July 20, 2005
Another Golden Rule
By Brady Willett

If global capital flows continue to funnel into the US based upon favorable yield conditions, 2005 may end up turning out to be a lot like 2000.

Following last weeks viewpoint on gold I received an influx of email from prospective gold traders thanking me for sharing with them a successful trading strategy. Although I may have been the first to explicitly mention the 20%-40% rule, I can not take credit for discovering some hidden secret in the COT statistics.  For that matter, I do not want to take credit for highlighting a trend that has only been around for less than 4-years and is unlikely to remain relevant for the next 4-years. Others that have covered the influence of the COT on the price of gold, including Ted Butler and countless authors at Le Metropole (R),   deserve the attention.

This is not to say that I do not believe the gold investor should be aware of the 20%-40% rule of thumb. I do.  But being aware is not necessarily the same thing as investing your money based upon on a single trend.  Lets be honest, betting that the price of gold will rise simply because the commercials are holding a 20% net short position could be extremely dangerous. As for shorting gold when 40% is reached, shorting any market is dangerous, period.

While the 20%-40% rule has been statistically sound since 2002, it has had its share of short term setbacks.  For example, buying gold in May 2004 based upon the forecasted strike of ‘20%’ could have left you holding gold during a $20 an ounce slide, and selling gold in October 2004 (as ‘40%’ was struck) could have meant that the investor miss out on $40 an ounce rally! Thus, while the rule has has never failed, in order to trade the rule in 2004 you would have needed some deep pockets and tonnes of stubbornness not to have been burnt.

In short, although I do think that some individuals get overly excited as the POG rises and the commercials aggressively add to their shorts (and if forced to I would short rather than buy gold at 40%), I also believe that the commercials are destine to lose control of the gold market.

More Golden Rules

Another trend that every gold investor should be aware of seasonality. Gold’s seasonal pattern is best displayed when studying historical open interest trends. 



Although discussed before, what deserves reiterating is as follows: “the best time to buy gold is in late August (or before open interest is expected to rise dramatically in Sept/Oct)”. Open interest usually coincides with trends in the price of gold (i.e. rising open interest usually coincides with a rising price of gold and vice versa).

In six out of the last seven years the lows gold hit in August were not seen again for the rest of the year.  In other words, if you bought gold near its August lows in each of the last seven years, you made a profit 85% of the time by the end of the year.

As impressive as these odds seem, it should be noted that in the 18-years prior to the period mentioned (1998-2004), only twice did the average price of gold in August remain below the average price seen in Sept, Oct, Nov, and Dec. Accordingly, as good as the ‘buy the low in August’ has been, it is not an historically reliable indicator.

Conclusions

The last time the lows in August didn’t hold for the remainder of the year (in 2000) the US economy was beginning to slow down and the Fed had just finished tightening US interest rates. Gold declined in 2000 and formed a base in 2001.  The 20%-40% rule came into play in 2002 (the commercials have not held a net long position since December 11, 2001).  What 2000 taught the investor is that gold - historically a hedge against inflation - typically does not agree with slower economic growth unless it is accompanied by financial crisis, and gold definitely does not agree with rising US interest rates (which can help support the US dollar).

The final speculation to be made isn’t that the commercials are covering their positions in quick order and the outlook for gold is turning bullish (even though this looks to be the case based upon the forecasted COT*).  Rather, it is that if the investor believes the gold bull is intact they should try to buy gold in August, and definitely buy/accumulate gold before September.

But is the gold bull intact? With global imbalances suggesting that the US dollar is, eventually, set to decline, I happen to think so.  However, there is no golden rule to say that gold prices will agree with the bulls in the near term.



* Last weeks net commercial short position as a percentage of open interest was 35.7%. Given that the commercials covered 29,576 short contracts even as gold was stable week-over-week, it is logical to assume that the commercials have continued to cover their net short position – perhaps even more aggressively – in the latest COT week (current as of yesterday). In fact, since 2002 the numbers suggest that the NCS as a % of OI is currently sitting around 23.54%.  The statistics are released on Friday. 

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