The more I read, the more I realize that those reporting in the mainstream financial media have basically no understanding of the mentality of the gold owner (either as private individuals or as nation-states).  They live in a fairytale world where P/E ratios and cash flow models are infallible value metrics, and anything that can’t be valued through these methods must surely be worthless. They try to pigeonhole gold as a risk asset, and predict its performance accordingly.  So in a way, I can’t blame them for calling for a capitulation in gold.  To them, it is logical.  But I have a question for these opinion makers:  Do you even know why stock owners ‘capitulate’?  Because when the bottom starts to fall out, their scared out of their minds that their pieces of paper are going to be 100% worthless!!! – A fear, mind you, that is rooted in historical reality. 

By contrast, the average gold owner owns gold specifically because he knows that it will NEVER go to zero!

China shares the same sentiment toward gold, begging the question: Why in the world would a country that has been steadily acquiring metal over the past decade suddenly capitulate and drain their gold holdings because of a falling price?  They wouldn’t, unless of course Gordon Brown was their prime minister.  If anything, they’d acquire more, and you can bet China is licking its chops at the prospect of any such ‘capitulation’.  Whether or not they can find any metal to buy if this happens is another story altogether.   

Speaking to that point: Did you also know that if gold does go to $700, it will be approximately $500 below mining production costs, and almost $700 below all-in costs for the major producers?  Did you also know that with the falling price and the already committed assets and manpower, mines are now mining their highest-grade ore just to stay profitable?  Many mining analysts believe that we are right smack dab in the middle of peak production for gold mines, right now.  It doesn’t take a PhD in Economics to see that $700 an ounce is not the kind of price that can sustain a stable supply/demand paradigm. 

Capitulation more likely with the paper gold market shorts than physical metal owners  

Moreover, if there ever were to be a capitulation in the gold market, it would come in the paper market, where traders of the metal treat gold as a number on a screen rather than a wealth preservation asset.  BUT THERE’S ONE HUGE PROBLEM WITH THIS!  The traders (especially at the institutional level) are overwhelmingly SHORT! Not to mention that many would argue these short positions - and their inherently limitless supply - are actually one of the primary catalysts when gold declines in the first place.  So simply put, how can there be capitulation amongst the speculators when the vast majority of the speculating volume is on the short side of the market to begin with?!  If anything, when the downside proves resistant, your capitulation is going to come at the exhaustion of the shorts, not the longs.   

Don’t believe me:  Check out these graphs/commentary on current futures positions in the market.  Charts courtesy of the CME group.

Graph Commentary:  The above graph shows the net long/short positions of the producer/merchant/processor market participants. A producer/merchant/processor/user is an entity that predominantly engages in the production, processing, packing or handling of a physical commodity and uses the futures markets to manage or hedge risks associated with those activities. While this segment of the market is always for more short than it is long, it is worth noting the increase in the gap between the shorts and longs from the beginning of the year to present.  Moreover, the aggregate number of longs is about half of what it was at the beginning of the year. 

Graph Commentary:  The above graph shows the net long/short positions of the Managed Money positions in the market.  A "money manager," for the purpose of this report, is a registered commodity trading advisor (CTA); a registered commodity pool operator (CPO); or an unregistered fund identified by CFTC. These traders are engaged in managing and conducting organized futures trading on behalf of clients.  Put simply, this is the best representation of ‘the public’.

While still slightly more long than short, it is worth noting that the short positions are over triple where they were at the beginning of the year, or even as recently as the beginning of August. Put another way, the managed money market is three times as short as it was 12 weeks ago! Also very telling is the rapid increase in shorts at the beginning of September, coinciding perfectly with the near top seen in gold in the mid $1320’s and the decline we’ve experienced ever since. "

Graph Commentary:  The above graph represents the Swap Dealer net positions within the market. A "swap dealer" is an entity that deals primarily in swaps for a commodity and uses the futures markets to manage or hedge the risk associated with those swaps transactions. The swap dealer's counter parties may be speculative traders, like hedge funds, or traditional commercial clients that are managing risk arising from their dealings in the physical commodity.  In other words, we’re talking about the big boys.

Again, always short more than they are long, especially near the interim top in gold back in July, I was actually taken aback by the trend differences here when compared to the Managed Money market.  Clearly, the gap between short and long at the swap dealer level has closed considerably from where it was over the summer.  In fact, as of November 4^th, Swap Dealers are representing more long contracts and fewer short contracts than they have had at any point this year.  November 4^th also happens to be the day that gold bottomed (for the time being) at $1140.00. 

Makes you wonder, who has it right?

When adding the data from all three of the market segments together, the futures market is about 4.5 million ounces more short than it is long.  To give that some context, that is akin to being short 140 tonnes of gold, or just over 5 billion dollars worth of the yellow stuff – paper yellow stuff that is.   As recently as a month ago, the gap was closer to 200 tonnes and $7.5 billion dollars.

When we talk of capitulation, I reiterate a thought I posed earlier.  It appears in these reports, especially when focusing on the Managed Money positions, that the herd money is on the short side, not the long.  Look no further than the obvious spike in retail short positions in just the last three months.  It seem to me that these shorts are actually the weakest positions in the market, and the ones most likely to ‘capitulate’ when the trade doesn’t go their way.  You might even say, that is what’s happening right now.  As I put the finishing touches on this article, gold has stormed back $30+ intraday, and is pushing back toward the $1200 level.

All told, I can’t say if this is the bottom in gold or not, but I’m inclined to think that a massive panicked wave of selling is as outrageous at the $700/ounce predictions associated with it.

Here’s my call: 

Whether its already behind us, or it comes next week, next month or next year, the gold market will bottom with a whimper, not a bang, and every one of these financial pundits will miss it.  The one thing they always seem to overlook is that the herd can, and will, run in either direction, and when that occurs, these same pundits will find themselves ironically returning to square one with their predictions. 

Jonathan Kosares, USAGOLD Executive Vice President of Sales & Marketing, graduated cum laude from the University of Notre Dame with a dual major in Finance and Computer Applications. He has been with the firm since 2002.. He is the moderator of the USAGOLD RoundTable series, has authored numerous articles on the gold market and manages client activity for the high net worth division as well as the USAGOLD Trading and Storage Program.