The silver market has been remarkably quiet in the wake of China’s destruction of the gold market. This week, we’ll touch on a couple aspects, specific to silver that show while commercial traders have been buying this decline, it may be prudent to wait a bit longer before stepping in. Normally, I take a bottom up approach to putting these pieces together beginning with macro issues and finishing with trade details. This week, we’ll set the stage and then move from myopically focusing on the current setup before discussing the potential dangers of this viewpoint.
The Commitment of Traders report published weekly by the Commodity Futures Trading Commission breaks down the weekly market participants into several categories. In the age of big data, we reach a point where it’s easier to collect than it is to make sense of. We keep it simple at COTSignals.com by focusing our analysis on the commercial trader category of the Commitment of Traders Report. Subjectively, it makes sense that the people with a hand in producing or, consuming a given commodity have a fundamental sense of value that speculative traders simply lack. Furthermore, producers and end line users of a given commodity base their actions on the best collective models and strategies focused on their singular market. Quantitatively, we’ve proven the correlation and predictive value of their actions time and again.
I’ve been designing, testing and publishing trading systems since I left the floor of the Chicago Mercantile Exchange(CME) more than 15 years ago. I had my first program, DCB-Bonds published in Futures Truth in 1999. This system is still actively traded and bounces in and out of their top 25 systems and is currently sitting at 26th. My philosophy with system design has always been to start with a fundamental premise and begin testing from there. Occasionally, circumstances change and can render the fundamental premise moot. This was the case for a suite of mechanical programs I published in December of ’05 in Futures Truth.
This is the third cautionary report I’ve written on the stock market in six weeks. The last time I focused this heavily on the stock market was in early 2009. Back then, I was making a point to everyone who’d lost their shirt on the way down that employing the leverage provided by stock index futures contracts would be a great way to recoup some of their lost funds when the market bounced. This week, we’ll discuss the same strategy only in reverse. I’ll explain how to use leveraged futures to protect your equity portfolio ahead of time in case you haven’t taken the appropriate actions.
Gold and silver have exploded in recent years. The contributing factors of low interest rates, economic uncertainty, global fear and pending inflation have done their share to boost precious metals’ outsized gains relative to the stock market. Gold has rallied more than 150% over the last five years while the broad stock indexes are all flat to lower, depending on the day. Silver, for its part, has nearly doubled in the last five years. Given our still historic low interest rates and the growing economic trouble overseas as well as our ballooning governmental budget deficit, it’s reasonable to believe that the forces behind this trend continue to remain intact. The question has changed from, “Should I be invested in precious metals,” to “What’s the most cost effective way to maintain a presence in precious metals.”
The boom in the precious metals market has brought with it the familiar hype of the gold bugs. It has also fostered the invention of precious metal Exchange Traded Funds (ETF’s) and cash for gold TV commercials. Commodity futures markets have also benefited from the added attention being paid to gold. Each of these has a place in the marketplace and each has a vested interest in hyping their product as the one that’s best suited to your needs. However, if you are ascribing to efficient portfolio theory and seek to include precious metals ownership as a part of your portfolio diversification plan, the best bang for your buck is through commodity exchange traded contracts which are regulated by the Commodity Futures Trading Commission (CFTC) and guaranteed by their appropriate exchange.
The market sectors mentioned above can be lumped into two categories: small speculators and investors. Gold bugs and cash for gold are for people with left over jewelry, some family heirlooms and gold coins like American Eagles or South African Krugerrands. Typically, this type of gold ownership sell side biased. This means owners of small pieces or collections are keeping an eye on price and hoping to sell when they think the market has peaked. When they bring their physical collections to market, they will end up at the coin shops, pawn shops, cash for gold, or their local jewelry shop. The willing buyers are always waiting and ready to pay below market value for collections that may have taken a lifetime to accumulate. Upon recent survey of the available outlets, prices to be paid were typically $40 per oz under market value for gold and $.30 per oz under market value for silver. Those on the buy side of this equation, looking to add to their private physical collections will find themselves paying up $30 – $50 per oz over market value in gold and up to $1.20 over per oz in silver. Therefore, small speculators in the physical precious metals market may lose more than 10% of the value of their collection in the buying and selling process.
Passive investment in the precious metals can be done in two ways, ETF’s and commodity exchange traded products. The benefits of ETF’s are that the amount to be invested can be determined beforehand and the investor can pick their own allocation, even if that amount is less than the price of one ounce of gold. The downside is these ETF’s typically underperform the actual market they are designed to track. Typically, one would expect a dollar for dollar rise and fall between the price of the metal and the value of the account. However, due to administrative fees, expenses, incentive fees, cost of acquisition, advertising, etc, the longer the ETF trades, the further behind the actual price they fall. Therefore, it is possible to lose money in a flat market, or realize a smaller return than one would expect in a rising market.
Finally, exchange traded commodity contracts like those listed with the Chicago Mercantile Exchange Group are the actual proxy to which ETF’s and local dealers tie their prices. Perhaps the single biggest drawback to these products is their preset size. There are about half a dozen precious metals products listed ranging in full cash value from $18,000 to $125,000. These contracts have several benefits for passive portfolio diversification. First, these are standardized products fully assayed and certified by the appropriate exchange. This assures the investor that their 100 ounces of gold is 24 carat and their silver is .9999 fine and that the value of your holdings can be found 24 hours a day, rather than being quoted by the guy in the shop down the street. Secondly, there are no administration fees, advertising costs, or incentive fees. The only charge is a one- time commission to your commodity broker, typically, around $50 per contract. Also, you will control the actual metal and not find yourself invested in mining sales or land right options because you didn’t read the prospectus thoroughly. Finally, the biggest reason exchange traded products are so much more cost effective is the use of margin and the amount of cash it frees up for the individual investor. The $18,000 contract mentioned above requires a cash deposit with the exchange of $1,150. This allows the individual investor to use the remaining $16,850 in excess cash for a money market account and earn interest on top of any return produced in the actual market itself. Therefore, those wishing to pursue efficient portfolio theory and diversify their holdings can most efficiently implement this process through the use of commodity futures markets.
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 in investing in futures.
Sixteen years ago, I considered myself a rookie trader on
the floor of the Chicago Mercantile Exchange. Bright eyed and eager to learn, I
followed every market I could. I actively traded the S&P 500 but, I always
went in early for the currency and interest rate openings, as well. I actively
and, knowingly took advantage of any of the major market players willing to
have a cup of coffee with me. The economic times were significantly different
than those of today. Trading volume was ushering in a major stock market bull-
run, even as memories of the ’87 crash still lingered. The trading floors were
flush with people who made more in one day than most make in a year or some, in
a lifetime. The technology wave was just beginning to trickle in and financial
modeling was at the forefront of quantitative investment strategies.
I still come in early and I still actively trade the stock
indices. I still actively and knowingly pick the brains of the market players I
am fortunate enough to gain an audience with. Sixteen years later, I find
myself at the beginning of the cycle…..again.
I know many of you are thinking that I must be nuts.
However, if you give me a chance to explain, I think I can tease this out in
terms simple enough for myself to understand. I’ve read so much over the last
month that I feel like I’ve learned an entirely new language. Separating the
wheat from the chaff and allowing myself an opportunity to collect my thoughts,
thank goodness for rainy weekends, I’ve come to the conclusion that we’re near
equilibrium and will extend beyond the mean before finally reverting and
building a base very similarly to the process of the early 1990’s.
Economically, the circumstances couldn’t be more different.
In the 90’s, many of the excesses of the eighties had already been purged. The
savings and loan crisis had been effectively dealt with (net cost- 85 billion) and
the stock market crash provided everyone with a whole new perspective on what
risk really was. Interest rates had been coming down for more than a year,
falling from 7.25% to under 3% in less than a year. The U.S. Dollar was still
king having been defended effectively from the Pound by George Soros. This
helped check global inflation and kept commodity prices low while commodity
demand remained, primarily, domestic. Finally, on a quantitative note, the
S&P 500 was at 415 and had a price/earnings ratio of 19.6.
Trading volumes are soaring as technology has removed so
many of the barriers between the pits, the customers and finally, the world.
Money has never moved at a more rapid pace (good or bad). This same technology brought with it a
generation of misguided applications. Historically, it will be my generation
that brought computer modeling to the financial and commodity markets. We are
the poster generation for “GIGO” garbage in – garbage out. Computer modeling
and optimization provided us with “statistically valid” risk models that would
allow us to take on more leverage and increase the bottom line. Apparently, the
one market excess able to survive the savings and loan crisis as well as the
’87 crash was greed.
History has proven time and time again that there is no
economic free lunch. The tech boom of the ‘90’s made millionaires out of John
Doe’s the same way that the crash made overnight millionaires out of pit
traders. Intelligence and ability should never be confused with being in the
right place at the right time. The separation of those with ability from those
with geographical good fortune can only be told over the course of time. The
trading pits took away the free lunch of pit traders (The Epitome of Free
Trade) just as the dot com bust erased other, unearned fortunes. Currently, it
is the financial industry being forced to endure their comeuppance. Their
computer modeled diversification of bundled risk and carefully designed
tranches sold to global institutions allowed them to over leverage low interest
rates and put people into homes and businesses that should never have been put
into existence. The models that were designed were put into action based on
their ability to compress risk while adding to the bottom line. Does anyone
remember Long Term Capital Management or Enron?
Finally, it is the long term global nature of hubris and
contrition that drives the long term cycles of the stock market. Contrition is
clearly the leading factor since October. Fortunately, just like the oil
market, we have tools to tell us when the fat part of the move may be over.
Fundamental analysis of the Commitment of Traders Report to find under and overvalued markets
fairly successfully while our humility has allowed us let the markets tell us
just what over and undervalued means in real terms. I’ve been writing for more
than six months that the stock market will revert to its mean… and then some.
Markets always overshoot. If this is a normal bear market, we can assume the
following set of parameters.
ratios decline by approximately 60%. The peak for this run was around 43.
decline is approximately 30% form peak.
length is around 14 months.
If we look at these figures, it appears as though it’s going
to be a gloomy holiday season. I believe we entered an, “official” bear market
at a 20% decline from market peaks. Depending on the index, this started in
July. The P/E ratio, even with today’s declines, remains near fair value, at 17
and change. Just as markets tend to overshoot on the upside, so too do they
overshoot on the downside. We will grind our way through and there will be
rallies and failures, just as there always are. The question investors should
be asking themselves is, “How do I best manage my way through this period
without affecting my long term goals or, giving into short term emotions?”
I believe that this is where the commodity futures trading industry, through
stock index futures like the S&P 500, Dow, Nasdaq 100 and Russell 2000
should be employed. They are offered in a wide range of sizes and can be
tailored to cover most any equity portfolio. The margins and account sizes are
exceptionally favorable, as well. Currently, an individual can still protect
$30,000 worth of tech holdings with a $5,000 account.
Individuals who don’t utilize the futures markets to limit
their losses on the way down or, to maximize their return on the way up are
simply hiding their heads in the sand and pretending that they don’t know better.
Any investor who feels they are responsible for the lifestyle of their
retirement should act in their own best interest and take advantage of these
opportunities. I thank goodness that I can see the beginning of the next
sixteen years far more clearly than I was able to see the beginning of the
The CME Group has modified their allocation method for distributing electronic order executions. This is simply the most fair and equitable marketplace in the world.
How many times have you bought the high or, sold the low on a stop or market order? My guess is that it’s happened to you far more often than you’ve been able to buy the low or, sell the high. In the past, the reason for this has been the manual execution of orders in the open outcry markets on the trading floors of the various exchanges. Here’s the way this process used to work:1) Your order is placed with your broker on the phone.2) Your commodity broker places the order with a phone clerk on the floor of the appropriate exchange.3) The phone clerk sends the order to the pit broker’s clerk.4) The pit broker’s clerk gives the order to the broker…………….That’s the order placement part of the process………………….1) The broker determines how many contracts he needs to buy or sell.2) The broker looks into the pit of 400+ traders to see where the market is trading.3) He rapidly deciphers the hand signals and noises to ascertain the best bids and offers at the prevailing moment.4) The broker decides that the best offer is coming from one guy—across the pit and looking the other way.5) Deciding that he is unable to get the opposite trader’s attention, the broker sees a small trader near him willing to make the same offer.6) The broker makes the trade with the guy in front of him. The small trader waits for the guy across the pit to make his offer one tick better then buys the offer of the guy across the pit and pockets the profit of one tick X the number of contracts traded…………….That’s the execution process…………………….The broker tells his clerk who tells your broker’s clerk so, your broker can then report the fill back to you.
Now, I ask the following questions:1) Is it fair that the small trader got to pocket the free money without taking the risk of actually “making a market?”2) Is it fair that the large trader got his trade done at a worse price while taking the risk of making the market?3) Is it fair that the customer got a worse fill because his clearing firm’s broker couldn’t get the attention of the large trader?4) Is it fair that the customer got a worse price and a delayed notification because the many links in the execution process?
Welcome to the Era of FREE TRADE!!!
The single greatest benefit of the electronic markets has been the equalization of customers, traders and brokers. The second greatest benefit of electronic markets has been the ELIMINATION of floor traders unwilling to make a market or forecast market direction or, in any other way earn a living through their intellectual abilities. ……….The electronic process…………1) Anyone places a bid or offer at a specified price and number of contracts.2) The first bids and offers at a given price are the first ones executed. FIFO.3) Your computer tells you instantly that you have an execution.
If you would like to know the details of how the CME Group makes allowances for partial fills at a given price or, how it justifies a single contract’s importance over a thousand lot, please read their announcement. Otherwise, take my word for it. We have the best system ever devised for true commodity trading price discovery. This is the epitome of fair trade!