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Dazzling 2016 gold story unraveled

Gold and its miners’ stocks are rocketing higher as speculators and investors alike return to this left-for-dead sector.  This sudden deluge of capital inflows has crowned gold stocks the best-performing sector of this young new year by far, shocking traders.  And this stunning reversal of fortunes in both the metal and the companies producing it is only starting, so it’s exceedingly important to understand what’s going on.

Gold was inarguably the world’s most-hated investment in recent years.  No one wanted anything to do with it, because no one felt any need for it.  The world’s stock markets were relentlessly levitating, thanks to record easing by the world’s elite central banks.  And with stocks seemingly destined to do nothing but rally indefinitely, there was little demand for counter-moving gold for prudent portfolio diversification.

But as global stock markets started sliding in 2016, the bubble in central-bank confidence rapidly started to burst.  Central banks indeed quickly stepped in to try and stave off the waves of selling, but to no avail.  Extreme central-bank jawboning and actions that would’ve dramatically goosed stocks in years past failed to have much impact, helping shake traders awake from their years-long central-bank-induced stupor.

These newly-alert traders started remembering that markets are forever cyclical, they can’t move in a straight line forever.  What’s high and in favor after rallying for years will inevitably roll over and head the other way, a bearish portent for central-bank-levitated stocks.  Conversely what’s low and out of favor after years of selling will inevitably mean revert higher.  Thus investment demand for gold is rekindling.

The dazzling 2016 gold story truly is that simple.  Stock markets are rolling over into a long-overdue new cyclical bear that central banks artificially held at bay for years.  So investors are diversifying into gold, which generally moves counter to stocks.  And with investors migrating back, speculators are flocking in as well to ride gold’s momentum.  With this strategic context in place, let’s dig into what’s been moving gold.

The recent seeds for 2016’s new gold upleg were sown late last July.  Years of central-bank-levitated stock markets had left gold with major secular support between $1150 and $1200.  As gold slumped to the lower end of that zone in its usual summer doldrums, a large bearish speculator decided to press his bets in spectacular fashion late one lazy Sunday evening in July in a record gold-futures shorting attack.

Within one minute around 9:30pm, nearly 24k gold-futures contracts controlling about $2.7b worth of gold were sold short!  This brazen attempt to shatter gold’s support worked, blasting it almost $50 lower in that single minute.  With $1150 broken, gold would drift down near $1084 by early August.  But with bearish futures speculators’ selling exhausted, gold rebounded sharply in what would become a multi-month uptrend.

The American futures speculators who dominantly manhandled gold in 2015 had been overwhelmingly bearish on the yellow metal.  Their core thesis was very simple.  Since gold yields nothing, the coming Fed rate hikes would decimate investment demand for this metal.  Higher yields in bonds would make zero-yielding gold even less attractive, and the resulting capital flight would smash gold way under $1000.

The Fed’s Federal Open Market Committee meeting in late October played right into this bearish-gold outlook.  The very morning of that decision, gold was trading near $1182 and had more than recovered its record-shorting-attack losses.  But the FOMC surprised that day coming across as very hawkish, by declaring it might very well hike rates for the first time in a decade at its next meeting coming in mid-December.

So American futures speculators dumped gold with a vengeance, at rates so extreme several major new all-time records for gold-futures selling were hit.  That frenzied gold-futures selling petered out by early December, with gold pounded back down near $1053.  There were almost no gold bulls left, with even those who called themselves bulls universally predicting another drop down into the $800s before gold bottomed.

But for a handful of contrarian students of the markets including me, this was supremely irrational.  Gold too is forever cyclical, its price can’t fall forever.  And with literally everyone hyper-bearish on this metal and utterly convinced it was doomed to keep spiraling lower indefinitely, peak fear had to be near.  When a trade gets that epically one-sided, everyone susceptible to being scared into selling low has already sold.

And the seemingly-logical core case for this extreme gold bearishness, that a new Fed-rate-hike cycle would devastate zero-yielding gold, was totally false historically!  I started researching gold’s behavior during past Fed-rate-hike cycles last summer.  If higher rates indeed suck capital out of gold, that would be crystal-clear in the historical record.  Surely the gold-futures speculators had done their homework, right?

It turns out there have been 11 Fed-rate-hike cycles since 1971, a large sample size over many decades.  On average during the exact spans of all 11, gold rallied 26.9%.  In the 6 where gold climbed, its average gains were a staggering 61.0%!  And in the other 5 where gold retreated, its average losses proved to be an asymmetrically-small 13.9%.  Historically Fed-rate-hike cycles were actually exceedingly bullish for gold!

The lower the gold price when a Fed-rate-hike cycle is launched, and the more gradual that cycle’s hiking, the bigger gold’s gains within it.  With the Fed’s imminent rate-hike cycle coming with gold near major secular lows, and promised to be the most gradual ever, it was hard to imagine a more bullish scenario for gold.  Yet the goofy futures speculators were so caught up in their masturbatory groupthink they were blind.

These traders make mind-bogglingly-risky hyper-leveraged bets where they can double or lose all their capital with a mere few-percent move in gold.  They can’t afford to trade on bad information.  Yet they didn’t even remember that gold soared 50% higher during the last rate-hike cycle between June 2004 to June 2006, where the Fed more than quintupled its federal-funds rate to 5.25% through 17 consecutive hikes.

Believe me, I didn’t keep this critical research to myself.  I originally published it in an essay back in early September, and deepened it considerably in mid-December just days before that FOMC meeting.  I did everything I could to alert investors and speculators to the epic contrarian opportunity in gold, and was ignored, mocked, and ridiculed for it.  People hate hearing when they are wrong for succumbing to groupthink.

The Fed indeed hiked rates for the first time in 9.5 years in mid-December, the very event that American futures speculators had long been waiting for to crush gold.  And the next day gold indeed suffered a kneejerk plunge, falling 2.1% to a marginal new 6.1-year secular low of $1051.  But in the subsequent days leading into year-end, gold didn’t collapse.  That was a massive clue consensus was dead wrong.

On New Year’s Eve when gold remained loathed and closed at $1060, I published an essay “Fueling Gold’s 2016 Upleg”.  In it I explained why “gold is poised for a mighty upleg in 2016”.  Speculators had to do vast gold-futures buying to mean revert their excessively-bearish bets back to normal levels, and investors had to do vast gold buying to mean revert their own meager gold portfolio holdings to normal levels as well.

And that’s indeed coming to pass already, just as I advised investors it would.  During the first 4 weeks of 2016 for gold-futures speculators, they boosted their long holdings by 22.3k contracts while slashing their shorts by 22.2k.  That’s the equivalent of 138.4 metric tons of gold buying from this group of traders alone!   And these guys still have another 163.3k contracts or 507.9t left to buy to fully mean revert to normal.

To put this into perspective, the World Gold Council reports that global gold investment demand during the first 9 months of 2015 (latest data) averaged 76.0t per month.  Meanwhile on the investment front, American stock investors have already put so much differential buying pressure on GLD gold-ETF shares that its gold-bullion holdings have surged 47.7t or 7.4% higher so far this year!   Gold demand is really back.

But how can this be when gold yields nothing?  Why do investors flock to it during Fed-rate-hike cycles?  The answer is simple.  A tightening Fed is the arch-nemesis of stock markets levitated for years by epic record Fed easing.  As Fed-inflated stock prices crumble into a new cyclical bear, smart investors have no choice but to diversify their portfolios.  And gold has been the premier portfolio diversifier for millennia.

This investment gold buying is only just starting, as is the powerful new gold upleg it is driving.  Late last year, American stock investors had just 0.115% of their portfolios invested in gold per the ratio between the value of GLD’s holdings and the S&P 500’s collective market capitalization.  Between 2009 and 2012 before the Fed’s third quantitative-easing campaign radically distorted markets, that was 4.1x higher at 0.475%!

There’s no doubt this new stock bear as the Fed’s gross distortions unwind will easily push this ratio back over 0.5% in the next year or two.  And that’s going to require vast gold buying by American stock investors alone.  During 2012 before QE3, GLD’s holdings averaged 1294.2t which is another 88% higher from this week’s levels.  That gold investment helped support gold’s average price of $1669 in 2012.

Just as stock-market-investment cycles take years to unfold, so do gold-investment cycles.  So realize the gold buying and resulting rallying we’ve seen so far in 2016 is just the tiniest tip of the iceberg.  Gold is not only going to fully mean revert out of recent years’ extreme central-bank distortions, but overshoot towards the opposite extreme.  We are truly looking at gold rallying on balance for years as investors return!

Investors can ride this great mean reversion back to normal gold-investment levels with physical gold bullion or the flagship GLD SPDR Gold Shares gold ETF.  Speculators can buy call options on the latter.  Gold is conservative and rallies during stock bears, which is far superior to cash.  But if you really want to multiply wealth as gold mean reverts higher, the gold miners’ stocks will greatly amplify gold’s coming gains.-Zeal Research