COMEX and Gold Prices

This process, over the years, of the gold price being placed on the floor of the COMEX instead of the spot market has been depicted as the tail wagging the dog, this means that the paper market “tail” wags the physical market “dog.” In turn, one of the players in the COMEX market has more influence on that day-to-day price mechanism than large-spec traders, the immense capital pools with the capacity of making immense bets on market direction either up or down. In turn, the large spec traders’ ability to touch off a cascading herd effect throughout the market has been quantified in several studies of futures market behavior.

An enlightening study by Bob Rankin, assistant governor to the Reserve Bank of Australia, with the title The Impact of Hedge Funds on Financial markets: Lessons from the Experience of Australia, frames the impact of these massive capital pools on price discovery:

• Hedge funds have found themselves in a strong position to exploit such trading strategies [re: speculative attacks on national currencies] following their success in the U.K. devaluation of 1992. The publicity generated by that event gave them enormous standing in financial markets and many traders adopted strategies that mimicked those of the hedge funds.
• In the foreign exchange market in particular, banks and investment banks systematically keep their better clients informed of the hedge funds’ daily trading strategies. Combined with the willingness of some hedge funds to use leverage to build very large positions, this status places hedge funds in the position of market leaders, with the ability to influence the behavior of others in markets.

The study concluded that “...the activities of hedge funds came to dominate the market during the middle of the year, affecting the dynamics of price discovery for the period while this dominance continued.”

For most of the period of the 1990s, the large-spec volume was on the short side of the market and the price was subdued. But then something very interesting happened in 1999. Speculative interest, for the first time in over a decade, swung decisively to the long side of the market, and prices in turn were driven dramatically higher, starting in the early part of the present decade. The question for investors interested in price direction is if those traders are on the long side of the gold market to stay or not.

Although the COMEX gold trading pit represents only a small part of the overall paper gold trade (the private contract London over-the-counter market dwarfs COMEX volumes), it nonetheless offers a reliable bellwether for the prevailing international sentiment.

The large speculative interests by and large have become very bullish on gold, as indicated by their persistently growing volume on the long side of the market. In fact, their extraordinary participation on the long side, starting in December 2002, was the principal ingredient in pushing the price to the four hundred dollar level – not just one time, but two times. Again, in 2004 when gold pushed past the four hundred dollar level and stubbornly remained at ten-year highs, the move was accompanied by immense participation on the buy side of the market by large speculative traders.

The synchronic relationship could be described as the very definition of cause and effect. When we begin to understand the motivation of the large speculative interests, we start to get a clearer picture of future prospects. We have had a clean break with the past, based on six important changes in the way gold is viewed fundamentally by these international market movers:

General apprehension about worldwide stock and bond markets, particularly the United States markets

The aftermath of the Central Bank Gold Agreement, which fixed and limited the amount of gold available for lease and sale

The atmosphere of competitive currency devaluation currently dominating the trading relationship among the G-7 nations

The trend-to- Zero interest rate phenomenon, which has killed the gold carry-trade (although this could very well turn out to be a short term consideration)

Mine company dehedging practices

The long-term trend change to a bearish psychology on the dollar ( based on radical growth in the trade and budget deficits)

These factors give a strong undercurrent for the quickly growing international demand for physical gold. Subsequently , that growth has spawned a new market psychology in three important arenas in the market of gold: big private money, the hedge fund, and the professional trading desk. This has made all the difference. This shift sentiment is one of the primary reasons the country entered into anew secular gold bull market in late 1999, and although we are going to experience some bumps along the way (as these same speculative interests take short term profits), the primary long-term trend is now appears to be definitively to the upside. We will add a qualifier to this analysis. When it comes to speculative trading, the past is not necessarily prologue. The foregoing analysis is meant as a view for the long term with respect to owning physical metal. It is not meant to be applied to short-term speculative trading. It is advisable to have the assistance of a qualified expert in the field of futures and options for that.