Bud Conrad,
Chief Economist
Casey Research
How can we explain gold dropping into the $1,300 level in less than a week? Here are some of the factors:
- George Soros cut his fund holdings in the biggest gold ETF by 55% in the fourth quarter of 2012.
- He was not alone: the gold holdings of GLD have contracted all year, down about 12.2% at present.
- On April 9, the FOMC minutes were leaked a day early and revealed
that some members were discussing slowing the Fed $85 billion per month
buying of Treasuries and MBS. If the money stimulus might not last as
long as thought before, the "printing" may not cause as much dollar
debasement.
- On April 10, Goldman Sachs warned that gold could go lower and
lowered its target price. It even recommended getting out of gold.
- COT Reports showed a decrease in the bullishness of large speculators this year (much more on this technical point below).
- The lackluster price movement since September 2011 fatigued some speculators and trend followers.
- Cyprus was rumored to need to sell some 400 million euros' worth of
its gold to cover its bank bailouts. While small at only about 350,000
ounces, there was a fear that other weak European countries with too
much debt and sizable gold holdings could be forced into the same
action. Cyprus officials have denied the sale, so the question is still
in debate, even though the market has already moved. Doug Casey
believes that if weak European countries were forced to sell, the gold
would mostly be absorbed by China and other sovereign Asian buyers,
rather than flood the physical markets.
My opinion, looking at the list of items above, is that they are
not big enough by themselves to have created such a large disruption in
the gold market.
The Paper Gold Market
The paper gold market is best embodied in the futures exchanges. The
prices we see quoted all day long moving up and down are taken from the
latest trades of futures contracts. The CME (the old Chicago
Mercantile Exchange) has a large flow of orders and provides the public
with an indication of the price of gold.
The futures markets are special because very little physical commodity
is exchanged; most of the trading is between buyers taking long
positions against sellers taking short positions, with most contracts
liquidated before final settlement and delivery. These contracts
require very small amounts of margin – as little as 5% of the value of
the commodity – to gain potentially large swings in the outcome of
profit or loss. Thus, futures markets appear to be a speculator's
paradise. But the statistics show just the opposite: 90% of traders
lose their shirts. The other 10% take all the profits from the losers.
More on this below.
On April 13, there were big sell orders of 400 tonnes that moved the
futures market lower. Once the futures market makes a big move like
that, stops can be triggered, causing it to move even more on its own.
It can become a panic, where markets react more to fear than
fundamentals.
Having traded in futures for over two decades, I want to provide some
detail on how these leveraged markets operate. It's important to
understand that the structure of the futures market allows brokers to
sell positions if fluctuations cause customers to exceed their margin
limits and they don't immediately deposit more money to restore their
margins. When a position goes against a trader, brokers can demand that
funds be deposited within 24 hours (or even sooner at the broker's
discretion). If the funds don't appear, the broker can sell the
position and liquidate the speculator's account. This structure can
force prices to fall more than would be indicated by supply and demand
fundamentals.
When I first signed up to trade futures, I was appalled at the powers
the broker wrote into the contract, which included them having the
power to immediately liquidate my positions at their discretion. I was
also surprised at how little screening they did to ensure that I was
good for whatever positions I put in place, considering the high levels
of leverage they allowed me. Let me tell you that I had many cases
where I was told to put up more margin or lose my positions. Those
times resulted in me selling at the worst level because the market had
gone against me.
The
point of this is that once a market moves dramatically, there are
usually stops taken out, positions liquidated, margin calls issued, and
little guys like me get taken to the cleaners. Debates rage about the
structure of the futures market, but my personal opinion is that a big
hammer to the market by a well-heeled big player can force
liquidations, increase losses, and push the momentum of the market much
lower than the initial impetus would have. Thus, after a huge impact
like we saw on April 13, the market will continue with enough momentum
that a well-timed exit of a huge set of short positions can provide
profits to the well-heeled market mover.
Moving from theory to practice, one of the most important things to
keep your eye on is the Commitment of Traders (COT) report, which is
issued every Friday. It details the long and the short positions of
three categories of traders. The first category is called
"commercials." They are dealers in the physical precious metals – for
example, gold miners. The second category is called "non-commercials."
They include hedge funds and large commercial banks like JP Morgan.
Non-commercials are sometimes called "large speculators." The rest are
the small traders, called "non-reporting" since they are not required
to identify themselves. The ones to watch are the large speculators
(non-commercials), as they tend to move with the direction of the
market. Individual entities could be long or short, but in combination
the net position of the group is a key indicator.
The following chart shows the price of gold as a blue line at the top,
and the next panel down shows the net position of these large
speculators as a black line. You can see that over the long term, they
move together. When the net speculative position is above zero, this
group is betting on rising gold prices. Of course, the reverse is true
when it's below zero. In this 20-year view, the large speculators were
holding net negative positions during the lowest point of the gold
price, around the year 2000. As the price of gold rose, their positions
went net long, and they profited.
An interesting thing about the chart above is that the increasing
amount of net longs reversed itself before gold peaked in 2011,
suggesting that these large speculators became slightly less bullish
all the way back in 2010. The balance remains net long, but it remains
to be seen how long that lasts.
What is not so obvious is that these large speculators are so big that
they can affect the market as well as profit from it; when they
initiate massive positions in a bull market, they drive the price of
the futures contracts even higher. Similarly, when they remove their
positions or actually go short, they can push the market lower.
So what happened a week ago was that a massive order to sell 400 tons
of gold all at once hit the market. Within minutes the price plummeted,
and over a two-day period resulted in the largest drop of the price
for futures delivery of gold in 33 years: down $200 per ounce.
We don't have the name of the entity that did this. However, the way
the gold was sold all at once suggests that the goal was not to get the
best price. An investor with a position of this size should have been
smart enough to use sensible trading tactics, issuing much smaller sell
orders over a period of time. This would avoid swamping the market;
and some of the orders would be filled at higher prices and thus
generate more profit. Placing a sell order big enough to affect the
overall market price suggests that someone with powerful backing wanted
to drive the price of gold down.
Such an entity could have been a large speculator who already had a
sizable short position and could gain by unloading some of its short
position once the market momentum had driven the price even yet lower.
Or it could be a central bank – one that might be happy to have the
gold price move lower, as it would provide cover for its printing of
more new money. Of course, it could be some entity that owned long
contracts and wanted to get out of the position all at once. We don't
know, but this kind of activity, resulting in the biggest drop in 30
years, raises more than just suspicion when we consider how important
the price of gold is to many markets around the globe.
Can markets really be influenced by big players? Well, was the LIBOR
rate accurately reported by huge banks? Have players ever tried to
corner markets? The answer to all the above, unfortunately, is yes.
There's
an even bigger problem with the legal structure of the futures market:
even the segregated funds on deposit can be pilfered by the broker for
the brokerage's other obligations. That is what happened to MF Global
customers under Mr. Corzine. (I had an account with a predecessor
company called Man Financial – the "MF" in the name. I also had an
account with Refco, which is now defunct. Fortunately, the daggers did
not hit my account, since I was not a holder when the catastrophes
occurred.) My take: the futures market is dangerous, and not a place
for beginners.
One last note: after the Bankruptcy Act of 2005, the regulations
support the brokers, not the investors, when there are questions of
legality about losses in individual investment accounts. Casey Research
will be producing a report with much more detail on this subject in
the near future.
So, what now? We aren't going to see a secret memo – no smoking gun to
confirm that what happened on April 13 was an attempt to affect the
market. Still, the evidence is suspicious. When big entities can gain
from putting on big positions, the incentives are big enough for them
to try – LIBOR, Plunge Protection Team, Whale Trade,
etc., all support this view.
The Physical Gold Market
Previously, there was little difference between the physical and paper
markets for gold. Yes, there were premiums and delivery charges, but
everybody regarded the futures market as the base quote. I believe this
is changing; people don't trust the paper market as they used to.
Instead of capitulating to fear of greater losses, the demand for
physical gold has hit new records. The US Mint sold a record 63,500
ounces – a whopping 2 tonnes – of gold on April 17 alone, bringing the
total sales for the month to 147,000 ounces; that's more than the
previous two months combined.
Indian markets, which are more oriented to physical metal, now have a
premium of US$150 over the futures price in Chicago. Demand at coin
dealers has increased as the price has dropped. And premiums are much
bigger than they were as recently as a week ago.
Here is
a vendor page
that quotes purchase prices and calculates the premiums on an ongoing
basis. It shows premiums of 50% and more in many cases. On eBay, prices
for one-ounce silver coins are $33 to $35, where the futures price is
quoted as $23. A look on Friday April 19 shows
one vendor out of stock on most items:
| Buy - Sell On Silver Bullion |
| 2013 Sealed Mint Boxes Of 1 Oz. Silver American Eagles - Brand New Coins |
500 Coin Min.
(1 Sealed Box)
|
Buy @
Spot + $1.80
|
Sold Out
|
| 2013 Sealed Mint Boxes Of 1 Oz. Silver American Eagles "San Francisco Mint" Brand New Coins |
500 Coin Min.
(1 Sealed Box)
|
Buy @
Spot + $2.00
|
Sold Out
|
| 90% Silver Coin Bags (Our Choice Dimes Or Quarters) $1,000 Face Value Figured at 715 Ozs Per $1,000 Face |
$1,000 Face
Value Min.
|
We Buy @
Spot + $1.70
Per Oz (Spot
+ $1.70 X 715)
|
Spot + $4.99 Per Oz
(Spot + $4.99 X 715)
|
| 90% Silver Coin Bags 50¢ Half Dollars $1,000 Face Value We Ship in 2 $500 Face Bags |
$1,000 Face
Value Min.
|
We Buy @
Spot + $1.90
Per Oz (Spot
+ $1.90 X 715)
|
Sold Out
|
| 90% Silver Coin Bags Walking Liberty Half Dollars $1,000 Face Value We Ship in 2 $500 Face Bags |
$1,000 Face
Value Min.
|
We Buy @
Spot + $2.10 Per Oz (Spot
+ $2.10 X 715)
|
Sold Out
|
| Amark 1 Oz. Silver Rounds ( Made By Sunshine ) Pure .999 BU |
500 Coin Min.
|
Buy @
Spot -15c
|
Sold Out
|
Clearly, the physical gold market today is sending different signals than the paper market.
The Case for Gold Is Still with Us
The long-term fundamental reasons to hold gold are undeniably still
with us. The central banks of the world are acting in concert in
"currency wars" or "the race to debase." As they print more money, the
purchasing power of each unit declines. They are caught between the
rock of having to keep interest rates low to support their governments'
huge deficits and the hard place of the long-term effect of diluting
their currency. If rates rise, even First World governments will be
forced to pay higher interest fees, leading to loss of confidence in
their ability to pay back their debt, which will bring on a sovereign
debt crisis like what we have seen in the PIIGS or Argentina recently.
The following chart shows the rapid growth in the balance sheets as a
ratio to GDP for the three largest central banks. I've extrapolated the
expected growth into the future based on the rate at which they
propose to buy up assets. One could argue about how long these growth
rates will continue, but the incentives are all there for all central
banks to bail out their governments and their commercial banks. I fully
expect the printing game to continue to provide the fuel for
hard-asset investments like gold and silver to increase in price in the
years to come.
Buying Opportunity or Time to Flee?
So what does it all mean? The paper price of gold crashed to $1,325 in
the wake of this huge trade. It is now hovering around $1,400. My first
reaction is to suggest that this is only an aberration, and that the
fundamentals of the depreciating value of paper currencies will
eventually take the price of gold much higher, making it a buying
opportunity. But what I can't predict is whether big players might again
deliver short-term downturns to the market. The momentum in the
futures market can make swings surprisingly larger than the
fundamentals of currency valuation would suggest.
Traders will be looking for a significant turnaround to the upside in
price before entering long positions. However, a long-term,
fundamentals-based trader has to look at the low price as a buying
opportunity. I can't prove it, but I think the fundamentals will drive
the long-term market more than these short-term events. The fight
between pricing from the physical market for bullion and that from the
"paper market" of futures is showing signs of discrimination and
disagreement, as the physical market is booming, while prices set by
futures are seemingly pressured to go nowhere.
In short, I think this is a strong buying opportunity.
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