Trader’s Narrative

Not surprising after the extremely negative sentiment in the US dollar index, the greenback has staged a modest rally. In response, gold has wilted. Here are few perspectives on what may be next for the precious metal:

Elliott Wave International
Arguing for the bearish case, is Robert Prechter of Elliott Wave International. He writes that since 1913, as shown in the chart below, the purchasing power of the US dollar has eroded by 96% (great job Fed!). If gold had simply offset this loss in purchasing power, it would have to have increased 25 times. But instead gold has multiplied in value by 50 times. Therefore, Prechter argues, it is 50% ‘overvalued’.

This is a strange sort of argument because most gold bugs would say that gold’s strength, the very fact that it has gone up so much, reflects positively on the precious metal. Prechter has had a very hot hand lately in timing the stock market so I’m willing to listen to his argument even if it sounds a bit odd. It appears that he implies that gold’s only sensible ‘value’ is to be the anti-dollar. However, I’m not sure that’s a valid point because as far as I’m concerned, gold is just another commodity with all the inherent susceptibilities to manias and panics we ascribe to other more traditional markets like stocks.

While I’m reticent to embrace this line of thinking, I do agree with something else that Prechter wrote recently about gold:
Continue reading ‘What’s Next For The Gold Bull?’

The CFTC plans to hold hearings into revoking the exemptions they had previously give to investment firms which removed limits on the amount of assets they could hold in physical commodity markets. This exemption, called ‘Bona Fide Hedging’, circumvented a 1936 law which protected price discovery by limiting the involvement of speculators. It allowed true hedgers, producers and speculators to participate in the same market without anyone bullying the others.

Before the Great Crash of 1929 the US financial market was largely unregulated. You could say that compared to today’s market it was the wild wild west. As a consequence of the crash a lot of sensible regulations and government oversight was instituted. But most of those sensible and necessary rules were removed as the power of absolute free markets took hold. The pendulum is now swinging towards more regulation. All we can do is hope that it doesn’t swing too much and the regulations that are put in place are useful.

The danger is that politicians will make hedge funds or any speculator to be a scapegoat to score cheap points. If the limits are too restrictive, then it will reduce liquidity. But as long as we can go back to the simple rules that worked for 50+ years, I think we’ll be fine.

I don’t think that anyone can look at the underlying supply of crude oil, which has been plentiful and without interruption and then look at the demand side, which has been waning and find any justification for the kind of price swings that we have seen recently. In less than two years, we’ve seen a barrel reach $145, then crash to $33 and then rise 50% to $70! All the while, no fundamental change whatsoever has occurred in either the demand side or the supply side.

Although I believe we should let markets work, when you have speculators controlling more oil than all the commercial oil held in storage in the US combined with the US government’s Strategic Petroleum Reserve… then things are clearly out of whack. The only reason this was allowed was because the CFTC gave exemptions to OTC swap dealers who needed to hedge their own exposure through the futures markets. Due to the size and amount of their OTC transactions, the needed to take mammoth positions.

It isn’t entirely clear what the CFTC will do but the hearings coming up will provide an answer. As usual, expect the FIA to push for less regulation. One possible solution would be more transparency. The CFTC will improve the detail in its weekly CoT report by reporting swap dealers positions separately.

The result will probably be less volatility, which is not that great if you’re a trader. But if the consequence is having a sane and healthy commodity market which will provide a foundation for a stable economy, then I’m all for it.

Finally, there was a rogue trader from PVM who pushed the futures price higher by an extra $2 recently and caused a $10 million loss. But that is not even chump change compared to the size of the oil market. If there was a ‘Nick Leeson’ type trader out there who was responsible for the run up in crude oil, it would let Goldman Sachs and other investment banks off the hook.

A recent article shows the chart to the left which demonstrates the correlation between crude oil prices and the size of the passive long-only institutional investor.

This is a topic that I’ve been harping on ever since last year, as a barrel went for $135: What is really going on with the price of crude oil?

It also confirms the previous chart showing the stampede of hedge funds and other large speculators to the long side of oil. Back then I couldn’t prove what was going on but the inflation adjusted price of oil certainly looked like a bubble.

There wouldn’t be a problem of course if these powerful market participants were taking both or either sides in legitimate speculation or hedging. But there is a problem for everyone, including these same institutions, when they pile into only one side, continuously going long the crude oil futures.

According to the article:

Passive investors increased their crude-oil holdings to the equivalent of more than 600 million barrels in June, up more than 30% from the end of last year…

So what is going on? How can these behemoth institutional players treat the crude oil market like their very own ponzi scheme? Last year the effects on the world economy were devastating. Wealthy economies stalled into a recession and poor economies were thrown into chaos as staple food prices soared.

Isn’t there a regulation to prevent the manipulative “walking up” of prices in commodities? Yes, yes there is. Or more accurately there was.

Matt Taibbi’s scorching article on Goldman Sachs (GS) in the most recent edition of Rolling Stone magazine explains. There was a 1936 government regulation which had successfully stopped this type of shenanigan. In effect it did not allow large speculators to lean on any commodity market and crowd out real producers and consumers. Until 1991. That’s when Goldman Sachs’ (GS) commodities subsidiary, J. Aron, request an exemption based on the flimsiest justification.

Amazingly enough it got it. And over the years the CFTC handed out 14 other similar exemptions. Goldman and its ilk were busy with a few other schemes and it wasn’t for a while that they started to really take advantage of the loophole they had gained. What followed was nothing short of astonishing. For example:

Between 2003 and 2008, the amount of speculative money in commodities grew from $13 billion to $317 billion, an increase of 2,300 percent.

What makes this even more astonishing is that last year’s oil spike (or bubble) happened when the world was awash in oil supply and faced a drastically reduced oil demand!

…according to the US Energy Information Administration, the world oil supply rose from 85.24 million barrels a day to 85.72 million. Over the same period, world oil demand dropped from 86.82 million barrels a day to 86.07 million.

By the summer of 2008, in fact, commodities speculators had bought and stockpiled enough oil futures to fill 1.1 billion barrels of crude, which meant that speculators owned more future oil on paper than there was real, physical oil stored in all of the country’s commercial storage tanks and the Strategic Petroleum Reserve combined.

This whole bear market has been a massive lesson in the validity and value of smart government regulations. As Ritholtz counts off in his book “Bailout Nation”, over a number of years and even decades, the threads of regulation where one by one removed. As the regulatory framework deteriorated in tatters, things started to go wrong.

Of course, as you may recall, that explanation was not the one offered when we were in the thick of things last year. The old and tired theory of “Peak Oil” was on everyone’s lips and many actually believed it.

The problem with that is, in the market when something is obvious to everyone, it is obviously false. And as I’ve said before many times, while no one disputes that the supply of oil is finite, it is a non sequitur to posit that as this resource is exhausted, the price of oil will spike.

If you believe otherwise, then get into your time machine, go back to the 1800’s and corner the whale blubber market.

A few weeks before crude oil topped out at $147.90 in July 2008, I kept pointing out that something was just not right with that market. In “What is Really Going on With the Price of Crude Oil?” I pointed out the role of large institutional funds and a few days later I showed a graph of the inflation adjusted price of crude oil which should have put the question to rest.

Follow the above link to see the chart because I truly marvel at how anyone could have looked at that and not realized that what we were seeing was not “peak oil” but the same imbalance that any run of the mill bubble produces. The 2008 run-up dwarfed both the late 1970’s oil shock and the 1991 Persian Gulf war spike.

Since then, we’ve seen the great unwinding of that frenzy take oil down to $35 - less than a quarter of its high in 2008. But now hedge funds and large institutional traders are, once again, returning to commodities in a big way. Below is a chart of the large speculators’ net long positions according to the US Commodity Futures Trading Commission:

Source: Bloomberg

Of course this shows all 20 major commodities monitored by the CFTC. Oil is in there somewhere having recovered its 200 day moving average, and risen 85% from its low in late 2008. But the money is flowing to agricultural products, metals and softs as well.

All that it will take is for the large speculators to pile on as they did before and the commodity bull will become a self-fulfilling prophecy. While that may nip the ‘green shoots’ it may also cancel out any remaining deflationary pressures.

I received a lot of questions regarding my post on the extremely bullish commitment of traders report. So let me explain it and answer the questions that were raised. Then I’ll cover the most recent COT report and its significance.

What is the COT?
The Commitment of Traders report is a static snapshot of how the 3 different market participants (commercials, large speculators and small speculators) in any futures market are positioned. Each week the Commodity Futures Trading Commission (CFTC) reports how many contracts each of the three are long and how many they are short. The classical viewpoint is that commercials are the savvy group with inside information (who knows more about gold than a mining company?) and the small speculators are the ‘dumb money’ easily panicked by fear and lured by greed.

But interpreting the COT is as much art as it is science. It not only provides an amazing snapshot of the make up of the market, with each participant’s net position explicitely laid out but it also is a treasure trove of historical information. However, you have to navigate the data with a very nuanced approach.

There are a few details that can throw you off course. For example, the threshold for what is considered a small speculator as opposed to a large speculator can and has changed over time. And how reliable is it if a contract lot of, say, 990 is considered ’small’ but just 10 more is considered ‘big’?

There is a lot of information on the web if you google the term and some variety of words like trading, signal, bullish, bearish, etc. If you’re totally new, read up on the vocabulary so you know what the terms mean. And then from there move to the more advanced stuff.

One great new source of COT data as well as actionable trading information is the blog COTs Timer, written by fellow Canadian Alex Roslin. As opposed to my mish-mash, back of the napkin methods, Alex does thorough backtesting.

How bullish?
Now, on to the current COT data. The latest report shows another record setting bullish position by the commercial traders. They are now holding their largest aggregate net long position for the past 7 years. I think this is where a lot of the confusion came from in my last mention. Many thought that I was talking about one specific contract rather than the group of equities futures contract (in aggregate).

This is significant when you consider that the usual net position for commercials is to be short equities. Since they already have exposure to the market by the very nature of their business, they naturally want to hedge that exposure by going short the futures. So for them to even eliminate a net short position, that is be neutral, is quite a bullish sign.

But for them to actually go net long… well, that is a rarer sight indeed.

The SS Queen Mary
So while right now the commercials are net long for the S&P 500 minis they are not so for the larger contract. While this sort of ‘conflicting’ data can seem confusing, if we look at an aggregate number, rather than an individual futures markets we get a more holistic view. This market ‘gestalt’ can be useful in setting up an over arching view of the market.

While the put/call ratio or the LowRisk sentiment survey can be like zippy little speed boats, this aggregate view of the COT report is more like the SS Queen Mary. Can’t turn on a dime. But when it turns, boy, does it have an astounding amount of power behind it.

That reminds me. I have to do a better job of pointing out and categorizing the various market indicators mentioned. Otherwise it can be really confusing:

I’m bullish on the markets from an intermediate to long term perspective, but I do think that we are seeing a bit of an over extension here which warrants caution.

Now that I’ve said that… watch the market zip higher!