Trader’s Narrative

Last week I wondered if the strength in gold was due to the implicit strength of the precious metal itself or whether it was merely a by product of the weakness in the US dollar: US Dollar’s Weakness or Gold’s Strength?.

It is obvious now that the US dollar is being thrown to the carry trade wolves in order to save the economy. This is the same play that central banks made several years ago with the exception that back then it was the Yen that was sacrificed.

In any case, gold continues to walk higher on the chart - it reached $1,064.20 today at COMEX. The distinction may be a moot one because as long as it continues, those on the right side of the trade will profit. But since there was some questions regarding the way I tried to strip out the US Dollar effect on gold price, here’s another chart which uses a slightly different method:

Source: Elliott Wave Intl

The song remains the same. Gold hasn’t reached a new high when we strip away the effect of the dollar. The second chart above looks at gold relative to a basket of other currencies (Yen, Euro, Swiss Franc, Australian Dollar, Canadian Dollar and the Pound).

Also, as noted previously, large speculators have crowded into the long gold trade. The most recent COT shows them to have 50% of open interest. But in general sentiment towards gold is relatively muted - especially considering the many times it was unable to climb above $1000.

From a purely technical point of view, this is a gold bull market. But I’m trying to deal with some nagging questions. For example, if there is inflation on the horizon, why hasn’t it registered on the CRB? After all the commodity index is rading below its 30 year average and it is flat since June 2009.

Honestly, I can’t see any signs of inflation anywhere. In fact, you don’t have to look hard to see deflation almost everywhere. So the gold story is one written on the back of the US dollar. And with the US dollar sentiment so incredibly negative, it makes me cautious on gold - bull market conditions notwithstanding.

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.

From a historically low reading of 10 earlier in the year, volatility as measured by the CBOE’s VIX has all but tripled. On Friday it closed lower but intraday it reached a high of 29.84.

That’s high both on a nominal basis and relative basis (see graph below). In the preceding two corrections, volatility only reached 20 something. And relative to its 50 day moving average, volatility is now about as stretched as then.

This is par for the course when we are operating with a correction thesis. Volatility spikes, the market gets spooked, smart money moves in (hopefully you) and the market resumes its merry way upwards.

But a funny thing happened that is giving me concern about this recent volatility spike. Funny as in weird. Not ha-ha.

VIX Futures
A little over 3 years ago, the CFE started trading in VIX futures. This allowed people to go long/short “pure volatility” for the first time. So we now have a futures market in volatility itself. And we can analyse this market like any other futures market.

Although we have limited history, what we see in market corrections is a move by the commercials to reduce their long positions in volatility and a concomitant move by the retail crowd (small speculators) to increase their long positions. A good example is last summer’s market action in June.

Smart Money vs. Dumb Money
So it is a bit disconcerting to now find the smart money commercial players in this market actually going more and more net long, even as the VIX has increased. And to kick things up another notch, the dumb money, small speculators are now extremely net short.

Perhaps the commercials are hedging some of their gargantuan net long index futures positions? or perhaps some other wrinkle is in the works? One solace we can cling to is that the only other time when the commercials and small speculators were this long/short in the VIX market was in July 2006. Which worked out just fine as the market continued to recover and roar higher.

Whatever it is, I’d still prefer to see the commitment of traders in the volatility futures market acting according to its past script.

Hat tip to Jason Goepfert at SentimenTrader.com

On April 25th 2007, I wrote that gold bulls would be disappointed (again). Lets take a look to see what happened since then and what we can tell for the sector going forward.

I pointed to the Commitment of Traders report, which showed the “smart money” commercials being markedly net short. Since then that lopsided situation worked itself out.

On April 17th 2007, the commercials position was: long 79,882 and short 254,480, which is a net short position of 174,598 contracts. From the previous week (April 10th 2007) the commercials had reduced their longs (-7,564) and added considerably to their shorts (+13,830). Meanwhile, the small speculators were long 54,973 and short 15,733, for a net long position of 39,240 (on April 17th 2007).

Now compare that to the COT on May 29th 2007. The commercials had a long position 125,989 of and a short position of 244,684 for a net short position of 118,695 contracts. And the small speculators were long 57,428, and short 33,630 for a net long position of 23,798 contracts.

An important metric to watch for the COT is the open interest. Currently it is at 425,688 contracts, a 12 month high. Usually important changes in trend develop when the market is positioned lopsided (commercials vs. speculators) and when the open interest reaches significant levels. We saw this happen in late February 2007 where the commercials had been increasing their net short position while the small and large speculators were going more more long. With the open interest at around 415,000 contracts, things hit their climax and it started to unwind.

As well, the Rydex sentiment measure was flashing a caution sign. Considering also that the gold index fell to an area of previosu support, it wasn’t surprising to see it rally last week. It started with hammer on Wednsday and then two back to back long range up days:

Last week may have gotten the gold bugs rejoicing. But when you step back and look at the larger picture you see a very lackluster performance. Relative to the general stock market, the gold sector has lagged significantly. It is stuck in a wide trading range and is no where near break out levels. If it does approach the 370 level without looking too overbought and if the k-ratio is low enough, then I might change my overall outlook on this sector.