This post is featured from The Commodity Analyst newsletter. Originally sent to subscribers Monday December 20, we are sharing portions of the content a few days delayed here. For details and samples of the newsletter, see here: http://realfinancenewsletter.com
The past week saw an increase in risk aversion, with stocks, commodities and the euro all dropping on the week. A fading of optimism surrounding the latest EU meeting was evident, but risk assets accelerated to the downside after the Fed indicated that no new stimulus is forthcoming. On Tuesday, stock and commodity markets were comfortably ahead on the day, but then turned solidly negative in the 2 hours after the FOMC statement was released.
It appears that once again the market is desperately awaiting renewed quantitative easing. Especially given how (relatively) good US economic data has been recently, we were very surprised to see the market react so negatively to what was largely anticipated to be a mum FOMC statement. Commodities, especially gold, silver and WTI crude, took it on the chin the remainder of the week as reasons for holding commodities as an inflation/monetary debasement hedge appear to far-fetched at the moment. We continue to expect no QE3 from the Fed for the foreseeable future, or at least not until Europe has already caused asset prices to fall much further from current levels. The FOMC’s decidedly more positive language regarding the trajectory of the economy, and the sole dissenter arguing for more easing indicates that the FOMC is moving farther and farther away from increasing the size of the Fed balance sheet. As a result, we expect commodities to continue to decline, especially precious metals.
The following charts show the CRB Raw Industrial index as well as the GSCI Total Return index.
For the week, the GSCI index fell 4.6%, and the CRB RIND fell 2.3%. While this does not sound like much for the CRB RIND, this is quite a big weekly move for it, and should be cause for concern. The last time we saw such an aggressive decline was the week of the September FOMC meeting, which coincided with a 130 point drop on the S&P 500 within 2 weeks.
The market is beginning to understand that US stimulus to bail the world out of European problems. In addition to the Fed standing pat, top Republicans as well as President Obama himself indicated that the US would not lend to the IMF in order to bail out Europe. The powers that be in this country have decided that it is time to hunker down and focus on our own economy, and further debasement of the monetary supply will not be tolerated. As can be imagined, this poses a huge problem for precious metals bulls.
Gold
Gold was the headline mover of the week, dropping almost 7%. Longtime readers of The Commodity Analyst know that we have been bearish on gold for quite some time, but even we were surprised by this week’s move. Nevertheless, we see further downside for both.
The following chart shows the price of gold in yellow and Managed Money net longs in blue.
While Managed Money interest is certainly not extremely high, it is also not necessarily very low. While Managed Money longs most likely dropped a good amount after Tuesday (when the CFTC report is accurate until), gold Managed Money longs are nowhere near the lows seen in 2008 when the metal fell and washed out many weak long holders before moving higher. Furthermore, the red trendline of gold’s uptrend since 2008 appears to be on the verge of being broken. This upcoming week could be critical for the price of gold.
The following chart shows the price of gold in on OHLC bar chart.
From a simple technical standpoint, we can see that gold has made consistently lower highs since peaking in September. Gold is also significantly below both the 150 day and 200 day moving averages, levels that served as ironclad support for the past 3 years.
Even more critical, gold is now within striking distance of the intraday low put in by gold on September 26th. That day, gold opened lower on the Sunday night electronic session after margin requirements were raised the previous Friday. The selling quickly cascaded, taking gold down over $100 intraday by 2:45 am EST, or the middle of the European trading day. However, gold then rallied just as strongly as it fell, ending up finishing the day down only $10 from Friday’s close, and going on to rally to 1700 within weeks and 1800 within a couple months. This type of intraday fall and recovery was also seen on August 25th, which precipitated another move higher. These moves are in contrast to gold’s fall over the past few days.
While Friday saw gold briefly retake the $1600 level, it has yet to have a large intraday price spike downwards accompanied by buyers stepping in en masse to support the metal. We believe if gold breaks below 1560 initially, and then critically at 1535-1530, it could easily fall to 1475 and possibly 1300 in a hurry. Considering prices were at 1300 as recently as January, continued selling pressure in the equity markets would put heavy pressure on managers to liquidate the one asset that has actually gained in 2011, gold. With prices still up 12.5% on the year, managers are highly likely to sell into gold’s weakness, as its chart looks very poor, and its high degree of liquidity providing quick cash.
Another large factor to consider is both wide retail ownership of gold, as well as John Paulson’s outsized GLD holdings. The following table shows the top holders of GLD, and the chart shows total number of ounces of gold held by exchange-traded products.
As can be seen, John Paulson’s funds continue to hold over 20 million shares of GLD, or almost 5% of the entire fund. This is especially problematic, as Paulson’s poor performance this year (his main funds are down 30-50% year to date) will most likely lead to redemptions. As Paulson needs to raise liquidity, he will probably reach for the one asset he can sell at a gain, gold. Given that Paulson’s remaining GLD holdings comprise quite a bit more than one full day’s average volume of GLD shares traded, heavy divestment of GLD by Paulson could singlehandedly cause gold to fall an additional 5-10%.
Additionally, retail investors have become extremely enamored with gold over the past 5 years. The chart above shows that exchange-traded funds’ holdings of gold have skyrocketed from 20mm ounces in 2007 to over 75mm ounces today. Of course this number does not incorporate all the physical holders of gold who were seduced by Monex.com and other endless television advertisements for the “next big investment.” If and when gold prices continue to move lower, a good deal of panic selling by retail investors could easily ensue, especially if equity markets move lower. Gold has fooled most every retail investor into thinking that it is a safe haven asset, so if gold actually moves lower with force, it could face waves of selling by panicked retail investors who are now simultaneously losing on stocks as well as their false security blanket, gold.
For all these reasons, it is critical for gold bulls that gold at least break downward momentum and stabilize at current levels immediately. Just a 4% loss from current levels could lead to significantly lower prices in a hurry, with $1300 as a perfectly reasonable target.
Also, despite numerous goldbugs recently claiming that the current fall in prices presents a good buying opportunity in order for gold to climb a “wall of worry,” implied volatility data indicates the opposite. The following chart shows the GVZ, which is the gold VIX. It measures the implied volatility on GLD options.
As can be seen, gold volatility is actually near a 4 month low at present levels. By contrast, the last time gold traded near these prices, the GVZ was well above 40. To us, this indicates complacency on the part of gold bulls, which is not at all indicative of a market climbing a wall of worry. Furthermore, the relatively low implied volatility presents very good opportunities for bearish traders to enter positions.
Trade Recommendation
With implied volatility this low and with gold bulls claiming that this is yet another short-term blip, buying put options on gold to speculate on lower prices seems like a highly attractive risk/reward trade. The $1400 put option expiring on January 26th, 2012 can be purchased for $6.10. This trade would be profitable if gold closes below $1393.90 on January 26th.
While this is a low strike price, we believe a decline to or below these prices is fully within the realm of possibility. Furthermore, we believe that a deeper decline will most likely materialize soon if it is in fact in the cards, so purchasing these options with an eye towards reselling them upon further price weakness seems like a highly attractive proposition. Conservative traders could cut their losses if this option loses half its value.
Natural Gas
We indicated last week that we have turned bullish on the price of natural gas. While we remain bullish on a slightly longer timeframe (2-3 months), we see a high possibility of significantly lower prices in the near future.
For the past 2 weeks, natural gas storage numbers have turned in decidedly bullish readings, yet prices have failed to stabilize. 2 weeks ago, the draw was expected at -12, but came in at -20, and this week the draw was expected at -92 but came in at -102. In both cases, prices initially rallied, but quickly lost steam throughout the rest of the trading session. We believe this action belies significantly weaker prices in the near future, although that could be very short-lived.
With last week’s break below 3.20, front month natural gas is now at its lowest point since September 2009 when it hit 2.50. To be sure, a natural gas price of at or near $3 is frankly ridiculous, as cost of production for most producers in $4 or higher, so production must eventually be turned off. However, epidemic bearishness for natural gas has sprung from cheaply productive shale plays, as well as warmer than expected weather on the US east coast. While speculators are at least partly to blame, Managed Money data indicates that traders are not nearly as short as we would think given how low prices have fallen. The following chart shows natural gas net longs in white and the price of natural gas in orange.
While the correlation between extreme highs and lows in natural gas prices is clearly not great with Managed Money net interest, it is concerning that Managed Money has actually covered 30k net short contracts recently with no positive effect on natural gas prices.
We believe that a break below $3 would have speculators jumping on natural gas to the short side, possibly bringing prices down to the $2.50 level quickly to challenge the September 2009 low. However, we advise building bullish exposure to natural gas even if prices were to fall to this level, as this is an unsustainably low price. As the winter inevitably turns colder on the east coast, and prices rally at all, traders will jump back on natural gas to the upside as quickly as they did the downside.
Trade Recommendation
We recommend building a short put position on natural gas at the $3 strike price for 2-4 months out. At current prices, the $3 put expiring on January 26th can be sold for 0.11, or $1100 per contract. This trade would be profitable as long as natural gas closes above $2.89 on January 26th. Given that the February contract is currently trading at 3.174, this trade would be profitable as long as nat gas does not decline an additional 9% in the next 6 weeks. Given the possible continued move lower in natural gas, we recommend scaling into this position, perhaps by the desired total position size in thirds over the next 2 weeks.
US Stocks
We continue to view US stocks with an extremely bearish disposition due to their stubborn strength as of late even in the face of certain recession in Europe. While equity market investors continue to remain optimistic that somehow the US can escape the slowdown occurring in emerging markets and Europe, we believe US stocks will eventually succumb to the same forces, with corporate earnings in the US coming in nowhere near current 2012 expectations. Additionally, volatility as measured by the VIX is extremely low in our view considering the likely pitfalls that lie ahead.
The following chart shows the VIX index.
As can be seen, the VIX is now at levels not seen since June and July, when most investors were completely unaware of Europe’s problems. Just as with gold, we believe this low level of volatility indicates a very high level of complacency among equity bulls. In contrast to October’s powerful rally when the VIX remained above 30 almost the entire way up until the peak on October 27th, the VIX is now 50% lower than its level reached on August 8th, the day after the US lost its AAA credit rating.
With the massive deleveraging yet to come out of Europe combined with decimated European economic activity due to austerity, we believe there is much more risk than reward possible from equities at current prices. We believe the current complacency in the equity options market presents an ideal opportunity to both hedge long stock exposure, as well as speculate on further downside.
Trade Recommendation
Equity investors’ lack of fear makes the purchase of put options an intriguing play. Specifically, the SPX 900 puts expiring March 17th 2012 can be purchased for $6. Such a trade would be profitable if the S&P 500 were to decline to 894, or 26.6% from current levels. While this is a large downwards move in equity prices, we believe that European deleveraging coupled with a soured view on US economics could easily take us to such levels. Furthermore, a smaller decline occurring in the near term coupled with an increase in the VIX would make for a highly profitable exit of this trade before expiration. Given that this same option traded for $50 on August 8th, upside could be quite substantial in the event of further equity market turmoil.
Investors can also look at purchasing the 1000-900 SPX put spread expiring June 16th, 2012 for $13.15. Such a trade would entail risking $1,315 per contract for a possible profit of $8,685, or 660% on invested capital. The trade would reach maximum profitability if the S&P 500 declined to 900 on June 26th, or 26% from current levels. Again, this trade requires a significant downwards move to reach peak profitability, but could also be exited if near-term equity market weakness increases volatility.
Aggressive traders can also look to purchase futures directly on the VIX index. The front month futures contract expiring December 20th is trading at 26.10. This contract could be purchased in the hopes of the VIX rising this week, but exposure could also be rolled to the January contract if such hopes fail to materialize. With the VIX January futures currently trading at a 4 point premium to the spot VIX index, investors should be careful, but we believe that any spike in the VIX should take it well above the 30 level, making such a trade profitable.
ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
