risks. At 35.4x, a mere 2.8% gold move against speculators’ gold-futures bets would wipe out 100% of their capital risked! This constant threat of ruin forces these traders’ focus to an ultra-myopic short-term span, days or weeks at most. All they can do is ride gold’s immediate momentum, piling on.

As if arbitrarily declaring $1 of gold-futures capital should have up to 35x the influence on gold prices as $1 invested outright isn’t ridiculous enough, it gets worse. Unscrupulous traders can wield gold futures’ extreme leverage like a weapon to manipulate gold prices at key technical and sentimental junctures. One way is spoofing, slamming the market with huge gold-futures orders that are canceled before being executed.

This is not theoretical. In late June the US Department of Justice levied $25m of criminal fines on Merrill Lynch Commodities for this very behavior! And that’s just the tip of the iceberg for gold futures’ extreme leverage being abused to defraud normal investors. This seriously needs to be legally capped at vastly-lower levels. The DoJ’s actual press release did a great job explaining how gold-futures spoofing works.

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