Commercial Traders Capitalize on Gold and Stocks

We noted early this month that small traders were overpopulating the gold market and that commercial traders had begun viewing this market as significantly over valued. Several factors this week have pushed this market well into bubble territory and the risks can be seen both fundamentally and technically.

The gold market’s rally has been fueled by fear of a declining stock market and the devaluation of multiple global currencies. The perception of gold as a safe haven investment can be seen in its valuation compared to the S&P 500. The two markets are compared several different ways. One of the simplest is to divide the price of the S&P 500 index by the price of an ounce of gold. This ratio is currently at .62. This level has not been seen since December of 1988. To put this in perspective, the all time high is 5.57, which was made in July of 1999 while the all time low is .135, which was made in January of 1980. Clearly we are pushing the lower boundary as fear of the stock market pushes more people into gold.

This fear can also be measured by the flow of funds and net asset values of Exchange Traded Funds. This week, for the first time in history, the net asset value of GLD, the largest gold ETF, surpassed the net asset value of SPY, the largest S&P 500 ETF. In fact, due to the flood of money into gold-based ETF’s, the combined bullion holdings of all gold ETF’s now surpass the gold holdings of all but four central banks. This fills their warehouses with more than 2,600 TONS of gold or, more than 83 million ounces with a face value of more than $149 BILLION. Individual investors are expecting the value of gold to surpass the earnings plus stock appreciation of the entire S&P 500 index.

We also want to take a look at the inter-market signals the market has been providing us with. The silver market peaked on April 25th. Since then, the market has sold off and consolidated. Last week’s sympathy rally in silver still failed to push it past key retracement levels. Similarly, platinum’s peak is still bound by the 2008 commodities rally and copper hasn’t made new highs since February of this year. The divergence between gold and the other metal markets helps to illustrate the life of its own that gold is taking on.

Technically, we’ll touch on one simple trigger. Trends are frequently measured by an indicator developed by Welles Wilder called, ADX. Typically, any reading higher than 40 is considered a strong trend. Gold is at 57. This is the highest ADX reading of any current commodity market. The importance here is that along with the high ADX reading we are also experiencing increasing volatility. This is to be expected in a bubble market as it jumps and jumps. However, we have seen an increasing number of outside key reversal days as this trend has extended. This is an illustration of unsure market participants who are both afraid to stay in at these lofty levels while simultaneously being afraid to miss the next part of the move.

Finally, the same commitment of traders data that points to an overbought gold market also points to an oversold stock market. Commercial traders have bought the decline in the stock market at a feverish pace. They have nearly doubled their holdings of stock index futures in the last three weeks.  Their view is that this is not a repeat of the 2008 financial crisis and that these markets are both approaching near term inflection points.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Chinese Invasion of the Credit Markets

Largely lost beneath the noise of the S&P downgrade and the legitimate discrepancy allowing France to maintain their AAA rating was the Peoples’ Bank of China’s actions creating new financial channels for opening up their currency and banking markets to the global economy. China is increasing the pace at which it seeks to become a globally dominant economy as it restructures the archaic financial systems that are the foundation of their stranglehold of restrictive trade and capital controls.

A basic background of their policies is necessary to understand the importance of their recent developments. The Chinese international money market is basically divided into two geographic locations with separate operating governances, rules and restrictions. The Peoples’ Bank of China controls the totality of all currency and lending practices as well as determining fiscal policies and international debt purchases. This group, headquartered in Beijing is the largest owner of U.S. debt with holdings of more than $1 TRILLION in U.S. Treasuries.

The primary hub of international currency trade and repatriation in the Yuan is Hong Kong. Hong Kong operates in a dysfunctional family sort of way. They are clearly under the supervision of main land China. However, they develop their own international trade relations, fiscal policies and domestic governance. Hong Kong is the eighth largest holder of U.S. debt with just under $120 billion in U.S. holdings.

These two units operate at such an arm’s length that there is a large gap in the exchange rate between Yuan held in Hong Kong versus Yuan held in China even though it is the same currency. China has been issuing certificates of deposit to Chinese citizens that earn a yield of 3.37% while Hong Kong’s offering to its citizens earns only 1.6%. China does not allow direct investment by foreign people, banks or, corporations while Hong Kong does. Therefore, the primary global access to Yuan currency appreciation has come through the Hong Kong financial markets. The demand for Chinese Yuan and its expected appreciation is what is driving Hong Kong yields below those of China’s.

The issue at hand is that main land China is easing its regulations on the Hong Kong banking markets to sell Yuan based debt to global institutions. The primary step in this process is opening the gates of Yuan flows from Hong Kong back to China. This will help even out the yields between the two countries, which in turn will allow Hong Kong’s financial markets to accept much greater inflows without tremendously fueling domestic inflation.

China just issued 20 billion Yuan in Treasury Bonds through the Hong Kong financial markets. This is the third time in three years with the previous years’ issuances at 8 and 6 billion Yuan, respectively. The increasing size of these auctions is a clear signal that China is re-balancing their currency portfolio and at the same time, generating inroads to the global Treasury markets. Main land China is still controlling the allocation of their issuance. The allocation was preset by country and type of investor to curb outright currency speculation.

The point is that this is a game changer in the international financial markets. The strongest economy in the world is adopting western exchange mechanisms. The more transparent their regulations become, the more competition there will be for debt issued in Yuan at a time when U.S. Treasuries and the European Central Bank become mired in the abyss of their own hubris. We are witnessing a paradigm shift in real time.


This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk of loss in investing in futures.

Clear Thinking in Confusing Markets

We have alternated our writing to encompass both the behind the scenes reasons for market movement as well as how to navigate and trade the market’s movement. We clearly stated that the debt ceiling rally should have been sold and further strengthened those comments by our suggestion that the risk in the stock market may be more than a buy the rumor, sell the news event in the debt ceiling negotiations. Therefore, people should take a genuine look at hedging their portfolios for something deeper and more structural. Did we expect the S&P to sell off 13% in a little more than two weeks? Of course we didn’t.The newscasts are full of contradictory reports and editorials. Some of their points are valid while others are simply for shock value. I think there are a couple of key points remember as we navigate our way through this. First of all, this is not a repeat of 2008 here in the U.S. The major sub prime, deleveraging and balance sheet issues of our, “too big to fails,” have begun to be addressed. In other words, here in the U.S. the fumigation process has begun.

Overseas, they’ve just begun to turn on the kitchen lights. They’re no longer able to assume that the only roach they see is the only roach they have. As a result of their shared economy, we’re watching the blame game while they assess responsibility for their problems. This is most clearly seen in the Societe General liquidity rumors of Wednesday’s trading followed by the instant questioning of the rest of the Euro Zone’s banking heavy hitters like RBS, Deutchebank and Barclays. Does this remind anyone of Shearson, Goldman, AIG, etc?

Traders choosing to participate in these markets may want to participate in the options market rather than directly in the equities or futures arenas. Options allow market participants to trade a general idea, rather than actual chart points. Being able to trade the idea allows us to withstand a higher degree of volatility while still maintaining our general investment thesis.

The two primary variables in an options price are time to expiration and volatility. Time to expiration is obviously a linear component. The more time there is to expiration, the greater the opportunity there is for that option to pay off, thus a higher premium must be paid. Thinking in insurance terms, a policy written for 12 months would have twice the probability of a claim written for 6 months.

The non-linear variable in the option pricing equation is volatility. The more a market moves, the more volatile it is, thus more likely an option is to end up in the money. Insurance terms say a policy sold to someone with an excellent driving record is less likely to require a payout than a policy sold to someone with a history of moving violations. The unpredictability of the second driver is the same as option volatility.

Option trading as it equates to insurance can be seen in two ways. A trader can write the policy, which is a calculated assumption that the policy or option won’t be collected on or, the policy or option can be purchased because a trader feels that there is a good chance to observe a collectible incident. The option buyer expects the driver to have another accident while the option seller expects the driver to be on their best behavior.

Volatility increases the option premium which makes the policy more lucrative to sell and more expensive to purchase. I have been focusing on selling the options as we’ve declined dramatically and I feel that we are more likely to rebound than we are to decline another 20% in the next couple of weeks. In other words, I expect the market to shape up its act rather than behave as wildly as it has.

The math works like this. September S&P options expire on September 16th. I can sell an option and collect $450 on a $4,000 investment per contract based on the notion that the S&P will still be above 900 in one month. Depending on when you look, this is another 20% lower than where we are today and more than 33% from the July highs. Finally, should the market rally, I can always offset the position prior to expiration for a smaller profit and if the market does tank, there are trading methodologies that can be employed to hedge my risk on the way down just like the re-insurance markets that the big boys use on their policies.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Commercial Traders Wary of Risks Ahead


Commercial traders are building the case for their negative
outlook on the stock market. Their actions in several markets can be seen as
increasingly defensive over the last several weeks. Their behavior is also
beginning to be confirmed by several technical indicators, some of which are at
levels that haven’t been seen in nearly 15 years.

Last week we used the employment situation, profit margins
and earnings to suggest that it would be an historical event to start a new
bull market leg upwards from these levels and therefore, the short term pop on
the debt ceiling rally could be sold in the stock index futures market to
generate a short term profit. Deeper analysis reveals that selling stock index
futures at these levels may be an appropriate hedge for the longer term.

We all know that trading volume declines in the summer
months and the, “dog days of August.” Lower volumes and fewer market
participants leads to higher volatility. Monday morning’s sell off in the
S&P 500 was dramatic enough to make me sit up and take notice. The market
opened at 9:30 better than 1% higher thanks to the resolution of the debt
ceiling deal. The market then promptly sold off nearly 3% in a couple of hours.
The speed of its fall is what is noteworthy. A closer look shows that the
number of market participants as measured by open interest is the lowest it has
been since 1997. Open interest peaked in December of ’08 at more than 755,000
contracts. It is currently under 300,000.

Declining open interest becomes increasingly negative the
farther the market moves. Friday’s close marked the first week the S&P has
closed under its 40 week moving average since September of last year. A simple
timing model using the 40-week average and some interest rate calculations will
provide far superior risk adjusted returns simply by staying out of a weak
market that is trading below this level.

Moving to commercial trader analysis, we can see that they
have increasingly sold stock index futures since mid-June, in line with the
debt ceiling concerns. Their defensive trading behavior can also be seen in
their purchases of U.S. Treasuries. They have been solid buyers over the last
several weeks with a strong emphasis on short duration maturities like
Eurodollars and the 2 and 10 year Treasury Notes. The last part of the
inter-market puzzle is the strong move to U.S. cash reserves via the U.S.
Dollar Index. Commercial trader buying has increased by a startling 70% or,
more than 17,000 contracts in the last week.

Given the troubles coming to a budget agreement I looked
into why money was coming into the Dollar. The simple answer is that it’s a
value play relative to the Euro currency and the gold market. The recent
European Central Bank bailout of Greece is seen as a band-aid on a chain saw wound.
Two ECB questions remain, when will Greece default and will Italy and Spain be
next? The markets continue to question whether they will be able to continue
paying their debts and this can be seen in the record high interest rates they
are being forced to pay in the open market.

Finally, commercial traders see the typical safe haven of
gold as overvalued. Small traders and funds are holding a near record long
position in the gold market. The concern is that when the stock market fails
and cash needs to be raised, it can only come from positions that are
profitable. This would lead to profit taking in the gold market and drive it
lower. Since small traders and funds are typically quicker to react to major
market moves, the concern is that when the gold market falls, it could fall
quickly and deeply. This would wash out many of the small traders and put gold
back into play for the commercial hands waiting to buy the market again.