August 16, 2022

Short Covering No Longer a Driver for Gold
In the last six weeks, metals and mining stocks have been on the comeback trail along with the broad equity market. Short-covering activity has unquestionably served as a major catalyst behind the recent gains in the metals, but now that much of those short positions have been covered, it’s time to ask the question many investors have been dreading, namely: “What—if anything—will fuel the next leg of the recovery?”

The reason for the reticence is obvious. While the benchmark S&P 500 index (SPX) has gone on to make a string of higher highs during its recovery rally, recently hitting its highest level since early May, most metals stocks and ETFs haven’t kept pace with the SPX.

One of my favorite ways of tracking the dominant trend in the overall precious/industrial metals market is via the SPDR S&P Metals & Mining ETF (XME). As the following chart shows, while the metals ETF is above its key trend lines (a bullish factor), it hasn’t yet overcome its nearest peak from early June. This means that XME is lagging the SPX on a relative basis—hardly an encouraging sign from a short-term technical standpoint.

On the gold market front, the rally that has been underway since last month was largely fueled by small-time speculators being forced to cover one of their highest short position levels in years. Indeed, bearish bets against gold by speculators reached the highest level since November 2018 as of late July, according to CFTC Commitments of Traders (COT) data.

Along those lines, DailyFX analyst Thomas Westwater recently observed, “By August 2, as gold prices rose, those short bets fell 23.3%, helping to fuel further gains as traders bought back those borrowed contracts.”

More recent COT reports for gold, however, have shown that short positions have fallen to historically normal levels. With the lower level of short positions to serve as fuel for further major rallies, the going for gold prices in the near term looks to be a bit bumpier than what we experienced in the last few weeks.

Meanwhile, the upcoming U.S. retail sales data release for July, along with the latest FOMC meeting minutes due on August 17 (this Wednesday), should shed more light on whether or not gold will get another major supporting bid from safe-haven buying (assuming retail sales data is weak—indicating a possible recession on the horizon) or from a more accommodative Fed stance toward interest rates (which would improve the opportunity cost of owning non-yielding gold vis-à-vis Treasury bonds).

In contrast to gold, however, other precious metals still have the benefit of high short interest levels that can serve to potentially fuel additional gains in the near term. Foremost among the high short interest metals is platinum (see chart below). Recent COT data has revealed that managed money positions in the catalyst metal are above normal levels, while long positions are below normal.

Elsewhere in the metals market, lithium has resumed a leadership position on the back of tightening global supplies and relentless demand for clean energy- and battery electric vehicle-related applications. For this reason, I’m moving to add another position in our trading portfolio to take advantage of the strength.

Updates
Alliance Resource Partners (ARLP) is a producer of metallurgical coal (for the steelmaking industry) and thermal coal (for electrical utilities), with approximately two billion tons of coal reserves in several U.S. midwestern and southern states. Alliance is currently the second-largest coal producer in the eastern U.S. with additional mineral and royalty interests in the highly productive Permian, Anadarko and Williston basins. (The company markets its mineral interests for lease to operators in those regions and generates royalty income from the leasing and development of those mineral interests.) ARLP has been one of the few standouts in an otherwise weak market as coal prices surge around the world (forming what one analyst called a “space needle pattern”) in response to the recent natural gas crisis in Europe. Consequently, many industry experts foresee shortages and sky-high energy prices persisting until at least 2024. During Q2, the company’s average realized coal price was $72 per short ton—$25 above the prior quarter’s prevailing price. The recent earnings also revealed the firm’s revenue increased 70% from a year ago, to $617 million, while per-share earnings were $1.23 (29 cents above estimates). Management indicated that coal operations have delivered “significant” year-over-year per ton margin expansion, adding that it sees ARLP well positioned to see further margin growth in 2023 and 2024. Speaking of growth, Mining.com has drawn attention to the record-breaking results of many of the world’s biggest coal producers in the latest quarter, pointing out that “energy market shockwaves from Russia’s invasion of Ukraine mean the world is only getting more dependent on the most-polluting fuel.” This has resulted in “mega profits” for coal giants like Glencore, and the outlook bodes well for firms like Alliance in the foreseeable future. On a technical note, I suggest raising the stop-loss on the remaining position (after our recent profit-taking move) to slightly under 20 on a closing basis, where the 50-day line currently resides. HOLD A HALF

Cleveland-Cliffs (CLF), North America’s largest flat‑rolled steel and iron ore pellet maker, just reported mostly upbeat second-quarter earnings. Revenue for the steelmaker in Q2 rose 26% from a year ago to $6.3 billion, while per-share earnings of $1.31 missed estimates by five cents. Other highlights included free cash flow that more than doubled from the prior quarter, plus the firm’s largest quarterly debt reduction since it began its transformation two years ago. The company, which enjoys a leadership position in providing steel for the U.S. automotive industry, expects the enormous backlog for vehicles will result in higher steel demand in the coming quarters, which could help push prices for the metal higher. The stock, meanwhile, is subject to what looks like a growing short-covering squeeze as 9% of the float is currently sold short. Traders recently purchased a conservative position in CLF using a level slightly under 17 as the initial stop-loss on a closing basis. BUY A HALF

Our recent examination of the copper/gold ratio revealed that copper tends to rally when the ratio falls under 0.19, which it did recently. A 14-year statistical survey further shows that in every case without exception, copper posted a meaningful price gain (i.e. between 30% and 50%) in the six-to-12 months following the signal. With that in mind, participants who don’t mind the short-term volatility risk recently purchased a conservative position in the Global X Copper Miners ETF (COPX) using a level slightly under 28 as the initial stop-loss on a closing basis. BUY A HALF

Ratings firm Fitch pointed out in a recent report that the small presence of major lithium miners in the development of new projects—with undercapitalized junior exploration companies mainly undertaking them—poses a risk to the execution of those projects. In other words, the tight supply situation that has characterized the market since at least 2020 will likely continue. Fitch expressed confidence that most new lithium projects will eventually pan out in the coming years as more experienced players enter the market. However, Fitch cautioned that several of these projects will “face delays” in the intermediate-term with some of them “unlikely to be developed due to the characteristics of the competitive landscape and the location of a number of projects in markets facing significant economic, political, operational and mining risks.” The fundamental backdrop for lithium accordingly remains tight, which supports the strong recovery witnessed in lithium stocks in recent weeks. To that end, I’m placing the Global X Lithium & Battery Tech ETF (LIT) back on a buy. Participants can purchase a conservative position in LIT here using a level slightly under 73.75 (closing basis) as the initial stop-loss. BUY A HALF

My favorite silver-tracking fund, the iShares Silver ETF (SLV), has shown some notable technical improvement in the last several days. SLV is back above its 25-day line after spending the better part of the last four months under it. The fund is still under the more psychologically significant 50-day line, but with short interest factors in silver’s favor (per our recent discussions), the odds favor SLV eventually getting back above this key trend line. Accordingly, investors recently purchased a conservative position in SLV. I suggest raising the stop-loss to slightly under 18 on a closing basis. BUY A HALF

Reliance Steel & Aluminum (RS) is the largest metals service center operator in North America, providing metals processing, inventory management and delivery services for several industries, including construction, energy, electronics, automotive and aerospace. Reliance expects its average selling price per ton sold for the third quarter of 2022 to be down 5%, due to recent weakness in aluminum and steel prices. Despite this, however, the company sees improving demand and pricing for higher value products sold into the aerospace, energy and semiconductor end markets. In Reliance’s just-released Q2 report, revenue of $4.7 billion was 37% higher from a year ago and surprised estimates to the upside. Per-share earnings of $9.15, meanwhile, beat estimates by 13 cents. Looking ahead to Q3, management sounded a sanguine note, observing that “customers tend to hold less inventory in times of declining metal prices and increase their reliance on us to provide the metal they need quickly and more frequently, as well as to fulfill their value-added processing needs.” Wall Street expects Q3 sales to increase 8% with full-year sales expected to jump 20%, both of which could prove too conservative if the dollar weakens and the industrial metals market reignites. In view of the strong relative performance of this dual steel/aluminum company in recent weeks, traders recently purchased a conservative long position in RS using a level slightly under 175 as the initial stop-loss. I now suggest raising the stop to slightly under 180 (closing basis) where the 50-day line currently resides. BUY A HALF

The Sprott Physical Platinum & Palladium Trust (SPPP) is arguably the lowest-cost way to play a potential palladium market short-covering rally. As mentioned above, I view this as an asymmetric trading opportunity given the strong short-covering trend among commercial hedgers in the palladium market. Moreover, the white metals should be prime beneficiaries of China’s reopening from recent Covid-related shutdowns as industrial activity (particularly in the automotive sector) ramps up again. However, because this ETF is coming off a major low and doesn’t enjoy the tailwind of forward momentum (as most of my recommendations do), it also represents an above-normal volatility risk. Accordingly, participants who don’t mind the risk recently purchased a small position in SPPP. I now suggest booking 50% profit in SPPP after its 11% rally and further suggest raising the stop-loss to slightly under 13.60 (closing basis) on the remaining position where the 50-day line currently resides. HOLD A HALF

Buy means purchase a position at or around current prices.
Buy a Quarter/Half means allocate less of your portfolio to a position than you normally would (due to risk factors).
Hold means maintain existing position; don’t add to it by buying more, but don’t sell.
Sell means to liquidate the entire (or remaining) position.
Sell a Quarter/Half means take partial profits, either 25% or 50%.