Trader’s Narrative

The poor besieged dollar gets a short reprieve as the gold bull market pauses. But the gold bugs suddenly have an unexpected and persuasive ally in their camp. As an interesting addendum to what’s next for gold? in the most recent quarterly client letter, Paul Tudor Jones II builds a fundamental case for a long term bull market.

He compares the relative historical value of the precious metal to the US monetary base, crude oil and the S&P 500 index. Their econometric model declares “gold is 20% undervalued over the next 24 months”. But the rationale is not restricted to the monetary forces which are at play.

Strengthening his case, he delves into the basic demand and supply of the commodity. On the supply side, mining production has been stagnant for the past 10 years. And central bank selling has slowed to a trickle with no new sales planned in the future.

On the demand side, the physical investment allure of gold continues strong. As well, to that we can add the penchant of modern investors for digital investment in gold. Relative to the gargantuan size of the equity market, the bond market and alternative investments (real estate, timber, etc.) gold’s share continues to be lilliputian. This means that even a sliver of asset flows diverted to gold will dramatically alter the equation.

Source: Tudor Investment 3rd Quarter Letter

Gold ETF holdings as a ratio of above ground stocks has increased incrementally 4 years. And the trend, does not look like it is about to reverse.

While Paul T. Jones presents a text book case for the long term bull based on fundamental analysis, I can’t help but think it is all an elaborate window dressing to rationalize a position he has arrived at through other, shall we say, more esoteric means. Clients obviously prefer logical, well thought out reasons for why a professional is allocating their money a certain way.

No one would be comfortable to be told that their trust fund is being gambled on nothing more than squiggles and trend lines or better yet, something called Elliott Wave (which we know, by the way, that Paul T. Jones II used to make a killing on Black Monday while practically everyone else on Wall Street was busy having an aneurysm). Interestingly enough right now Elliott Wave is bearish on gold.

This is just speculation on my part, of course. I have no way of knowing exactly why Tudor Investments is bullish on gold. Maybe I’m too cynical and we can take them at face value. In any case, even if the long term gold case is solid, you might want to fine tune the entry by looking at the gold sector sentiment.

Here is a chart comparing the price of gold and the Hulbert Gold Sentiment Index, which measures a subset of newsletters which time the gold stock sector:

Source: Risk Management and Convex Return Profiles

While the Hulbert gold sentiment metric isn’t as high as we’ve seen it historically, at these levels it does not bode well for another leg up. At least not without a pause first. As I mentioned before, to me it isn’t just the altitude of the bullish sentiment, it is also the attitude: as gold has corrected recently sentiment continues to reflect the same amount of optimism.

With US dollar sentiment at historic lows, the dollar continues to be about as popular as a leper. In contrast, the yellow precious metal continues to be the belle of the ball. Today it closed at a new, all time high at the Comex. The December futures contract closed at $1045, decisively higher than even the intra-day high in March 2008 (when the fall of Bears Stearns lead to a panic).

Here is a short video covering the recent move and a look ahead at what’s coming up at the hard right edge of the chart (make sure to watch till the end for a bonus):

It wasn’t too difficult to anticipate a successful break above the hitherto challenging $1000 level. An analysis of the investor sentiment in gold revealed a mostly bland response to its advance this time around. Unlike previous rallies.

As well, gold’s seasonality was the wind at the back of its uptrend. However, as you’ll notice from the seasonality chart in the previous link, a pull back is to be expected for gold in October. At least, that’s what has been average historical pattern.

Checking in with the K-Ratio (the ratio of the price of gold to the Philadelphia Gold Bugs index), we see it in neutral territory:

This recent move helps to cement the long term uptrend for gold, however it isn’t smart to chase it higher. Once a decisive break through tough resistance like this is made, it is typical to see a pull back to that level again as it acts as support. With the seasonality weakness about to kick in, that’s what I’d expect to happen. So keep watching this market for a good opportunity.

Also keep in mind that there are many ways to play this. You don’t have to buy gold futures or the Gold ETF (GLD). There are many highly leveraged mining companies that provide a fantastic proxy for this precious metal. The K-ratio still has room to move higher, which means that relative to gold, gold equities are not expensive.

Finally, the bigger picture is the slow decline of the dollar. I expect a rally in the US dollar, especially as the sentiment is so extremely pessimistic. But the long term trend is clear. There are some rumblings in the background that oil producing Middle Eastern countries, along with China and Russia are working together to stop pricing crude in US dollars. As well, the Reserve Bank of Australia wins a gold star for being the first among industrialized nations to start on a tightening cycle.

I had read about the problems with US Oil Fund (USO) but it wasn’t until I plotted a simple graph comparing it to crude oil futures contract that I understood just how little badly it has performed:

The chart shows the ratio of USL to the crude oil futures contract (West Texas intermediate) since the ETF’s founding on April 10th 2006. Here are the four variables that influence the difference in the performance of the USO ETF vs. the crude oil futures which they are supposed to mimic:

• contango/backwardation
• MER (0.45%)
• rollover impact
• interest earned (on 90% of fund assets)

The MER is too low to account for the enormous valuation drift. So too is the (positive) effect provided by the interest earned on the majority of the ETF’s assets. Right now interest is so low that we can assume these two cancel each other out. Therefore, the other two variables are the key.

Contango occurs when later futures contract prices are more expensive than current contract prices. Backwardation is the opposite. We’ve been experiencing contango for about two years now. Right now the current NYMEX contract (November) is $70/barrel. Meanwhile the March 2010 is $72/barrel. This has meant that USO has had to buy slightly more expensive contracts every month, in effect, shaving a little off their asset valuation little by little.

As well, due to the gigantic size of the fund, the impact of rollover exacerbates the already existing difference between expiring and forward month contracts. As USO sells their holdings, they push down prices and as they buy, their demand increases prices. Of course, other market participants can count on their rollover to front run their obligatory monthly cycle.

All this means that the fund has done an abysmal job in tracking the crude oil market. From the start of the year until now, crude oil futures have gone up about 50%. But if you tried to replicate that by buying USO instead, you would have been out of luck as the ETF has gained less than 5% for the year.

To mitigate these concerns, a new fund was created: the United States 12 Month Oil Fund LP (USL). As the name implies, it holds 12 months worth of contracts so that each month only 1/12th of the fund is rolled over. While we have much less data for this ETF, as you can see by the chart below, the same valuation drift is at play:

Year to date, USL has returned about 16% while crude oil futures have increased in price by about 50%. A little better than USO’s horrendous under performance but still, not even close to tracking their underlying commodity.

The conclusion is that you shouldn’t simply assume that an ETF will do what it is supposed to do. Almost all ETFs and for that matter any retail structured product is created to “feed the ducks” when they’re quacking.

USO and USL are imperfect products when we use an intermediate to long term time horizon. They are appropriate for intra-day trading or swing trading but holding them as a proxy for the futures contract is self-defeating due to the valuation drift. If you want long term exposure to oil, buy the futures contract. Otherwise, buy small to medium size oil companies or explorers like Anadarko Petroleum (APC).

Last week we reviewed the white hot Chinese stock market with a cautionary note. I wanted to return to it briefly because the situation is serious and deserving of much more attention.

Putting aside price charts of the Chinese equity market for now and turning to monetary measures, we can see something rather alarming happening. China’s M2 has enjoyed a constant rate of acceleration as shown in the chart below (in semi log scale). But in late 2008 the rate of acceleration suddenly increased dramatically:

This was a consequence of the massive stimulus plan put into motion by the Chinese government. They pumped unprecedented amounts of liquidity into their economy to offset the world-wide economic slowdown. There would be nothing singularly alarming about that since all central banks around the world, as well as governments in charge of fiscal policy, have orchestrated a collective burst of activity.

What is alarming is that the Chinese economy, stock market and especially real estate market are just now displaying bubble-like characteristics. The government controlled banking sector is a mystery wrapped in an enigma. No one can begin to fathom the amount of non-performing loans on the books. Unlike the US which went through a gut wrenching cleansing - thanks to the largess of the lobby-less taxpayer, the financial sector is once again back in fighting shape (privatized profits, public losses). China has yet to address their toxic assets

As we briefly touched on before, since last year’s low the Shanghai market has now appreciated more than 100%. Once again the stock market has enthralled the average person in China with thoughts of wealth and the possibility of making more in a month than what they earn in a year at their regular job. Speculation in the market is seen as not only a legitimate way to make money but a very lucrative one with low barriers to entry.

A sure sign of a bubble is extreme turnover. Recently, the total Chinese stock market turnover (in one day) reached $63 billion. That’s more than the combined total turnover of $58 billion in London, New York and Tokyo for the same day!
Continue reading ‘China’s Bubble 2.0 Threatens Global Recovery’

If you’ve read Irrational Exhuberance, you may recall reading about Robert Shiller’s aspirations to create liquid markets to allow for hedging of real estate assets. Now, that dream is reality. Shiller’s company MacroMarkets has created two products which allow anyone with a brokerage account to trade the wider US housing market.

Although they may look like ETFs, these are really derivative constructs, so tread carefully. Technically they are an ETP or Exchange Traded Product and come with a hefty MER of 1.25%. By now, we’ve become used to double and triple leveraged ETF products. So it won’t be a stretch that the MacroShares ETPs are triple leveraged to the underlying index they track.

The MacroShares products, UMM and DMM, have been trading for 5 days, and already made a 19% move:

The MacroShares Major Metro Housing Up (UMM) and the MacroShares Major Metro Housing Down (DMM) will be tracking the S&P/Case Shiller 10-city composite index. Although you may think at first that it would only be necessary to have one product, which can be held either long or short, it is necessary to have two because of the nature of the asset.

The MacroShares don’t actually hold houses as assets, but rather short term Treasury bills. They track the value of the S&P/Case Shiller Index through a simple mechanism: they shift assets between each other to reflect the underlying changes in the index every day.
Continue reading ‘Trading The S&P/Case Shiller Home Index’