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Silver stocks leading after gold bear trap reversal

Commentaries & Views

With market focus having mostly been on the Federal Reserve in recent weeks, a banking crisis in Europe began to shake things up heading into quarter-end last week. The recent events surrounding the Bank of England (BoE) being forced to intervene to shore up its markets is bringing the realization that the trigger for the next recession could very well be abroad.

After the BoE pledged to engage in strategic buying of long-dated bonds in order to support sinking bond markets, this form of quantitative easing was a surprise reversal of the central bank’s plan to start selling its existing holdings of government bonds. What this means is that a major central bank is now injecting monetary stimulus at the same time it is raising interest rates.

Although the most important recent financial international event affecting markets reported by the mainstream media has been the weakness in the UK’s bond markets, the German Long Bund (FGBL) market has collapsed as well. With the energy crisis about to hit Germany hard as we get closer to winter, pension funds in Europe are being forced to liquidate as bond markets have imploded.

Then to begin Q4 this week, British Prime Minister Liz Truss was forced on Monday into a humiliating U-turn after less than a month in power, reversing a cut to the highest rate of income tax that helped spark turmoil in financial markets and a rebellion in her party.

In response to these events, the gold price has made a key upside reversal from the depths of gold bug despair after reaching a new low for the move last week at $1620. Gold made fresh 52-week lows mid-week, then reversed, taking out the high of the previous week and closing above that level on the last day of the quarter.

Before the reversal took place, S.S. Gold Bear had become overcrowded with naysayer passengers insisting the secular gold bull market had come to an end in Q3. And who could blame them? Despite all the continued economic malaise, the gold market has fallen sharply for the last six consecutive months.

Gold's disappointing price action has brought bearish investors out in full force as negative sentiment had pushed to its highest level in four years. The gold price losing critical support at $1675 in late September even had a select few of the most ardent gold bulls flipping long-term bearish.

Although the idea that a central bank might simultaneously buy assets while raising interest rates seems completely absurd, the stock market has also reversed sharply to the upside on expectations of the Fed pivoting monetary policy prematurely. There is a growing investor acceptance that the BoE is not going to be the last central bank to cap rates, and eventually, the U.S. will follow suit.

With the BoE announcing the continuation of rate hikes while the U.K. economy is in recession, even the United Nations is urging the Federal Reserve and other central banks to ease up on rate hikes this week. The agency is warning that tighter monetary policies are pushing the global economy into a recession.

How gold and silver perform in the face of the sovereign debt crisis heating up, coupled with a likely heated U.S. election as the global economy heads towards recession will be critical for prices going into year-end. As I type this missive, gold prices have dropped into negative territory, testing support above $1,700 an ounce following stronger-than-expected U.S. labor market data.

A weekly close above $1750 in Gold Futures would confirm a bear trap low, as retail short sellers at the Comex are in the process of covering the largest net short position since November of 2018. In silver, a weekly close above $22 would suggest a sustainable bottom being in place.

The CFTC disaggregated Commitments of Traders (CoT) report for the week ending Sept. 27 showed money managers dropped their speculative gross long positions in Comex Gold Futures by 4,373 contracts to 74,171. At the same time, short positions rose by 2,026 contracts to 117,265.

Gold's net spec short positioning now stands at 43,094 contracts, up nearly 17% from the previous week. Positioning is at its lowest point since November 2018. I expect to see this position being reduced considerably, with room for more shorts to capitulate, when the next Gold CoT report is released later this afternoon at 3:30 EST.

The last time gold investors were punished with six months of consecutive declines was from April to September 2018. The precious metal went on to build a strong uptrend that culminated with prices pushing to a new record above $2,000 an ounce over the following year. This same pattern is also forming in the bearish speculative positioning in silver, and just before another strong rally in silver prices.

In contrast, since March 8, the total commercial net short position in gold has declined by more than 230,000 contracts (23mln oz) and by as much as 70,000 net contracts (350mln oz) in Comex silver, among the largest reductions in history. Commercial banks (smart money) went net-long precious metals in September as retail speculators (dumb money) went net short, setting the stage for the commercial bear trap of the managed money shorts now in progress.

In fact, silver has been the biggest winner recently, seeing an even more substantial short squeeze to begin Q4 by moving its price up 8.5% on Monday alone. This impressive move has also bullishly brought down sharply the closely watched gold/silver ratio towards the key 80 level. A move back down below 80 will bring more bulls and momentum traders back into this tiny sector.

Meanwhile, silver stocks are showing relative strength to the gold complex, along with the silver price, as weakness in the mining space is being bought this week. The formerly falling 50-day moving average on all four precious metals stock ETF’s, which has begun to curl up, has been strong resistance since the capitulation phase in the sector began in April. With follow-though metals buying this week, this strong line of resistance is becoming support in GDX & GDXJ, while both SIL & SILJ have been showing relative strength.

Market volatility will likely only get worse as we head into Q4 as currency turmoil has become the norm of late and, like the bond markets, investors are not sure how all this will end. Central bank interventions of this scale have not been seen since the Wall Street Crash in 1929, the Black Monday stock market collapse in 1987, the Global Financial Crisis in 2008 and more recently, the 2020 Pandemic.

After sinking with the stock market during the past two marketplace crises in October 2008 and March 2020, gold stocks made sharp moves higher from similarly depressed levels as the Fed was forced to lower interest rates and print our way out of recession each time. 

While the past two years have been like Chinese water torture for precious metals stock investors, the light at the end of a long frustrating tunnel is no longer an on-coming train. Once we see a strong close with conviction above $35 in GDXJ, a sustainable bottom will likely be in place.

Historically, the best time to accumulate a basket of quality juniors having 5x-10x upside potential is during the tail-end of capitulation events. Gold stocks always perform best after they look their worst and vice-versa during corrections. Buying fishing lines and selling rhino horns in quality gold stocks has served me well over the past 20 years of investing in the most challenging sector on the planet.

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