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.

This post is featured from The Commodity Analyst newsletter.  Originally sent to subscribers Monday November 21, 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 abatement of buying pressure on all risk assets, and potentially a trend-changing reversal. There were not any immediate headline reasons for such a selloff, which bodes well for the trend continuing to the downside, as investors continue to take risk off the table. Also, we finally saw a breakdown in inter-asset correlations, which also could mean that fundamentals are returning to the market, making our job of identifying macro fundamental trends much easier.
The following charts show the CRB Raw Industrial index as well as the GSCI Total Return index.

The CRB RIND index made a new yearly low on Thursday, a phenomenon to which we are now accustomed.  Interestingly, it appears that the GSCI index is finally playing along, falling 2.6% for the week and now negative for the year.  To us, this convergence will most likely continue, with the GSCI index falling to play catch up to the CRB RIND as fundamentals in Europe and emerging markets continue to deteriorate.

Europe

The European situation continues to evolve into a nightmare.  From anecdotal evidence, it appears that the ECB needed to step in and buy bonds each day this week to prevent a complete meltdown.  Even still, European bonds had a rough week overall.

The following charts show this week’s action in Italian, Spanish, and French 10 year bonds.

All three countries were under heavy selling pressure this week, causing the ECB to step in at multiple junctures.  To highlight the fever pitch of the action, Thursday’s chart tells the European debt story.  The ECB bought bonds, in a presumably very large size, directly before debt auctions by Spain and France.  The ECB tends to concentrate their bond buying immediately preceding debt auctions because they are trying to drive down the yields so that investors will accept lower yields at the auction.  However, it is becoming painfully obvious that the ECB is the only party supporting these bonds.

As we have stated before, European banks have about 1 trillion euros of debt coming due over the next year, and are also being forced to raise capital ratios by June 2012.  What this amounts to is massive forced selling of debt.  Because European banks’ non-sovereign holdings are concentrated in proprietary loans that are illiquid and difficult to value, the first thing they will sell are their sovereign debt holdings.  Add to this fact that sovereign debt is becoming increasingly volatile and losing value quickly, and you can see that it won’t take much to set off everyone rushing for the exits at the same time.  Banks from Soc Gen to BNP to Deutsche Bank have all indicated their intention to continuously decrease their sovereign debt holdings.

At this point, the only idea keeping the markets where they even are is the notion that the ECB will reverse their stance on monetization of the debt, and start printing euros to backstop Europe’s sovereigns and banking system.  Literally everyone in the market is banking on this, from the bulls buying stocks, to the bears shorting the euro.  As contrarians, we are forced to ask the question, what if this doesn’t happen?

While admittedly we are still in the camp that the ECB will most likely print, there have been some important signs lately that this may not necessarily be the case.  First of all, German and ECB officials are now saying on a twice-daily basis that monetization of the debt is not an option.  The market is wholesale betting that this is merely just posturing, but it is worth considering that maybe these officials are trying their best to indicate to the market that monetization of the debt is not a possibility.

However, even more concerning is Germany’s recent political overtures.  A leaked document (http://www.telegraph.co.uk/news/worldnews/europe/eu/8898213/German-memo-shows-secret-slide-towards-a-super-state.html) this week showed that Germany is making plans multiple sovereign insolvencies, which would then trigger “European Union” (read: German) control over those countries’ politics and economics.  If this happens, it would be more shocking than a Lehman moment ever was, in that essentially Germany would stand idly by as more and more countries fell, only to completely exert their political will on them.  Already, Italy and Greece have forced out their leaders for essentially EU puppet governments.  In a hugely perverse system of incentives, it may actually benefit Germany for these countries to experience more sovereign debt troubles.  While the world would be thrust into a renewed recession, politicians are much more concerned with increasing their power rather than doing what’s best.

If Germany could usurp Europe’s sovereignty by way of withholding further financial support, this may prove too enticing a prospect for their politicians to resist.  With the German population already disgusted with the perceived bailout of other European nations, this seems a golden opportunity for Germany to exert their political will for generations to come, even if it means enduring short-term financial pain.  As it becomes clearer that there is no solution other than money-printing, and that a European depression is unavoidable, Germany could easily decide that they might as well support their own banks, allow these other sovereigns to go as they will, and pick up the pieces afterwards in return for a complete sacrifice of national sovereignty.  Such a scenario has not even been partially priced into the market, and could cause catastrophic consequences.

Germany’s horrific experience with hyperinflation, specifically referenced by German officials this week, is also extremely strong motivation to not go down the money-printing road.  In fact, one of the reasons that the ECB was created in the first place was to ensure that this type of monetization does not occur.

When viewed from this angle, it is not surprising that the euro is as high as it currently is.  Considering global currency wars, the euro is actually the most “hard money” currency there is right now.  The US, Britain, and Japan have all engaged in massive quantitative easing, which is just a thinly-veiled form of currency devaluation.  Japan has intervened three times this year (all unsuccessfully) to weaken their own currency.  Excluding Europe, the developed world is literally trying to devalue their way into prosperity.  Even the former safe haven Swiss franc has drawn a hard line in the sand and warned against investors owning their currency.

Ironically, even though the ECB is easily the most hard money of the major currencies, it has still lost value against all major currencies this year.  The current decline can be attributed to investors anticipating a reversal in ECB hard money stance, as well as investors liquidating euro-denominated assets due to impending recession in Europe.  Given the Fed’s constantly-looming guillotine of further QE, it is not surprising that international investors have been reluctant to turn to the dollar as an alternative.  Instead, they have turned to gold, crude oil, and other commodities, as evidenced by gold’s incredible performance on the year, as well as crude’s incredibly stubborn advance.

However, eventually macro fundamentals will come back into play, and the dollar will strengthen, causing commodity speculators to greatly cut their longs.  In scenario 1, the ECB will print money, causing the euro to drop hugely in value against all competitors, with the dollar being the primary beneficiary.  In scenario 2, the ECB will not print, causing a major depression in Europe and multiple sovereign bankruptcies, which will cause investors to liquidate European assets and invest elsewhere.  The downside for the euro is much greater in scenario 1, and certainly this is scenario that the market is betting on.  But the euro should suffer from pure macroeconomics in scenario 2, even if it is only in the short-term because the Fed will initiate more QE in response to a deep European/global recession.  This is why the net short position on the euro reached the 2nd-highest level this year this week.  Investors shorting the euro are betting on a heads I win, tails I win scenario.

While we believe this is the case as well, the extremely large net short position in the euro is worrisome.  Any perceived good news for the euro (or bad news for the dollar) could cause a powerful short-term rally.  Also, if the ECB maintains their hard money stance until the end, the euro could actually trade higher in the long-term due to almost assured renewed easing from the Fed, even as European stocks and European sovereigns get decimated.

Trade Recommendation

For the reasons discussed above, we recommend covering euro shorts at a price of 1.35 or better.   To be sure, this is not because of a bullish view on Europe, but rather an acknowledgement of how crowded the trade is, and the fact that there are other, better shorts in the market right now that play off the same theme.

Investors who wish to maintain exposure could switch their short futures exposure to long put spread exposure instead to maintain a degree of short euro positioning with limited downside.

Furthermore, the short euro trade could be hugely adversely impacted by the ongoing US debt supercommitee negotiations.

US Debt

Attention has been shifting recently to the negotiations of the Congressional debt supercommittee.  The committee is charged with finding $1.2 trillion of budget savings, or else have automatic spending cuts enacted in 2013 consisting of cuts on both defense and Medicare/Social Security.

While this situation is not nearly as deadline-focused as the debt ceiling issue back in August, there is a strong possibility the US could face a further debt downgrade from Congress’ continued inability to effectively get anything done.  S&P indicated in their August 5th downgrade that the US was still on review for further downgrade, and cited political inefficiency as a primary determinant of whether another downgrade would occur.  Similarly, Moody’s has indicated that the US is still on negative credit watch.  Even if none of the credit rating agencies downgrade the US again immediately, it is fairly obvious that a deadlocked supercommittee cannot be construed as good in the eyes of the raters.

Ironically, Congress doing nothing over the next few yearswould actually be hugely beneficial for deficit reduction.  By some estimates, the enactment of sequestration under the August bill, combined with planned expirations of the Bush tax cuts, payroll tax cuts, and other temporary tax reductions, would actually reduce the budget deficit by $7.1 trillion over the next 7 years.

However, a do-nothing Congress would certainly not be viewed favorably by the rating agencies, even if it meant that the deficit would be substantially reduced over the next few years.  Indeed, even if US debt is downgraded, this will have no effect on US treasuries or the market’s perception of US creditworthiness.  What it will have an effect on is the price of gold and the US dollar, at least in the short-term.

Another debt downgrade could potentially trigger massive short-covering in the euro as investors get away from the dollar, and also trigger a surge in gold prices.  The following charts show the performance of the euro and gold on August 8th and 9th following the August 5th downgrade.

As can be seen, the euro opened more than a full percent higher against the dollar, while gold climbed an impressive 4.5% on August 8th alone, preceding a march to above 1900 over the next couple weeks.  While the euro eventually fell precipitously after the initial rally, we believe this was more due to the greatly heightened tensions in Europe rather than a reversal of thinking.  That day marked huge ECB buying of both Italian and Spanish bonds, along with heavy European equity selling.

On August 2nd, the speculator futures position on the euro stood at net long 6,099 contracts.  Today, the figure stands at net short 108,471 contracts.  The euro rallied a full percent against the dollar even as speculators were already net long the euro.  If a similar situation occurred today, with the massive net short position built in the euro, the euro could appreciate by 2-3%+ easily, even if it later fell back because of European concerns.

Similarly with gold, investors will pile into the yellow metal as an alternative to the US dollar.  However, viewing silver prices shows an interesting divergence.

As can be seen, silver initially spiked as a correlation trade to gold’s rise.  However, silver continuously fell over the next 2 days while gold continued to rise.  The reason for this is silver’s much less accepted status as a monetary alternative, and its high industrial demand exposure.  For this reason, we believe a short silver position, especially one enacted on an immediate knee-jerk spike would be a highly prudent trade.  We remain short silver for clients, as we believe even in the absence of a US downgrade, recessionary dynamics from Europe will continue to have deflationary pressure on industrial metals.  We are also short gold, but we will be quick to cut this position in the face of a renewed gold rally.

While the euro and gold would benefit from a US downgrade, many other assets would not.  The following charts show a few other assets during the same time frame as above, directly after the last downgrade.

As can be seen, both the Australian dollar and crude traded down immediately after opening on news of the US debt downgrade. Both these assets fell continuously, with crude dropping an incredible 15% in just 24 hours.

While the Australian dollar is a currency alternative to the US dollar, it is much more linked to risk assets due to Australia’s status as a resource provider for emerging economies. Even if the US dollar were to generally trade down after a US downgrade, the Australian dollar would lose value against the US dollar.

On crude, while some investors do own crude as a currency alternative, concerns about economic slowing would greatly override any need to diversify currency holdings in a debt downgrade. Those investors who want to turn to hard assets would much rather own gold in such a scenario.

The chart of the DAX and NQ futures shows investors’ general risk aversion after the debt downgrade. Also, the DAX shows that European concerns were even worse than US, with the DAX falling by over 12% in the day and a half after the downgrade.

Trade Recommendation

For the reasons we mentioned above, we believe shorting the Australian dollar and crude are the best risk/reward trades going forward. We recommend shorting more Australian dollars at a price of 1.00 or better, as well as shorting WTI crude at $97.67 or better. As we discussed in a previous letter, the carry rate differential on the Australian dollar and the US dollar will most likely continue to compress as the RBA drops interest rates. Also, it does not benefit many parties to have the Australian dollar rise, unlike the euro. The Australian government would support a depreciated Australian dollar as a boon to Australia’s export-dependent economy, and so would China as an indirect measure of cheapening commodity prices by decreasing cost of production. The following section discusses our thoughts on crude oil in greater detail.

Crude Oil

Crude oil has recently disconnected from the rest of the risk asset complex, continuing to rise another 8% after October 27th even after the euro, Australian dollar, and equities all peaked. Contributing greatly to crude oil’s rise was the rumor and eventual news of the reversal of the Seaway pipeline, opening a direct line of transport between Cushing, OK and the Gulf of Mexico.

Such a development is important fundamentally because accelerating oil production in the Bakken shale in North Dakota as well as Canadian production was becoming bottlenecked in Oklahoma, causing WTI prices to come under pressure even as Brent crude prices stayed fairly stable. This phenomenon caused WTI crude to trade at a record $27 discount to Brent on October 14th. Since then, the spread has narrowed all the way to $10, hitting a low of $9.29 on Wednesday.

While the Seaway pipeline should help alleviate the inventory buildup in Cushing, WTI’s rise over the past month can largely be attributed to the breakdown of the spread rather than favorable demand dynamics. From its October 4th trough to today, WTI is up 30%. In the same time span, Brent crude rose only 8%. Considering Brent’s much wider use (Brent is used by China, Europe, etc.) Brent prices are a much better gauge of crude demand than WTI. Indeed, RBOB gasoline was actually down 0.5% in the same time span, indicating that increased gasoline demand did not accompany crude’s rise. It appears that WTI’s rise is primarily being caused by a massive unwind of the long Brent, short WTI trade, as well as a generally increased long posture by Managed Money.

The following charts show the price of WTI against Managed Money longs, as well as the gross Managed Money short position.

As can be seen, crude Managed Money net longs remain at an elevated position, but most striking is the collapse in Managed Money shorts. Managed Money shorts reduced their position to the lowest since May 17th. This short covering certainly contributed to crude’s incredible recent rise, but given the deteriorating macroeconomic environment, we believe crude shorts could shoot right back up.

Further lending credence to the view that energy demand remains weak is a comparison of WTI crude and RBOB gasoline prices.

As can be seen, while WTI and RBOB usually move in lockstep, the performance of the past month has been an anomaly. RBOB has shown weakness while WTI has been on a march straight upwards. While this could theoretically give way to both rising together, we believe the larger macroeconomic picture favors the downside. With US consumers stretched, deleveraging, and completely devoid of confidence, further prices increases will destroy demand for energy, a fact reflected in RBOB’s continual downward trend. We expect WTI to reverse course presently and follow RBOB downwards.

Trade Recommendation

Given its stretched Managed Money long positions and the general negative macro environment, we view WTI crude as an ideal short. As stated above, we recommend shorting WTI crude at a price of $97.67 or better. To contain risk, investors could place a stop-loss order slightly above the 61.8% Fibonacci retracement level of $99.60, with the Fibonacci retracement drawn from the April 29th high to the October 4th low.

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.

This post is featured from The Commodity Analyst newsletter.  Originally sent to subscribers Tuesday November 15, 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 sideways, albeit volatile, movement of risk assets. While last Wednesday was a large selloff, the indices made back almost all of what they lost on Thursday and Friday, with the euro and Australian dollar recovering as well. Despite the seemingly lackluster action in equities and risk assets, fixed-income market fundamentals continued to deteriorate, and we believe a collapse in asset prices could be imminent.

The following charts show the CRB Raw Industrial index and the GSCI Total Return index.

As can be seen, the breakout of the GSCI index has hardly been confirmed by the CRB RIND.  While the CRB RIND has at least slowed its pace of decline, it still remains within a quarter of a percent from yearly lows, while the GSCI index has rallied magnificently since October 4th.  As we have indicated before, this continues to signal a preponderance of speculation on a recovery rather than a real recovery.  Given that the CRB RIND rebounded well before equities themselves bottomed in the 2010 summer correction as well as the 2008-2009 bear market, we believe the CRB RIND’s stubbornness in turning upwards indicates a continued fall in aggregate demand that is afflicting developed markets, not a simple lack of liquidity that the ECB and Europeans would have us believe.  On that note, let us turn to our now weekly practice of dissecting the latest news (or lack thereof) out of Europe.

Europe

The ECB had to again buy sovereign bonds in the secondary market this week to calm investor fears about Italy’s insolvency.  However, the more bonds the ECB buys, the less liquidity there is in the sovereign market and the less confidence investors have in the sovereigns.  Shown below are charts of the Italian and Spanish 10 year bonds.

As can be seen, Italian yields went absolutely parabolic on Wednesday of last week, rising to an astonishing 7.5% before ECB buying on Thursday and Friday drove them down to 6.5%.  However, yields rose back up to 6.7% today as the ECB stepped away.  Interestingly, while the Italian bonds at least showed a respite from selling for 2 days, the Spanish bonds did not.

As many have surmised, speculators and hedgers alike will move from country to country, much too fast for the ECB to keep up.  Even though the ECB was able to somewhat calm Italian yields (for a whopping 48 hours), investors simply moved to shorting Spanish bonds.  In essence, shorting Greek, Irish and Portuguese bonds is no different than shorting Spanish, Italian or even French bonds.  All of these countries suffer from the same problems: lack of growth, massively bloated financial system and overindebtedness on the sovereign, corporate and individual levels.  To top all of it off, none of the Eurozone countries can print its own currency and monetize its debt.  The only difference between a France, Italy or Spain at this point is what stage of the crisis they are in.  Indeed, even German bonds will likely come into question at some point if the ECB maintains their “virgin” stance.

At this point, most every investor, economist and analyst expects the ECB to print money, and therefore save the world economy.  However, the market is getting far too ahead of itself here.  As long as the status quo in the equity markets persist, the ECB will not be nearly motivated enough to embark on such a departure from their sacred covenants.  We know this from the daily, deliberate statements by ECB officials that they will absolutely not monetize Europe’s debts.  It will take a renewed deflationary crisis to get the ECB to finally move off their hardline stance, and we are nowhere near this point.

Today’s news that Germany has approved legislation to allow countries to exit the euro, as well as Fisher’s statements that US growth remains strong enough to discourage further easing attempts show that regulators and politicians are clueless as to the environment we are entering.  While QE out of the US and Europe will eventually happen, they absolutely will not while markets remain at these elevated levels.  If and when the S&P 500 reaches around 1000 or the euro-dollar cross goes below 1.20 or so, the respective central banks may be inspired to act, but there is not even a chance of this at current levels.

US Stocks

While US stocks remain at fairly elevated levels as compared to early October, they are showing signs of cooling off.  The S&P 500, the euro, and the Australian dollar have still not exceeded their October 27 highs.  From a technical perspective, this break in upward momentum is bound to be a bearish signal for traders.

Posted below is a chart of the AAII Bullish sentiment readings divided by Bearish sentiment readings, as well as a chart of just the Bearish readings.  These are surveys conducted with individual investors on a weekly basis.

As we reported 2 weeks ago, this index is very useful as a contrarian indicator.  2 weeks ago, this index was at 1.72, meaning 1.72 bulls for every bear.  The index then promptly lost 6% over the next 3 trading sessions.  Today, this index stands even higher at 1.82.

The last time the index was slanted this bullish was February 17th of this year.  As shown by the chart above, the S&P lost 7% almost immediately after this reading.  Also, the last 2 times there were this few bears in the survey (as denoted by the AAIIBear Index chart above) were on February 17th and July 7th.  The S&P posted losses of 7% and 19% very soon thereafter both of these readings.

While these are purely technical sentiment readings, they are indicative of the complacency in markets nowadays.  It seems as though individual investors as well as commodity investors have decided to largely ignore the macro risks for the time being and focus on the upside.

While the S&P 500 at large is trading at a fairly cheap 13.2x earnings, a deeper look into the market reveals a not so necessarily cheap market.  The Dow Jones US Financials Index is trading at around book value and 12x earnings, which is not all that cheap considering assets on banks’ balance sheets from the bubble years are still held at book value, not to mention the systemic risk of contagion from the European banking system.

The Nasdaq 100 is trading at a 16x P/E, which is low historically, but certainly does not sound all that low in a vacuum.  Especially considering that Apple makes up 14% of the index, and that Apple, the world’s largest company by market cap, trades at a premium multiple to the stock market at large, stocks do not look priced for a recession.

The energy services sector seems to be the most frothy.  The OSX is now trading at a 19.50 P/E, significantly above the 5x it traded for in the depths of 2008.  With WTI crude at 98 and Brent at 112, crude itself seems overpriced, and the services sector may be even more overpriced.  Both could endure swift falls in the case of renewed recession.

Trade Recommendation

Traders can take advantage of the implied to historical volatility disparity in the energy services sector.  We recommend purchasing the January 2012 119.1 put for $5.35 per contract.  With the current 30 day historical volatility at 51.26% and the implied volatility of this option at 44.62%, this option can be purchased at somewhat of a discount, given the assumption that recent volatility continues.

Crude Oil

WTI crude has gone on an amazing run since October 4th, rising an incredible 31.22%.  While this is somewhat in line with the rest of risk assets, crude has had an especially good run.  The last few days can most likely be chalked up to speculators buying due to a perceived geopolitical risk from Iranian hostility.  However, just as in the Arab Spring, these speculators will eventually need to liquidate, taking prices down significantly from current levels.

The following chart shows the price of crude in orange and the Managed Money net long position in white.

As can be seen, the managed money position has grown to a high level, in the 91st percentile of readings going back 5 years, with prices only in the 79th percentile.  This indicates a preponderance of speculators driving prices up.  If and when there is an easing of geopolitical tensions and/or signs of economic slowdown, speculators could exit the crude market very quickly, driving prices near recent lows around $75/barrel.

Trade Recommendation

We recommend shorting crude oil futures at a price of $98.50 or better.  A stop could be placed at the $100 level or just above, as this is psychological support/resistance.

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.

This post is featured from The Commodity Analyst newsletter.  Originally sent to subscribers Sunday November 6, 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 was packed with fresh concerns over Greece, combined with renewed ECB Italian bond purchases and RBA and ECB interest rate cuts…and that only got us to Thursday.  Despite the relative strength of equity and risk markets, the economic situation here in the US and abroad is tenuous at best, and we believe the next few months will turn fears of renewed recession into reality.

The following charts show the CRB Raw Industrials as well as the GSCI Total Return index.

As can be seen, the CRB RIND continues to show no signs of rallying despite the GSCI index as well as the S&P 500 remaining at elevated levels as compared to early October.  This ongoing situation is consistent with our view that the global economy is suffering from a lack of aggregate demand rather than simply dealing with the European debt crisis.  By contrast, the equity and speculative commodity markets have already priced in a fairly rosy economic future after October’s spectacular run.  As we will discuss below, it is our view that the bulk of the economic softening has yet to begin, and that this optimism will quickly fade as recession becomes reality in the developed world.

Europe

The following charts show the German, Italian and French Purchasing Managers Indices.  This is a survey of purchasing managers in these countries, and is frequently used as a forward gauge of economic activity.

Viewing these charts is downright scary given their aggressive, vertical dropoffs recently.  Italy and France are trending almost straight down, with multiple months under 50, which signals contraction.  Now, even Germany has crossed below 50.  These figures are consistent with Europe re-entering recession.

Indeed, even Mario Draghi, the new ECB President, indicated that Europe is headed for a “mild recession” by year-end.  Considering how massively overleveraged both Europe’s banks and Europe’s sovereigns are, is there really a possibility that this recession will simply be “mild”?  Given how deeply even countries like France are now cutting spending, these austerity measures will cut deeply into European GDP and cause already weak economies enter protracted recessions.

Also, European banks must refinance 1 trillion euros of senior debt in the next year, a truly staggering amount.  The drastic coincident dropoff in bank lending that is about to happen in Europe will cripple growth in the region for years.  As we detailed last week, European banks are massively overleveraged and undercapitalized as compared to their American and Asian counterparts.  Because of the concern around European banks, there has only been one debt deal done by a European bank, Deutsche Bank, in the last 3 months.

The European Banking Authority has already asked that the EFSF be used to guarantee some bank debt to jumpstart the bank debt market, but there is absolutely no money for this.  The EFSF is already stretched to its limit (and much farther in our opinion) by the implied guarantees on Italian debt, so there is not a single cent left for bank guarantees.

Instead, the EU’s decision was to have each nationality assist in recapitalization of their own domestic banks, if necessary.  The problem with this is that the European banking system is so bloated as compared to the size of the European economy that this is an impossible task.  BNP Paribas alone has 809b euros in short-term borrowings, while France as a country has only 1.6 trillion euros in outstanding debt!  Even a slight, partial guarantee of bank financing by France would cause an immediate French sovereign downgrade, which would cause this crisis to come to a head very quickly.

Since the ability of the EFSF and/or nationalities to assist bank refinancing is limited at best, European banks will be forced to make up the bulk of the capital shortfall and bond maturities by firesaling assets.  Herein lies yet another problem, in that the majority of European banks’ assets are proprietary bank loans, not publicly-traded stocks and bonds.  Because 80% of private capital in Europe comes from direct bank lending rather than public stock and bond markets, European banks are bloated with private loans.  Disposing of these illiquid, proprietary assets will be an extraordinarily difficult and lengthy process due to the one-off nature of these loans and the fact there are no ready buyers.  While private equity firms and other banks will be willing to absorb some of the more attractive loans at bargain prices, the aggregate buying power of these parties is capped in the low 10s of billions, while the European banks will likely need to offload at least half a trillion.

The recent decision of the EU that banks increase their tier-1 capital ratio to 9% by June 2012, combined with the massive bank refinancing, means that banks will not only be disposing of assets, but that their new lending will be severely constricted.  Without new credit, a massively overvalued currency, and no engine for organic growth, Europe will and has already begun to fall into a deep recession.  As European GDP decreases, their debt and deficit to GDP metrics will get worse and worse, further exacerbating the problem.  And if you think the US will somehow be spared from this, think again.  The following chart from Google Public Data Explorers shows US GDP growth vs. Germany over the past 40 years.

As can be seen, there has never been a period in which either the US or Germany suffered a growth slowdown without the other following suit.  In short, if Europe goes into recession, so does the United States.

Trade Recommendation

While our economic thesis continues to revolve around Europe, our trade recommendation may be somewhat surprising.  We recommend shorting the Australian dollar at a price of 1.035 or better.

As the Australian economy is basically entirely dependent on China, the Australian dollar has become a great proxy of both risk aversion and global economic concerns.  If things go badly in Europe, China will undoubtedly slow as China’s largest trading partner, Europe, enters recession.  Also, because Australia has the highest interest rates in the developed world, traders’ reliance on its “carry,” meaning holding long positions in the AUD while funding it with short positions in low-yielding currencies like the USD, means that traders will sell AUD and buy back USD shorts quickly as risk aversion takes hold.

Posted below is a chart of the spread between the RBA cash interest rate target and the Fed Funds target vs. the price of the AUD.USD currency cross.

As can be seen, the AUD carry rate decreased for the first time since 2009 last week, as the RBA rate was decreased by 25 basis points last Monday.  While this is not a huge decrease, it does mark a symbolic shift away from rising rate spreads to declining rate spreads.  This was the main fundamental driver for the increase in exchange rate over the past 5 years, as more and more traders jumped on the long Australian dollar trade to generate both capital appreciation and interest rate returns.  However, as seen in 2008, this trade can unwind alarmingly quickly, and can produce heavy losses in a hurry as traders buy back their USD shorts.  The last period in which the carry rate was at 425 basis points, between May and November 2010, the Australian dollar traded in a range from 0.81 to 0.98.  With the Australian dollar trading at 1.035 today and Europe quickly entering recession, this seems like a highly attractive risk/reward trade.

Also, the massively bearish sentiment in the euro is another reason to add to Australian dollar shorts rather than euro shorts at this level.  The chart below shows speculative longs in the AUD futures vs AUD price.

As can be seen, the AUD futures longs increased this week to over 26k contracts from a small net short position just 3 weeks ago.  This means that there are 26k contracts worth of prospective sellers of the Australian dollar is things take another turn for the worse.  By contrast, here is the chart for the euro.

As can be seen, while euro shorts have come in somewhat, they remain at a highly elevated position.  While this is one reason the euro is staying stubbornly high, we believe there may be more subversive market factors at play in supporting the euro, including Chinese buying in support of the euro.  However, with respect to the Australian dollar, China has no reason to support the AUD and in fact has a vested interest in its depreciation, as Australia is one of their largest suppliers, so they could theoretically benefit from a weak AUD.  Even though most of Australia’s exports to China are priced in USD anyway, the Chinese government has no reason to support the Australian dollar, and will gladly let it depreciate.

While we remain short the euro, the believe that the short Australian dollar position may be a better candidate for size increase over the coming weeks and months due to its continued support by carry traders.

Crude Oil

WTI crude staged an immense rally during October, rising an incredible 18% during the month, and an incredible 26% from its October 4th trough to the October 24th peak.  However, we believe that the rally is quite overdone at this level, and will most likely fade as renewed concerns about the economy resurface.

The following chart shows the price of crude in orange and the Managed Money net long position in white.

As can be seen, the Managed Money net long position is around where it was before the “Arab Spring” events caused crude to briefly jump into statospheric levels.  Even more interesting is that crude prices are actually above where they were before the Tunisian and Egyptian unrests.  To us, this indicates that current prices are being set by speculators increasing their economic and inflation expectations rather than renewed demand from consumers.

With the Managed Money position as large as it currently is, the potential for long liquidation is high at these levels.  With crude pushing up against the 200 day moving average but not yet able to break through, crude appears to be facing stiff resistance technically as well.

Trade Recommendation

We recommend shorting WTI crude December futures at a price of 94.50 or better.  Conservative traders can use the 95.10 level as a stop-loss, as that level is above recent highs as well as above the 200 day moving average.

This Week’s Managed Money Charts

Precious metals Managed Money looks to be at fairly low levels, but we question whether this will be useful going forward.  Correlations between precious  metals and other risk assets are at all-time highs, and the precious metals ETFs control far more metal than do futures traders at this point.  With retail participation in the precious metals market this high, it seems that silver and gold prices will continue to follow equities either to the up or the down side.  Especially with the perplexing non-reaction by precious metals to the Fed’s  inaction this week, we recommend the sidelines for the moment as this picture becomes clearer.  If and when equities start to fall, gold and silver can be shorted alongside them as a proxy.

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.

Ananthan Thangavel was invited back to discuss his forecast for the top of the gold market during his interview with Fox Business 9/12, and also to discuss other assets he is currently shorting.

10/11/2011 Lakshmi Capital Fox Business News Video

From the video:

“To be honest, we are short pretty much all risk assets.  But probably the best one is the Australian Dollar.  The Australian Dollar is heavily economically linked, due to the fact that almost all of Australia’s exports are going to China.  Anytime China slows down, Australia is going to feel that twice as badly.  If you look at what’s going on in Europe right now, Europe is going into a recession which, in my opinion, is a foregone conclusion.  Once Europe goes into a recession, China will slow down.  If that starts to pierce the Chinese real estate bubble, you could have a major problem.  China buys a ton of copper and other commodities from Australia, with China representing 50% of worldwide copper demand, 50% of worldwide cement demand.  The Australian Dollar could take a real beating.”

“The story here is long US Dollar.  The US Dollar back in August lost its safe haven bid a little bit due to the debt debacle and dysfunctionality of the Government.  But, we expect now that the Fed has essentially stopped printing money it’s going to come with Operation Twist until June 2012.  Every other central bank out there, especially in the developed world, is just flooding the world with liquidity.  As the US Dollar regains it’s safe haven status, we really think that asset is going to outperform all others.”