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.

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.”

This post is featured from The Commodity Analyst newsletter.  Originally sent to subscribers Friday October 14, 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 a massive rally in risk asset prices.  Since the bottom on October 4th, the S&P 500 is up 14%, the Nasdaq 100 up 16%, Brent and WTI crude up 16%, and copper up 15%.  To be sure, risk asset prices experienced their strongest rally since the rally off of the March 2009 lows.

However, in the same time period, the CRB RIND rallied only 1.1%.  The following charts show the CRB RIND and the GSCI Index.

As can be seen, the GSCI Index has experienced the same massive rally as all risk assets, whereas the CRB RIND has barely responded.  This is of particular interest to us, as this would seem to suggest that speculators are getting ahead of actual commodity demand.

To illustrate this, the following charts show the percentage changes on the CRB RIND and the GSCI Index for September and month to date October.

As can be seen, in September, the CRB RIND fell 5.67% while the GSCI Index fell 8.85%.  This makes sense as speculative moves tend to be more exaggerated.  However, so far in October, the GSCI Index is already up 8% while the CRB RIND is only up 0.63%.  While the CRB RIND may be stabilizing, it seems that the GSCI’s advance is largely betting on the future, pricing in a robust increase in commodity demand which may or may not materialize.  In our opinion, not only will this increase not materialize, butwe will see a continued dropoff in demand for commodities.

Europe

Despite what risk asset prices and news headlines tell us, the situation in Europe is far from resolved.  The reason why Merkel and Sarkozy can only announce that they will have a plan at some point in the future, and that they are pushing back meetings, is because there is no mutually palatable solution.

At this point, the major European powers are at odds over the use of the EFSF.  As we commented on last week, France would prefer to use the EFSF immediately to recapitalize their banks due to their absolutely massive PIIGS debt exposure while Germany would prefer to use the EFSF only as a measure of last resort.  Given the bailout’s already high level of unpopularity in Germany, Germany will most likely prevail in this battle.  This will be the next major leg down in the European crisis, as France’s AAA credit rating will almost certainly get downgraded as they backstop the liabilities of their 3 largest banks.

To give an idea of the magnitude of this backstop, France just backstopped 36.5% of Dexia’s short-term liabilities, which comes out to about 30 billion euros.  Between the 3 of them, Soc Gen, BNP and Credit Agricole have 1.7 TRILLION euros of short-term borrowings (980 billion for BNP, 598 billion for Soc Gen, 153 billion for Credit Agricole).  France’s total public debt outstanding is just under 1.6 trillion euros currently.  Even if France only has to backstop one of these banks, their effective debt would absolutely skyrocket, leading to an assured downgrade of their credit rating, and sending French government bonds into freefall.

Another huge problem that developed this week was the admission that Europe is now seeking a 50% haircut for private Greek bondholders.  We won’t bother commenting on the inherent problem for Greece that this private haircut really doesn’t help them that much, as UBS has already published a great piece on it: http://www.scribd.com/doc/68776868/EWEF-141011.  However, what no one is really talking about is what effect this haircut will have on the other PIIGS countries.  With Ireland and Portugal suffering through their own austerity and debt crises, how exactly could the EU offer such a generous debt reduction for Greece but then tell Ireland it must continue to pay 100% of its debt?  These other peripheral countries will expect some sort of haircut if Greece gets such a sweetened deal.  Taking PIIGS debt ex-Italy, there is about 1.4 trillion euros of debt.  Applying a conservative 25% haircut, that is 350 billion euros of losses that must be taken on the debt.  Furthermore, even if the debt is probably already trading around that level, banks have not marked it to market because of accounting rules, while a haircut event would force that inevitability.  Such a scenario would trigger massive insolvencies in Europe and a complete collapse of their banking industry.

The basic problem in Europe has not changed, and that is that their sovereigns are massively overleveraged.  There are only 2 ways to solve a sovereign debt problem: either let the sovereign go bankrupt, or print currency to pay back the debt.  Europe has taken the tiniest of baby steps towards printing to pay the debt, but they must move much, much faster.  The most likely catalyst towards Europe accepting such a currency-deflating event will be a renewed market crisis in which the market completely stops funding the French banking system or even the German banking system.  In our opinion, we are very close to this watershed event.

Once Europe accepts their eventual fate and enacts a European version of the TARP, markets could calm and we could move forward.  However, this option is not even on the table right now for Europe, as they perceive everything to be ok with the markets.  It will likely take a significant and violent deepening of the crisis before Europe can gather the popular support they need to proceed with these Draconian measures.

On the other side of the Atlantic, the US needs massive fiscal and monetary stimulus before things can improve in this country.  However, the republicans will continue to hold this hostage, as a failing economy actually benefits their political cause by being able to blame all our woes on Obama.  The republicans have been able to convince the population that monetary and fiscal stimulus is somehow hurting them, a truly amazing feat.  Until things get very bad, the population will not support further accommodative measures from the government, at which point they will beg for them.

It is our opinion that significant pain is yet necessary to galvanize support around what needs to be done in both Europe and the US.  The population in both continents does not support the measures necessary to get us out of the current debacle, but they will once things get bad enough.  In this vein, we expect fiscal stimulus and QE3 from the US, but only after things get so bad that the population is left clamoring for them.  We expect a massively deflationary period followed by yet another bazooka of government intervention being fired to inflate our economy.

US Stocks

Obviously, our view is highly bearish for US stocks as it is all risk assets.  We view 900-950 as a reasonable target as to how far we could fall during this current bear market.  While this week saw a massive rally, such retracements are the hallmark of a bear market.

The following chart shows late 2008 with its bear market rallies.

As can be seen, the index experienced 3 quick rallies of 20% each during an otherwise brutal bear market.  Because so little confidence is in the market, the situation lends itself to massive moves either way, even though the general direction remains down.  The most important concept of bear market trading is to be sure to be able to stay in the trade to reap the eventual rewards of the downward trend.

Furthermore, the volume in this latest rally has been extremely low.

The chart above shows the weekly move in the S&P 500 index along with its volume.  As can be seen, volume on the S&P 500 was at its lowest point since the shortened Labor Day week even though prices moved magnificently.  This is usually a red flag, as it signals a lack of conviction and a lack of participants.  More likely than organic buying emerging is that market makers and short sellers are completely unwilling to be sellers here due to the headline risk of temporary bullish developments coming out of Europe.  This lack of liquidity has sellers increasing their asking prices while buyers continue to pay up.  However, it appears that the large money has stayed out, unwilling to pay ever higher prices for assets that cost between 10-20% less just 1 week ago.

While the stock market is fairly attractively priced based on a simple P/E ratio, we believe this may not be telling the whole story.  The following chart shows the S&P 500 in orange, trailing 12 month earnings per share on the S&P 500 in white, and total US public debt outstanding in green.

As can be seen, the response to the last 2 recessions has been to sharply increase the trajectory of government debt.  From a Keynesian point of view, this makes alot of sense, in that government needs to step in and stimulate to create the demand that is gone from the private sector.  However, the current Congress and administration has made it clear that cutting government debt is a priority, not increasing it.  Also, the Fed has made clear their aversion towards increasing the Fed’s balance sheet.  With both fiscal and monetary stimulus off the table at this point, what will be the engine to pick the US back up in case of a growth hiccup?

Furthermore, the increase in earnings during this bull market has been astounding.  Since the bottom, earnings have increased at an annualized rate of 54% during this current bull market.  The last 2 bull markets saw EPS increase at an average rate of around 15%.  With profit margins hovering near all-time highs, it doesn’t seem like there is going to be much of a catalyst to power EPS, and the stock market, higher.

US consumers remain tapped out, and are busy rebuilding their balance sheets in the face of persistently high unemployment.  With very little job security and stagnant or falling real wages, the US consumer cannot be counted on as the next major driver of global demand.  With the US consumer comprising 70% of US GDP, this is a very large problem.

While our analysis applies to all risk assets, the stock market tends to be the most leading of them.  The same analysis could be applied to realize that crude oil, copper and any other industrial commodity is due for a precipitous fall.

Trade Recommendation

We recommend short positions in US stocks.  S&P 500 futures can be sold at 1219.25.  In order to keep risk contained, one could place a buy stop at 1250 to get out of the trade if stocks do continue rallying.

Along the same lines, we recommend short positions in Brent crude.  With Brent crude trading at $112.23/barrel, this price will prove far too high when looking back 6 months to 1 year from now.  The Saudis have already claimed the market is not oversupplied and will not cut their production.  With the Saudis lofty social agenda, they need Brent to stay above $90/barrel to fund their social projects.   That makes $90/barrel a very reasonable target for Brent’s depreciation.

Precious Metals

We continue to be highly bearish on the precious metals complex.  Gold and especially silver could see quite a ways of downside in the coming economic environment.  As risk asset markets rally, gold and silver rally as well, but at a smaller magnitude of the increase.  On the other side, as risk asset markets fall, gold and silver will fall a greater magnitude of the decline.

Gold essentially has a ceiling on prices, as rising risk asset prices signal increasing inflation, but also exponentially decreased chances of further monetary easing.  While risk assets fall, gold will experience the devastating effects of deflationary expectations.  When viewed in this light, gold has a low ceiling and much lower floor.

Silver is even worse in that industrial demand will clearly be falling in the coming environment.  If investment demand falls as well due to gold prices stagnating, silver could easily see $20-25/ounce before the year is out.

We recommend shorting both gold and silver futures at the price of 1683 and 32.2, respectively.  Buy stops on gold could be placed at 1700 and 33 on silver, although one should do so carefully because these metals are extremely volatile.

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 September 4, 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 a continuation of volatility in risk asset prices, with the beginning of the week seeing a rise in equity prices, only to have all the gains erased by Friday’s close, leaving the S&P 500 down fractionally for the week.  The low volume of the week due to the last week of summer in both Europe and the US should make this week’s movements be taken with a grain of salt, but there are still some interesting observations we can make for the future.

Closing out the last week in August, markets still appear to be fixated on political actions rather than fundamentals.  As such, rumors and headlines have ruled the day, but the return of professional traders in September may cast the markets in a new light.  As the month wears on, economic data as well as government policy response should become more clear, giving us more insight into which long-term trends can be profited from.

Charts of the CRB RIND Index and the GSCI Index are posted below.

Surprisingly, this week saw a solid gain in the CRB Raw Industrial Index.  While we are very hesitant to think of this as a true trend reversal, the CRB RIND’s gain of more than 1% on the week bodes well for the health of the global economy.  In addition to this data, the ISM manufacturing numbers released on Thursday were significantly better than expected, signaling further expansion rather than the contraction expected by most economists.  Bears will point to Friday’s poor jobs report as further cause for concern, but considering the US debt ceiling debacle along with the precipitous stock selloff, and the fact that most executives went on vacation, is anyone really all that surprised that US employers did not add jobs in the month?  Of  course, at this juncture, the only reason investors care about this data is its perceived link to Fed action.  For reasons we will discuss, we believe certain markets have become delusional in their policy expectations.

QE3?
For the past month, markets have been obsessed with what, if any, actions Ben Bernanke and Co. will take to stimulate the economy.  Especially after the republicans essentially ruled fiscal stimulus dead, the market is desperate for some sort of monetary stimulus, even if it is only effective in psychology rather than function.  The most sought-after Fed action would be a renewed round of quantitative easing, or QE3.  While this is a possibility that the Fed has discussed in their recent statements on the economy, we believe the likelihood of this particular policy option is actually extremely low, with other options being much more favored.

The last two texts released by the Fed shed light into which way Bernanke may be leaning: Bernanke’s Jackson Hole speech, as well as the Fed minutes from the August 9^th meeting.

When considering the August 9^th minutes, context from the prevailing situation is very useful to keep in mind.  The US debt rating had just been downgraded by S&P, causing a 7% selloff in the major equity indices the day before.  Markets were falling apart, and the fall of 2008 seemed to be back in full swing.  August’s Fed meeting happened to be scheduled for the day after the huge stock market rout, and investors had high hopes that Bernanke would come to the rescue, pumping another enormous amount of liquidity into the system or a similarly drastic action.

From the backdrop of this dire situation in risk markets, policy makers had to come up with a response.  From the August Fed minutes, we can see that  a range of policy responses was discussed, from a renewed round of quantitative easing, a “twist” operation, setting explicit inflation and/or employment targets to doing nothing at all.  While the minutes are somewhat ambiguous, it appears that two FOMC members favored the nuclear response of more quantitative easing and renewed monetary expansion immediately.  However, the three dissenters from Bernanke’s eventual decision dissented because they believed no change in the language of the Fed’s statement was warranted.  These three FOMC members are inflation hawks, and prefer waiting to see whether economic fundamentals improve on their own or if further stimulus is warranted.

Interesting to note is that all FOMC members indicated that monetary policy response was not sufficient to address the employment problems, and a few of the members indicated that they believed monetary stimulus would have no effect on improving economic fundamentals.  Furthermore, the FOMC members stated that inflation expectations had picked up and remained stable since QE2 began.  The Fed minutes revealed a sharply divided Fed, but Bernanke’s final decision is interesting when considered in the light of the sharply contrasting views of his peers.

Bernanke’s essentially minimalist choice of adding a date target to the Fed’s low interest rate pledge reveals that he prefers the least amount of intervention possible.  While markets were absolutely falling apart, Bernanke still opted for what amounted to a verbal intervention in the market.  To his delight, it had quite a good effect, as that day marked the current low for the S&P 500 so far this year.  Bernanke is a very smart man, and he realizes that quantitative easing and other radical policy measures have diminishing levels of success each time they are employed.  Along those lines, he will only employ the most drastic of these tools, quantitative easing if he has no other choice and he has sufficient economic justification to back him up.  While most critics point to QE2 as an absolute failure, they are wrong on this point.  QE2 was successful in increasing inflation expectations, at a time when the threat of deflation was beginning to rear its head again.  While it also had the unintended effect of commodity hoarding, crude and other commodities’ recent fall indicates that these effects truly may have been transitory and the result of speculation, not true demand.

When considering the possibility of QE3, the economy and sociopolitical climate is in a much different state than it was a year ago.  Inflation expectations, as Bernanke has mentioned numerous times, are now stable and positive, whereas they showed signs of decreasing last year.  Furthermore, we are coming into a Presidential election year in which the number 1 issue is the economy.  We have already seen pundits such as Mitt Romney proclaim that Bernanke is a “traitor” for his implementation of easy monetary policy.  With the political stakes this high, Bernanke is even more afraid to implement aggressive policy changes if he does not absolutely have to.

Also, in the Jackson Hole speech, Bernanke glossed over possible Fed responses to further economic deterioration, instead spending the bulk of the speech on imploring government officials to take the proper fiscal steps necessary for economic growth, as well as emphasizing the Fed’s role in promoting stable, low inflation.  Specifically, Bernanke indicated only that the Fed has “a range of tools that could be used to promote additional monetary stimulus,” spending no time elaborating on what those tools might be or if they might be employed.  Bernanke repeatedly called out policymakers, stating that the US might be “well served by a better process for making fiscal decisions,” indicating that he believes much of the recent malaise is a fiscal issue rather than liquidity problem.  Finally, and most importantly, Bernanke indicated that the Fed’s most important economic role was to provide “monetary policy that ensures that inflation remains low and stable” and that “most of the economic policies that support robust economic growth are outside the province of the central bank.”

Bernanke has mentioned numerous times that the potential benefits of any monetary policy need to be accompanied by a consideration of the potential inflation risks.  He has also repeatedly stated that he sees the current outlook for inflation as being where he wants it to be, indicating his bias against pumping more liquidity into the system and further stoking inflationary pressures.  While the market has taken every dovish statement and action and amplified it to the extreme, we believe Bernanke is much skewed to the neutral side of the policy spectrum, and that there is very little chance of aggressive policy action.

In summation, we believe that Bernanke’s statements indicate he sides with the hawkish elements of the FOMC, although his preferred course of action is the status quo.  He will only be moved to the extreme policy action of QE3 by a truly extraordinary event: either a significant worsening of economic data, or a sudden, renewed plunge in risk asset markets.  At this time, we do not believe the situation to be nearly dire enough for him to be forced into QE3.  In fact, even if he decides to initiate more monetary policy, he will almost assuredly initiate a twist operation rather than an outright QE3; in the Fed minutes, the twist operation was discussed in more detail, and it was emphasized that such an action would not increase the size of the Fed’s balance sheet.  In our analysis of gold prices, we will explain why the size of the Fed’s balance sheet is important, and why current market sentiment on precious metals has shifted to an illogical extreme.

Gold
Attention on the gold market has reached a fever pitch, with almost every commentator stating their love for the metal’s currency and sociopolitical hedging attributes.  However, we believe the risk in holding gold has now reached unacceptable levels, and it is now prone to a collapse.

Our reversal of recommendation on the gold market has caught many of our long-time readers by surprise, but we believe it is in keeping with our objective of uncovering opportunity, and gauging market sentiment to make informed decisions.

At the beginning of 2011, we were outspoken and vocal in our support of precious metals.  At the time, silver traded for $25 an ounce and gold traded for around $1325/ounce.  Obviously both metals have taken off since then in accordance with our recommendation.  However, the precious metals market has now been altered fundamentally, and these assets are no longer hedges, but instruments of pure speculation favored by leveraged and momentum traders.

Consider the difference in market sentiment between now and January.  In January, sell-side analysts were lining up to call the end of the gold bull market, claiming that 2011 would see the global recovery become self-sustaining and investors clamoring for higher-yielding assets than precious metals.  We knew then that the market’s sentiment had turned to an extreme, and that the consensus was just plain wrong.  While we too believed that the recovery would not be as uneven and slowing as it has been, we knew that the European debt situation, as well as continued competitive currency debasement would fuel a prolonged rally in precious metals.  Furthermore, we viewed the negative sentiment on precious metals as a critical element for us to be initiating a contrarian long position.  When assets climb a “wall of worry” surrounding their advance, it is a very good sign that the trend will continue.  By contrast, when most everyone is bullish on an asset, there is a good chance that prices are headed for a precipitous fall.

Gauging market sentiment today on gold yields some alarming observations.  Turning on CNBC, the permanent ticker at the bottom-right of the screen now displays Dow, S&P 500, Nasdaq and gold quotes in repeating, alternating fashion.  For gold to be getting the same degree of attention as the S&P 500 is astounding, and a very bad sign for gold bulls.  Even more striking is the attention commentators are giving gold.  CNBC mentions gold about 10 times every 10 minutes, and they have even started a full-day, recurring special called “Gold Rush” to draw even more attention to the market, gold miners and end users.  This is the exact opposite market sentiment that we viewed in January.

With everyone in the investing public being inundated with pro-gold commentary, who is there left to buy?  Bulls point to India and China, but even emerging market demand is not without bounds.  For poorer, non-leveraged buyers such as emerging market consumers, price affects demand.  If a Chinese consumer is putting away $1,000/month into gold and silver, the amount of the metal they buy decreases as price increases, thereby eventually causing demand for gold to fall and price correcting lower.  By contrast, futures traders control 100 ounces of gold with $9,450 in initial marginregardless of the price of gold.  

This stark difference between physical gold buyers and futures traders is evidenced in the recent volatility of precious metals prices.  This type of volatility, even when associated with upward movements, is not a good sign for long holders, and is indicative of the risk inherent in holding precious metals at this time.

The following chart shows the Managed Money net long position on gold.

As can be seen, Managed Money net longs actually decreased in the week ending August 30^th.  However, as we have previously stated, this is not necessarily bullish for gold, as we saw a very similar pattern play out in silver, as silver rocketed higher in April even with Managed Money ditching their net long positions.

Retail buyers through the GLD and other ETFs seem to be doing quite a bit of buying, supporting gold prices on a week when futures volume was markedly lower than the last few weeks.   This participation by retail is concerning, as retail investors are almost always the last ones to find out about a legitimate investment trend, and then push that trend to the bubble limit (think real estate in 2006 or tech stocks in 2000).

The current buyers of gold are no longer buying gold as a hedge against currency printing, or even US dollar devaluation, they are buying gold as a hedge against the stock market, or in the worst case, simply because it is the only asset reliably going up in price.  While it may seem that gold is now a hedge against stock market declines, this is much more of a temporary phenomenon than a lasting investment idea.

Gold’s bull market has been fueled by currency debasement.  Shown below is a chart comparing the price advance of gold since 2000 to the size of the Fed’s balance sheet.  The chart is normalized for percentage.

These two data points correlate remarkably well, and their interrelation is no coincidence.  As the Fed has embarked on more and more aggressive monetary easing policies, pushing the size of their balance sheet to unprecedented levels, investors have increasingly turned to gold.  While the government claims they support strong dollar policy, it is quite evident to even a casual observer that the Fed would prefer a weaker dollar to stimulate exports and breathe some artificial life into the US manufacturing sector.  Such conditions have caused a bull market in gold, and rightfully so.

In summer 2010, gold investors correctly anticipated an increase in size in the Fed’s balance sheet, buying up the metal right before and during QE2.  Between the time Bernanke hinted at QE2 in Jackson Hole in 2010 and the time QE2 actually began, gold rose 11%.  This time around, the anticipatory buying has been enormous, pushing up gold 13% in August, and an astounding 21% since QE2 ended, even though no announcement of QE3 has even been hinted at.  If buyers are disappointed with the Fed’s eventual actions, gold prices could snap lower in a hurry.

Current developments regarding monetary policy have changed the likely outcome markedly, while precious metals investors’ sentiment has diverged wildly in the opposite direction.  As we discussed above, we believe that the prospects for further quantitative easing are extremely bad, given the political challenges as well as the aversion towards excessive inflation that the Fed has recently commented on.  However, precious metals investors have taken any hint of support for QE3 from the FOMC and any stock market decline as reason to bid precious metals to ever-higher heights, perceiving that an equity market decline or a simple statement that an FOMC governor would be open to QE3 means that it is a foregone conclusion.  We believe the market’s belief in prospects for QE3 is now bordering on delusional.

Furthermore, the market has failed to follow this negative correlation with equities on the downside.  This past week, equities saw gains over the first three days, spearheaded by gains in European shares.  However, gold and silver remained flat or even higher, refusing to budge lower even in the face of good economic or equity news.  While short-term traders could rightfully interpret this as a sign of voracious demand for precious metals, we believe it a sign of a euphoric top nearing, and that long holders should be extremely cautious at these levels.

While there is no limit to how far this bubble can be pushed, we do believe the current market sentiment and price action of precious metals indicates a bubble mentality.  It is with great disappointment that we say this, as we have been one of the staunchest supporters of precious metals as an investment, but we believe we may be nearing the end of the gold bull market.  The fact is that the wrong people are buying gold for the wrong reasons.  Everyone from mom and pop investors to professional traders are buying gold to hedge their equity portfolios, and they could be sorely disappointed if the hedge itself fails.  While it is true that negative real interest rates do mark general periods of bull markets in precious metals, it is also true that precious metals are the most vulnerable assets to changes in market sentiment, and a large fall from current prices could permanently alter market perception towards precious metals as a hedge.

While assets such as tech stocks in 2000 or real estate in 2006 underwent huge drops in price, most of these assets were worth something, albeit a fraction of their previous price.  The problem for the precious metals market is that with gold’s average cost of production around $500/ounce (or in many cases lower), and silver less than $10/ounce, these precious metals are only worth literally what the next guy will pay for them.  If at some point market sentiment does turn on these metals, the fall will be quick, brutal and possibly permanent.

With market sentiment at extreme overbought levels, even a small downward turn in sentiment could cause a huge fall in price, with gold possibly correcting 15-20% lower.  While no market prognosticator can come up with a reason for why this might happen, when people cannot identify any way an asset’s price can fall is exactly when a fall is ripe to occur.  The market now fears not being in precious metals, and perceives them to be the best and only hedge in the current market.  As Nassim Taleb said, the market tends to hurt the largest number of hedgers, and we believe this case will prove no different.

Silver
Our analysis of silver lends credence to our position on gold prices.  While silver should see weakness due to the same aforementioned reasons as gold, we believe that the recent action of silver as compared to gold sheds further insight into why silver should continue to underperform.

The following chart shows the price of silver and the price of gold, normalized for percentage since August 1^st.

As can be seen, gold has significantly outperformed silver during this time period.  We expect this outperformance to continue due to silver’s industrial uses as well as silver’s safe haven status.  In short, if gold continues to rise due to equity market uncertainty, silver will most likely underperform because of its industrial applications.  Unlike gold, 50% of silver mined each year is used in industrial processes, so an economic slowdown is bearish for silver.  On the other hand, if gold falls due to a shift in market sentiment against precious metals, silver will do worse than gold as it’s smaller stature in the precious metals market means that the same amount of money coming out of it will influence it to a larger percentage degree.  Essentially, there are two ways to lose on silver whereas gold has just one.

Furthermore, gold’s outperformance of silver even as supposed safe haven flows increase the price of gold are further testament to the bubble mentality growing in the gold market.  If gold was truly being bought as a monetary easing hedge, silver would have increased by at least as much as gold if not more due to its usual status of being a higher “beta” gold alternative.  However, the fact that gold has markedly outperformed gold shows that buyers of gold are only interested in gold, and not as much the other precious metals.  This is because gold has become a speculative market, and the attention being placed on gold is causing the price appreciation, not a true secular shift into precious metals as a monetary alternative.

While the political situation out of Europe has been quiet as of late, now that summer is over and politicians are returning, things could heat up again quickly.  The dysfunction in Europe that we saw earlier in the summer has not gone away by a longshot, and is actually increasing.  The usual suspects of Greece, Portugal and Ireland are no longer the only concerns, with the ECB recently being forced to buy Spanish and Italian bonds in the secondary market to support their prices.  The situation is an absolute mess, and there is still no actual solution to the problem.  To make matters worse, the large economies of  France and Germany are showing signs of slowing, with GDP increasing very slowly if at all.  At some point, we expect the ECB to abandon their inflation-hawking agenda and actually decrease interest rates to spur growth, devalue the euro and increase exports.

On balance, we view the fundamental situation as bullish for the dollar, and market sentiment overly skewed against the dollar due to expectations of quantitative easing.  Such a divergence between short-term trend and long-term fundamentals are exactly the type of situation we seek to profit from.

Copper Managed Money remains in a depressed state, with traders now slightly net short the metal.  With the outlook uncertain, and with inventories refusing to show any sign of momentum one way or another, neutral exposure at this point is prudent, with a bias towards shorting the metal if economic data continues to disappoint.  If there is a rally due to Fed action or other stimulative measures, it could be a great short entry point, as no amount of QE can actually increase the amount of goods demanded, it only improves trader sentiment.

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 July 24 , we are sharing portions of the content a few days delayed here.  For details and samples of the newsletter, see here: http://realfinancenewsletter.com

Here at Lakshmi, we have been more frustrated than most by the lack of political cooperation in the US.  While we could go on a rant about the ineffectiveness of the US political system, it would serve readers much better for us to follow our usual “read and react” posture.  In short, when we read today’s political outlook, the US looks almost certainly headed for another recession. The current political direction in this country is alarming. The democrats want to raise taxes to cut deficits, whereas the republicans want to cut spending.  Either of these (or both of them in a compromise) would have the purpose of reducing the US budget deficit, and, hopefully, restore confidence  in federal government finances.  Sound like a great idea right?  WRONG.

The reason why we are so alarmed is that while neither party agrees how to do it, they both agree that the deficit must be reduced.  This is incredibly bearish for the US economy.  If you raise taxes, you kill consumption by reducing disposable income.  If you reduce government spending, you take dollars directly out of people’s pockets.

Between federal, state, and local governments, there are 22 million Americans working directly for the government, and any spending cuts will include them.  This doesn’t even include the amount of money that could be taken out of the general population’s wallets through reduction of entitlement programs.  This is called fiscal tightening, and it has the obvious and direct effect of reducing GDP.  At a time when US GDP growth is tenuous at best (and still negative when factoring inflation), the government is taking tightening steps, not the loosening steps they should be taking.  This will almost surely force the US economy back into a protracted recession.

The absolute best outcome at this point for markets would be a temporary extension of the debt ceiling with no real progress on deficit reduction.  If we sound hopeless, we apologize for our extreme negativity.  However, we must stress that the situation is indeed dire.  While the rest of the world waits for a “grand compromise,” we are here to tell you that the more the US budget deficit is decreased, the greater the likelihood, quicker the beginning, and deeper the severity of the next US recession.

While this sounds like an irresponsible view, the simple truth is that the US economy is based on debt and deficit spending, and if we try to cut that, especially if we do it quickly, the economy will suffer drastically.  The following chart shows US federal debt in green and the Consumer Price Index in white, and the chart has been normalized for percentage.

As can be seen, the US federal debt rose roughly in tandem with inflation until the ‘80s, when government debt started to absolutely explode.  From this perspective, republicans’ claim that the US deficit is all democrats and President Obama’s fault is laughable.  The real debt problem in the US started during Ronald Reagan ‘s presidency in the ‘80s, and was continued indefinitely by short-term minded politicians and their need to please constituents with a perpetually-vibrant economy.

The real truth is that the US economy is mature and cumbersome, and has no engine of organic growth.  Even the tech boom of the ‘90s was fairly short-lived when considering how the national debt has just absolutely skyrocketed from the year 2000 on (not coincidentally when Bush took office).  At this point, the only way the US economy can grow is to saddle ourselves with more debt.  However, this is not the worst thing in the world; it is actually a desirable outcome compared to fiscal tightening.

To illustrate the point, the following chart shows the same federal debt outstanding and CPI index as above, but also included now are the S&P 500 index and the price of gold.

The chart is from 1980 to present day and is also normalized for percentage.

As can be seen, the S&P 500 has actually underperformed when considering how much new debt the government has taken on.  In response to the last 2 stock market routs in 2000 and again 2008, the government can clearly be seen adding more and more debt, and what is even more alarming is that the pace at which government debt is accelerating is starting to go parabolic, yet the effects on the stock market appear to be more and more muted over time.  This does not bode well for us long term, yet our borrowing costs are at all-time lows.

In a normally-functioning, ceteris paribus global economy, the US and its consumers would not have unlimited borrowing power, meaning as we borrowed more and more, our ability to pay back debts would be in question and interest rates on our debt would rise.  However, with interest rates at all-time lows, the exact opposite has now become the case.  The following chart shows the yield on the 10 year US treasury note since 1962.

As can be seen, interest rates have gone nowhere but down since 1980.  If you were my lender, and I told you I was going to increase my debt by 100% in the next 5 years (the same amount the US debt has increased since 2006), would you give me a lower or higher interest rate?  The answer is higher (and you probably would not even lend to me!), yet the yield on the 10 year has actually decreased from slightly under 5% in 2006 to now 3%, a 40% reduction.

China, Japan, and other large buyers of US debt are not buying our debt because they think it’s a good deal.  They are buying our debt because they have no other choice.  The US is the world’s #1 consumer by far; our thirst for consumer goods, oil and other expensive products is insatiable.  Because the US is not producing any new money organically (we produce very little of value that other countries actually need), we need to finance our continued appetite for consumer expenditure by increasing our debt.

Since China and other emerging economies are selling a huge portion of their goods to us, it is in their best interest to artificially support our borrowing.  By being the largest buyer of our debt, they ensure that our interest rates remain low so that we can keep borrowing in order to buy their goods.  While this may be viewed as unsustainable in the long run, this has been the de facto state of the US economy for the past 30 years; first it was Japan, now it is China.

While pundits will point to Europe and say that we need to cut debt so we don’t end up like Greece, that scenario is not really possible.  Greece’s real problem is not that  they can’t pay back their debt (although that is a problem as well), it is that they don’t control their own currency.  The US has the ability to simply print dollars to pay back debt, unlike Greece.  Although this is not necessarily a good thing because it causes inflation, it removes the element of credit risk in our government bonds that European bonds are rife with.

If we decide to get our fiscal house in order, while that sounds like a good idea, it will cause a huge amount of pain for the US economy.  By removing any portion of the ability of the largest borrower in the world, the US government, to borrow, consumption across the entire world will fall. Risk assets such as stocks and high-yield bonds will experience huge selling pressure as it becomes apparent that the US economy is both not growing and is shunning debt for the first time in 30 years.  While government economists would point to the ability of the US corporate and consumer sector to increase borrowing (and indeed consumer and small business debt remains at depressed levels), why on earth would consumers and responsible small businesses do this if aggregate demand is falling?  Periods of fiscal tightening are no time to start building new factories and buying more iPads.

While the US debt situation is unsustainable in the long run, it is imperative that the fiscal tightening be put off indefinitely if the US wants any chance of avoiding another recession so quickly after the financial crisis.  The simple truth is that the US dug its own grave many years ago, and there is nothing to be done to stop the chain reaction.  The only question at this point is whether we would rather have a recession sooner or later due to government deleveraging.  My preference would be later.

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