Dear Friends,

A few brief comments on this week’s release of the Commitment of Traders data are in order due the price action of the last few days. Please keep in mind that this data only covers price action through Tuesday of the current week.

I have circled the areas on the chart that I wish to call attention to in white. The specific date that I am interested in is 8/25/2009 within those circles.

If you note, the current data to the far right of the chart shows the lines designating the Managed Money, the Swap Dealers, and the Commercial/Producer/Users category within very close proximity of the area within the white circles, particularly 8/25. That is significant because it is during this time frame that the gold market was still trading within a two-month long broad consolidation pattern bounded by $970 on the top and $930 on the bottom. One week later, specifically on 9-2-2009, gold launched a massive upthrust obliterating overhead resistance centered near the $970 level as it moved up to $982. The very next session, gold tacked on another $22 more barely missing the $1,000 level. It never looked back from that point on carrying all the way to $1,227 in December where it reached a new temporary top. Since then gold has been in retreat with open interest steadily bleeding out as positions were liquidated across the board.

That position liquidation, by both longs and shorts, has resulted in the categories containing the largest traders receding to the same levels at which the last strong upleg in gold commenced. Yet, when we look at the price chart in gold, we see that as of Tuesday this week (the date through which the COT data is current) the price was trading at $1,077, fully $100 higher than the last time the major categories of large traders had net positions of this size. How to explain this?

It really is quite simple but critical to understand this – bullion bank selling caps gold to the upside as they attempt to eat through the plethora of bids in a rising market. They cannot hold back the rise in gold but they attempt to contain it. Once upside momentum begins to wane, the technicals turn and then the fund money begins exiting as longs are liquidating. It is into this long liquidation that the bullion banks do their short covering as they lift the shorts by buying them back. However, and this is the big key to understanding gold, the biggest physical buyers of gold on the planet (including the Eastern Central Banks) who only buy when they believe gold is now “cheap”, step in and actually compete with the bullion bank buying. That forces these perma bears to rapidly cover shorts at a much faster clip than they would prefer. After all, if the speculative crowd is in the process of throwing away their gold, why get in the way? Let them throw away as much as they can and the bullion banks can leisurely continue their short covering letting the market sink lower and lower as they profit all the way down. The problem that they have is the huge physical market in gold prevents them from having the luxury of sitting on their hands while the market drops lower. They are therefore forced to buy back at a much faster clip. That is what drops the open interest down to near the same levels as the last upleg began but leaves the price at a much higher level than the initial breakout run.

This has been the pattern for gold throughout the entirety of its now near decade-long bull market. It runs higher as speculative money flows in, backs off and retreats in price as bullion bank selling eventually succeeds in pushing price lower causing this long side speculative money to begin liquidating, only to then stabilize at a higher price after allowing for this liquidation. The result is that gold forms a new base of support at successively higher and higher levels consolidating its price gains while end users and big buyers of size become acclimated to the new, higher price. The market then eventually gathers steam inducing another wave of speculative buying which takes it on to a new, higher price once again and the cycle then repeats.

Think of it this way – you go to the store to find a bag of sugar. You see it normally sells for $2.50. You go in next week and it is now $3.00. Two weeks later it is at $3.50. A month later it is $4.00. What would most people do? Unless they really had to have it, they would probably wait to see if they might buy it cheaper especially if they had been coming in to the store to buy sugar and the last four months it had been trading at $2.50. At $4.00 they experience sticker shock. But then the price begins to drop. Down to $3.75 it goes in two weeks time only to be followed by another drop down to $3.50 during the next two weeks. By this time the buyer is beginning to think of $3.25 sugar as a bargain if they can get it there. If and when it does get there, they buy it. If the price begins to rise once again before it got to $3.25 where they thought it was cheap, they come back in and buy their sugar because they fear that it might start climbing back up to $3.65 – $3.80 or even $4.00 again before they can get it. Through this process, the term “cheap” takes on a new value in the eyes of prospective buyers.

Apply this now to gold – How many of us would have said back in $2005, that $1000 gold was “cheap”? Not many I would dare say. Yet this is precisely how the physical market in gold works and why gold finds support and stabilizes in price at successively higher price levels. Once the market looks as if it is through going down, guys who were looking to buy it “cheap” rush back in out of fear that prices are going to move up too quickly leaving them on the platform as the bull train leaves the station without them. Then the momentum funds move in and up it goes to another new high.

What encourages me as I look at today’s release of the COT data, is this pattern is still intact. One could basically make the argument that nearly all of the speculative long side money flows that took gold from $970 to $1227 over a 3 month period has been washed out yet gold is $100 higher in price than when the move began. In effect, the market has experienced a healthy washout and price correction and is now in the position of having a relatively low level of open interest, especially speculative hot money from the managed money crowd.

If gold can continue to hold above the recent lows and consolidate the gains made during the last few days of this week, it is setting itself up nicely for the next leg higher. The net long position of the Managed Money category could expand significantly before it would be anywhere near the peak made back in late November/early December of last year. There is now a lot of room for the speculative crowd to come rushing back into gold should the technical momentum turn decidedly to the upside. It is not there quite yet but a move above $1130 would probably do the trick. The key is whether or not the bulls can take advantage of their impressive performance this week and keep price from breaking below $1,050 – $1,045 for any length of time. A continued standoff in which further range trading is the order would be a major victory for the bulls short of an upside breakout given the tendency for seasonal weakness in gold during February. The fact that the bears could not break gold lower even with the weaker Euro this week is very significant and should not be underestimated.

Once again, the gold war wages on.

Click here to view today’s COT charts in PDF format with commentary from Trader Dan Norcini…