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.
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 9th meeting.
When considering the August 9th 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.
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 30th. 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.
We believe maintaining a neutral stance on gold at this time is a prudent posture. We would look to establish short exposure on a sustained crack in prices, but with current gold volatility at an all-time high, such a position is risky. Unfortunately shorting hysteria is ten times as difficult as buying fear, and picking an entry and exit point on a short gold trade is very difficult. However, as the September Fed meeting approaches, the gold market should begin pricing in the reduced chance of quantitative easing, and prices should begin to fall, possibly using the catalyst of the Fed’s September statement.
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 1st.
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.
With silver’s limited upside in either a bullish or bearish precious metals scenario, we recommend selling call options on silver. The SLV October 48 calls could be sold for $1.00 each. In such a trade, investors would profit as long as SLV is under 49 on October 22nd. Given that 48.35 is the all-time high for SLV, and our bearish stance, we believe the risk/reward characteristics of this trade are attractive.
The same sentiment regarding quantitative easing being pursued into the perpetual future has overtaken the currency markets. While the euro has collapsed against many other currencies, it has shown remarkable resilience against the US dollar. The euro is only trading about 4% lower since peaking earlier this year, but we believe there could be significant downside as the currency markets come to the realization that US monetary policy is stabilizing and that the European situation is deteriorating.
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.
Due to recent volatility and the ability of the current dollar-negative sentiment to persist, we recommend shorting the euro on a trade below the 1.40 level. While prices have been moving in quite a tight channel for some time, if the euro breaks significantly below 1.40, the catalyst necessary for traders to start sustained selling of the euro and buying of the dollar could commence.
This Week’s Managed Money Charts
Natural gas bears took a slight break this week, causing the amount of Managed Money net shorts to decrease on the week. However, with short interest still at 120k contracts, there are plenty of shorts left to be covered, and we believe prices have a reasonably strong floor at the 3.75-3.8 level. We continue to be short put options at the 3.75 strike for clients, and will likely hold them until expiration. Aggressive traders could look for long exposure by buying call options for the 4 strike.
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