Much has been written recently regarding the record speculative short position in the gold futures market. Markets move in trends followed by periods of consolidation, sideways action and reversals. Most speculative trading is trend trading due to several factors outside the scope of this piece. Commercial traders on the other hand are swing traders. This is also referred to as value trading or, mean reversion trading. Their decisions are based on the perceived value they see between the commodities they need or produce and how current market prices impact the forward outlook of their businesses that use or, produce the commodity in question. The commercial traders in the gold market have just established their most bullish position since December of 2001.
The gold and silver markets have been perking up lately which happens to have coincided with the Fed’s talk of removing stimulus from the domestic economy. Logically, talk of higher interest rates has spurred interest in portfolio re-allocation towards gold and silver as investors attempt to get a jump on the beginning of a structural shift towards inflation. The result of this is that gold has rallied about 11.5% year to date and silver is up nearly 20%. Much of this rally has been technical in nature, as the markets have moved beyond some key chart points. Technical levels are always important in short-term trading. However, the fundamentals suggest that this rally may be petering out.
The United States has tripled its balance sheet since 2008 and Great Britain has quadrupled theirs in the same time frame. Theoretically, the growth in the currency base should be accompanied by a corresponding decrease in the purchasing power of our Dollars and Pounds. Many of us who’ve worked diligently for years trying to manage our personal budgets and build up our personal stores of wealth find the governments’ actions downright criminal. This is the scenario that’s drawn billions into the gold market. We’ve been taught that gold is the first choice alternative investment for fighting inflation and maintaining the value of our savings. This week, we revisit an alternative to gold as a hedge against inflation and currency debasement – the Bitcoin.
I published a piece on the Bitcoin in June of 2011 titled, “The World’s Strongest Currency.” Many viewed this as a passing novelty at best or, the next .com bubble. At worst, people saw it as the international street criminals’ Swiss bank accounts. Bitcoin is an Internet currency that is traded globally for goods and services and can be cashed out in the physical currency of your choice. It is, “mined” on individual computers that are placed, by anyone, on the network. The mining is basically using your computer to solve an equation. The equations get harder and harder through time. This ensures that the supply of Bitcoins grows at a stable rate. The publicly validated equations place more Bitcoins into circulation by the people who’ve mined them. The number of Bitcoins currently stands near 12 million. The next equation and number of coins in circulation are all publicly available in real time.
When we published the first piece in June of 2011, Bitcoins were trading near $14 per Bitcoin with 6.6 million Bitcoins in circulation for a market cap around $92 million. The Bitcoin mining equation is public information. It’s always known how many are in circulation as well as the growth rate. Furthermore, the total number of Bitcoins will be limited to 21 million by the equation itself. These are the currency controls lacking in today’s global economy. The proof lies in the adoption and acceptance rate of Bitcoins, which is growing exponentially. The current Bitcoin market is 12 million Bitcoins at $400 each for a market capitalization of $4,800,000,000. This places it between Exxon Mobil and Apple in market value.
This leads to the .com bubble argument. There’s no question this market is extremely volatile. Let’s put the volatility in context before Bitcoin is dismissed and demonstrate why it isn’t a fad. The S&P 500 declined by more than 50% in four months during the housing crash and has more than doubled, reaching all time highs since. The European Central Bank just cut their interest rates in half and gold is nearly 40% off of its highs. The world we live in is a volatile place. I’d argue that we haven’t seen this much change in the political/economic/social aspects of this world since World War 2. I’d argue further that it is precisely this volatility that has made Bitcoin a globally accepted alternative form of payment at both the retail and business-to-business levels.
Bitcoin has clearly passed the novelty stage. EBay as well as Amazon accept them. They’re even beginning to show up as an ATM. The first ever Bitcoin ATM was recently installed in Vancouver and it processed more than $100,000 in transactions in its first week. This is no ordinary ATM. There are financial controls on Bitcoin just like normal currencies. In Canada for instance, they are only allowed to exchange $3,000 per day without filing anti-money laundering documents. I recently visited Mt. Gox.com, the leading Bitcoin exchange and found their registration requirements to be every bit as stringent as the ones we face in the commodity futures markets. This degree of regulation continues to add validity to the Bitcoin system rather than hindering its growth.
We live in a world of fiat currencies subject to monetary adjustments or downright manipulations that many of us have no say in. Frequently, the decisions that are made for us negatively impact the very foundation that we’ve worked so hard to build. Bitcoin is a known quantity in a world full of unknowns. It travels globally without the processing fees of PayPal, Western Union or the banking industries. In fact, the current banking systems’ loss of processing fees is both a boon to Bitcoin business as well as the reason for the most vocal arguments against it. After all, JP Morgan has to recoup the $8 billion they’ve received in regulatory fines over the last two years somehow, right?
The gold futures market is still looking for support since reaching a high near $1,800 per ounce in early October. The market had fallen by nearly $200 per ounce as recently as early this month. Fiscal cliff issues as well as tax and estate laws fueled some of the selling. However, commercial traders were the dominant sellers above $1,700 per ounce as they sold off their summer purchases made below $1,600. I believe the gold market has one more sell-off left in it before it can turn higher with any sustainability.
Comparatively speaking, gold held its own against the Dow in 2012 with both of them registering gains around 7% for the year. However, the more nimble companies of the S&P 500 and Nasdaq soundly trounced the returns of each, registering gains of 13% and 16%, respectively. The relative advantage of gold in uncertain times may be running its course. There currently is no inflation to worry about and CEO’s are learning how to increase productivity to compensate for increased legislative costs. Finally, the S&P has risen by about 19% over the last 10 years while gold has rallied by more than 250%. Therefore, sideways market action in gold over the last couple of years seems justified.
Meanwhile, seasonal and fundamental support for gold hasn’t provided much of a kick over the last two months. Typically, the Indian wedding season creates a big source of physical demand in the gold market from late September through the New Year. In fact, the strongest seasonal period for gold is from late August through October in anticipation of this season. This effect should be gaining strength due to the rise of the middle and upper middle classes in India yet, the market seemed to absorb this support with nary a rally to be had. I think we’ll see the market’s second strongest period, which begins now, and runs through the first week of February provide us with a tradable bottom and rally point.
Finally, the last of the short-term negatives is the strength of the U.S. Dollar. The U.S. Dollar trades opposite the gold market. Gold falls when the Dollar rallies because the stronger Dollar buys more, “stuff” on the open market and while we’ve talked about commercial traders buying gold, they’ve also been buying the U.S. Dollar Index. Commercial traders have fully supported the Dollar Index at the 79.00 level. The Dollar Index traded to a low of 79.01 on December 19th followed by a recent test of that low down to 79.40. The re-test of the 79.00 low has created a bullish divergence in technical indicators suggesting that this low may be the bottom and could lead to a run back to the top of its trading range around 81.50. This can also be confirmed in the Euro Currency and the Japanese Yen. The Euro currency futures market has seen commercial traders sell more than 120,000 contracts in the last six weeks as the market has rallied from 1.29 to 1.34 per Dollar. Meanwhile Japan’s new Prime Minister, Shinzo Abe, has turned the country’s monetary presses up to 11 in an attempt to jump-start their domestic economy.
The absence of an expected rally in the gold market through the last few weeks leads me to believe that the internals simply don’t support these price levels, yet. Therefore, the market will continue to seek a price low enough to attract new buyers beyond the commercial traders’ value area. Typically, this would lead to a washout of some sort that may force the gold market to test its 2012 lows around $1,540 per ounce before finding a bottom.
Furthermore, the flush in gold would most likely be accompanied by a rally in the U.S. Dollar and could push it back above the previously mentioned 81.50 level. Proper negotiation and resolution of the pending debt ceiling would most likely exacerbate both of these scenarios while also including a large stock market rally. Conversely, a legislative fiasco would lead to a Dollar washout, as the global economies would lose faith in our ability to manage ourselves and treat our markets accordingly. Therefore, in spite of the inter-market, fundamental and technical analyses we will keep our protective stops close on our long Dollar position while waiting for an opportunity to buy gold at discount prices for the long haul.
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 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.
Analyzing the markets requires a combination of quantitative and correlational research. It’s easy to track jobless numbers, productivity, crop acreage or crude oil stocks. These numbers help define the fundamental supply and demand of the price equation. Trading, actual trading, is different from quantitative analysis because we are looking for actionable clues to imminent price movement and what will trigger it. These are the support and resistance numbers, spread ratios like gold to oil or, corn to beans. These are the chart patterns like head and shoulders, bull and bear flags and reversals that people watch for confirmation of the impact of their quantitative analysis.
Correlational research is an integral part of both fundamental and technical analysis. How many times have you heard the phrase, “Flight to quality?” This phrase is based on money being pulled out of risky assets and placed in safer asset classes like bonds, money markets or, the safe haven of gold. Investors are willing to settle for the bird in the hand rather than chase after the two in the bush. We also see this behavior in the inflation markets. How many times have you heard gold touted as an inflation hedge? Investors concerned with rising interest rates, a falling dollar or financial panic frequently place a percentage of their portfolio in gold because theoretically, its price should rise with inflation and panic.
Currently, there are several market relationships that are bucking their theoretical correlations. Positive and negative correlations provide clues into market behavior and when these relationships get out of whack, we should take notice. We can tie the examples mentioned above to two distinct market relationships. The flight to quality is typically measured as money coming out of the stock market and flowing into the bond market. This is visible on charts as a falling stock market and a rising bond prices. However, my application of flight to quality is based on the relationship between the stock market and the volatility index (VIX). The VIX measures market fear. The more fear there is in the stock market, the more anxious traders should be to pull money out of it. The typical relationship is for the VIX to rise as the stock market falls. Tracking the relationship in this manner means that I don’t have to search out the final destination for funds coming out of the stock market. It is clear from the chart below that there was far less fear in the stock market when we made the new lows in July than there was when we made the lows of the, “Flash Crash” in early May or the lows at the end of May when the VIX peaked at 48. The correlational assessment of this relationship suggests that there was far less fear in the market when we made the July lows and therefore, the stock market outlook may not be totally bearish.
The second chart illustrates the inflation relationship between U.S. Government bonds and the price of gold. Typically, this is an inverse relationship. We see treasury prices fall as gold rallies. This represents investors’ view of future inflation. Gold is purchased as a hedge during inflationary times and sold off in times of economic stability or falling interest rates. Clearly, we are not witnessing the typical relationship between these markets. The bond market is pointing towards lower and lower rates while the gold market has also enjoyed a considerable rally. An important point in the gold chart comes at the start of the downtrend. The stock market made its most recent low on July 6th. This is two days after the gold market began to sell off. In a panic situation, such as the stock market taking out the May lows, one would expect to see the gold market rally. This is especially true in a market that has enjoyed the strength of its current trend and was sitting so near its highs. The stock market’s sell off should have provided the catalyst to move gold ever higher. This is an important divergence. When markets behave abnormally, we must sit up and take notice.
Unfortunately, I have little to offer as an answer to this riddle. Over the last few months, I’ve seen other relationships breakdown as well. The U.S. Dollar typically moves opposite the oil market. However, oil has remained stagnant, in spite of oil’s seasonal strength and a weak Dollar since early June. Finally, the Commercial Traders that I track through the weekly Commitment of Traders Report have shown large and contradictory moves. Commercial momentum in the gold and stock markets continue to build. These two inversely related markets are continuing to see inflows of capital from far smarter men than myself. Just to complicate matters further, I have also seen a significant build in momentum going out on the term rate structure. This means that big money is flowing from nearby treasuries and into longer dated treasuries. These moves, charts and relationships should provide for an interesting third quarter. Hold on tight and feel free to share your thoughts.
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.
This blog is published by AndyWaldock. Andy Waldock is a trader, analyst, broker and asset manager.Therefore, Andy Waldock may have positions for himself, his family, or, hisclients in any market discussed. The blog is meant for educational purposes andto 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 suitablefor all investors. There is substantial risk in investing in futures.
This morning, (11/9/09) the U.S. Dollar is significantly lower and testing the ’08 lows. Gold is making new highs and holding over $1000 per ounce and crude is up $1.60. This is as it should be in a Dollar devaluing world, global assets priced in Dollars should climb in response to its decline. Economics 101 tells us that there is a negative correlation between global asset price and the price of the Dollar.
So far so good, right? Not so much. Every weekend, I download the Commitment of Traders Reports to see what the different categories of traders are doing. The three main categories I track are the commercial traders, the small speculators and the funds. As many of you know, a big portion of my trading is based on the momentum of the commercial traders actions. There are three main reasons for this. First, they understand the fundamentals of the markets they trade – their markets are their business. Second, as the fundamental players in the business of their markets, they have a vested bottom line interest in pricing their products profitably. Finally, when they act collectively, based on their fundamental knowledge of their markets, they have the resources to move markets. Therefore, when they move, I want to be on their side.
Typically, the commercial positions rise and fall with the ebb and flow of the markets. They may act within the channel boundaries of a trending market or, they may be trading against support and resistance in sideways markets but, typically, they use their fundamental knowledge to pick the right side for the coming period of time.
Occasionally, we see these relationships pushed to the extreme and this is one of those times. I’ve selected three markets to illustrate this point – Gold, Crude Oil and the U.S. Dollar. As the Dollar has declined over this past year, we’ve witnessed a steady building of commercial long positions with a net accumulation of approximately 20, 000 contracts. Crude oil has seen commercial net short positions increase by more than 100,000 contracts since July. This also places Crude at a new net short record, eclipsing the August of 2007 mark. Finally, we have the Gold market. It’s been in the news everyday. Beginning in September, we can see that once the market started to breakout above the $990 level, commercial traders began to increase the pace of their selling. They have increased their net short positions by more than 30%. The final point to make is that people on the other sides of these trades are just that, people. Remember that it takes both a buyer and a seller to create a trade. The commercial entities need someone to take the other side of their trades. Those someones are the small speculators and the commodity funds. The commodity funds will always maintain a certain percentage of their assets in a given market. They adjust their asset base according to price, adding to their positions as prices rise and paring back their positions as the markets fall. Most importantly, they position themselves from the LONG SIDE ONLY. The small speculators can and do, trade both sides of the market and they are typically long at the top and short at the bottom. So, if the commercials have accumulated large, in some cases historical, positions that are opposite the markets’ current direction, who do you think is on the other side of their trades with historically sized positions betting on the trend to continue?
These are interesting times with the elastic band of the markets stretched to historical proportions. As a trader, I’m never one to bet my money against a trend’s continuation as my bottom line is only effected by the last traded price. Markets can remain irrational far longer than I can hold a bet against them. However, it would behoove those participants on the side of the small speculators to tighten up their protective stops as a reversal of fortune could send a record number of players heading for the exits.
Many customers have been asking spread strategy questions
and last week’s action in the gold and platinum markets provides us with a
wonderful opportunity to have this discussion.
Take a look at the
The red line on the
bottom is how much gold is worth relative to platinum (gold close/platinum
close). This is a monthly chart and you can see that the spread, along with
platinum, have broken their trends going back to ’01. This means that the
prices of these two metals are converging. One should be short platinum and
long gold. The way I see it, the price of platinum has been beaten up far worse
than gold. I think the global slow- down scenario may be impacting the
manufacturing base for platinum more than inflationary/deflationary issues are
effecting the speculative nature of the gold market. Gold has also held above
its trend line, in spite of the U.S. Dollar’s significant rally.
Profitable spread trading requires more than predicting the
general directions of the two markets involved. The size of the contracts, tick
size and volatility also need to be considered. In this example, there is only
one platinum contract to choose from. However, there are four actively traded gold
contracts in three different sizes and on two different exchanges. Even the simple
assumption that one full size contract of each should be sufficient would be
incorrect. Recently, platinum is moving around $67 per day in the futures
market and gold is moving around $25 per day. Would it be appropriate to try to
even these out by trading two gold contracts versus one platinum contract?
Here is the method I use as a commodity broker to appropriately size my spread
trades. First of all, I calculate the average range for each market relative to
the time frame I expect my trade occur in. In this case, I am looking at
monthly charts. Therefore, I calculate the 21 day average range for each market
and come up with $21 for gold and $67 for platinum. The next step is to
multiply each of these average daily ranges by the market’s point value. Gold
is $21 X $100 = $2100 per day average movement. Platinum gives us $67 X 50 =
$3350 in average per day movement.
Clearly, one full
size contract of each is not an even spread. Now, since we know that we only
have one platinum contract to work with, our only opportunity for proper sizing
in the futures market (there are option strategies available, as well), is to look
at the list of available gold contracts. One full size gold contract gets us to
$2100 per day and leaves us with a $1200 per day deficit to make up. Chicago’s mini
sized gold contract is 33.2 oz. (1/3 full size). That would bring our total to $2793
on the gold side of the trade. This won’t square the ledger. New York’s mini
sized gold contract is 50 oz. (1/2 full size). That would make our total $3150.
That’s pretty close. Obviously, the other option is to use two Chicago mini
contracts and bring our total to $3486. At this point, it comes down to
personal bias. Would one rather be more or, less long gold relative to
I hope this brief description answers more questions than it
creates. However, please feel free to post any ideas, comments or, issues.