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 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.”

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