WEEKLY COMMENTARY

August 23, 2005

Demonizing The COTs

By Theodore Butler

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

The most recent Commitment of Traders Report (COT) confirmed expectations of a continued deterioration in the market structure in COMEX gold, and a further improvement in the market structure in COMEX silver. As mentioned last week, we have the unprecedented condition of gold holding at historic negative extremes, while silver sits close to its best readings of the past year and a half. Since this condition has never before existed, it is impossible to offer examples of prior resolutions. It’s new to us all.

The $25 gold rally over the past few weeks was propelled by a 110,000 net futures contract tech fund purchase/dealer short sale, the equivalent of 11 million gold ounces. Please make no mistake - this rally was caused by tech fund buying, nothing else. Moreover, the very largest tech funds had a disproportionate share of the contracts purchased and, therefore, the impact on price. A study of the changes in the concentration ratios of the four largest long-side and short-side traders indicates the largest tech fund longs bought many more contracts than the largest dealer shorts sold, further confirming the large tech fund impact on price. Now what?

Will the tech funds add more long contracts, driving prices higher still? Maybe, but the last few times they added 100,000 contracts or so, temporary tops were created. Will the tech funds start liquidating soon, as the key moving averages are violated? Maybe, and perhaps that is more probable, as those moving averages are relatively close to current prices. While no one knows for certain how it plays out, unless the tech funds radically alter their past behavior, what they do is what will determine near term pricing.

I am continually impressed by the amount of attention the COTs have garnered recently. And most of the articles and analysis is quite good. Sometimes, however, feelings can run somewhat astray. It is important to remember just what is the COT. Quite simply, it’s a market tool that one can choose to factor into one’s expectation of price movement, or choose to ignore. It’s not something to get worked up about.

In my opinion, it’s a great report and great market tool. In fact, I can’t believe how fortunate we are to have such a report. It’s a gift. After all, it doesn’t cost, it’s relatively error-free and it’s timely. I know some complain about it being three days "late" (the Tuesday cut-off, for the Friday release), but to a guy who remembers using the COT when it was only issued monthly, having a weekly report is like comparing a Gulfstream jet to a Piper Cub.

What makes the COT report so valuable is that it goes a long way towards answering one of the most sought after questions in any market – who is buying and selling? It tells you who is accumulating and distributing. Aside from the core fundamentals of supply and demand, everyone can decide for himself what is important as a market tool, whether it is charts or wave patterns or cycles or astrology. For me, the COT report is the most important.

Of course, the COT report is completely objective, as it is just numbers and positions, while the opinion of what it all may mean is necessarily subjective. Therefore, it is important if you are going to rely on anyone’s opinion of what the COT may mean that you understand what that opinion is based upon and how that opinion has fared in the past. If it is difficult to grasp the rationale behind an analyst’s opinion, or that analyst has not warned of danger at prior tops or opportunities at prior bottoms, you probably should look for other analysts’ opinions.

It’s important to put the COTs into proper perspective. They should be a tool for short-term market movements, not a substitute for long-term analysis. If one is only interested in short term trading, they are more important. It is possible and logical for there to be times for one to be very bullish on an item long term and cautious near term due to extreme COT readings.

As for me, I see the danger of a sell-off in the gold market based upon the current COT market structure. Not the end of the world for gold, just a sell-off. How big of a sell-off is unknown, maybe only $10-$20 from here, maybe more. I’m not going to focus on the price, but on the tech fund liquidation. It’s impossible to know the timing or the day-to-day price roadmap. Of course, it is always possible for the dealers to get overrun and to have them rush to cover their shorts at much higher prices, but, as always, the next time that happens will also be the first time that has ever happened in gold or silver.

As for silver, the COTs remain fine amid the very lackluster price performance. I’m thinking more and more about something I wrote last week, about my long-time feeling that there would be a shake out to end all shakeouts before the final price explosion. Aside from the rotten price performance recently, and the possibility that a sharp sell-off in gold now would put additional selling pressure on silver, there’s something else that is making me think this may be the last shakeout in silver.

I’ve been intrigued with a closer reading of the COT in respect to the commercial position. Not only is the net commercial short position approaching recent extreme low readings, an analysis of the two categories from which we derive the net position, namely, the gross long and short categories indicate something that has piqued my interest. It seems the gross long category has grown much larger than in the recent past, by some 15,000+ contracts, to around 35,000 contracts, over the past few months.