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The hedge fund industry has exploded in the past few decades. In 1990, hedge fund assets totaled $39 billion. Today, the number is over $2.5 trillion. Obviously the growth of hedge funds has outpaced the growth of opportunistic asset classes. The managed-futures market has exploded to a $337 billion industry. In addition, pension funds and other endowments have increasingly looked to alternative investments to boost returns and diversify risk.

The question is: are these alternative-investment markets deep enough and liquid enough to absorb this tidal wave of liquidity?

The short answer is, absolutely not. It is just a question of how soon a dislocation occurs due to overwhelming investment demand, and to what extent.

The symptoms of too much money chasing the same idea can show up in nearly any market although the currency market, U.S. government bond market, and some other financial markets are sufficiently deep to allow for large-scale positioning by hedge funds. Other markets like commodity futures and small-cap and mid-cap stocks are being distorted at times by the amount of investment. The idea is backfiring:

In the Russell 3000 index, the 100 most heavily shorted stocks are up by an average of 33.8% through August 16, versus 18.3% for all stocks in the index, according to a Journal analysis of data provided by S&P Capital IQ. Wall Street Journal, August 20, 2013

These stock short positions have badly burned fund managers. While a correct call on a short can have a huge payday, the size of the short position is a key risk in such a trade. Keep in mind that a hedge fund manager earns next to nothing unless they are profitable, so losing trades have to be capped, forcing the manager to make the difficult position of buying back a short position that they may feel strongly about.

Commodity futures pose a different set of risks than stocks. While gold (NYSEARCA:GLD) (NYSEARCA:PHYS) (NYSEARCA:IAU) may conjure an image of a giant, multi-trillion dollar market, the reality is that there is not nearly that much gold for sale at any one time. It can be volatile for the same reason as stocks: not many of the outstanding shares are offered within range of the current price.

It is clear that Asia is accumulating gold, and the trend has only accelerated. According to this Financial Times article from August 19, 2013:

UK gold exports to Switzerland, the hub of the gold refining industry, leapt to 798 tonnes in the first six months of the year, up from just 83 tonnes in the first half of 2012, according to data from Eurostat, the European Union's statistics office.

Swiss gold refiners are melting down 400 ounce bars into smaller denominations for Asian consumption. While this redistribution of gold from West to East does not directly impact the futures market, paper bets on gold are becoming more and more leveraged to the available supply.

Physical gold leaving for Asia, which we can consider "sticky" demand because the demand is rising from such a low base - China opened the gold market to its citizens only a decade ago. The West is forced to make more and more bets on less and less underlying gold. This is where I believe many fund managers underestimating the risk of being short such a tight market.

The silver (NYSEARCA:SLV) (NYSEARCA:PSLV) market is even that much more precarious to be short due to its much smaller market capitalization. Recently, fund managers amassed a net short position in silver while simultaneously pushing gold shorts to a several-year high. But the entire silver market supply is roughly a billion ounces, which is a mere $20 billion, or less than some individual hedge funds. Nearly half of supply goes to industrial applications such as electronics and solar panels, and then subtract jewelry demand and photography demand. It quickly becomes clear how easily investment demand can overwhelm such a comparatively tiny market.

To be heavily short silver at a time when record short bets are being placed by other fund managers is very scary. It would be hard to overstate how easy it would be for a squeeze to develop.

When I am trading gold and silver, I am cautious to not be betting on the same side as the herd when the herd reaches extremes, as a starting point.

In late 2012, at the same time that Wall St. was predicting $36 silver in 2013, hedge funds were too heavily invested in silver for my comfort level, which you can see in the following chart from Barchart.com:


(Click to enlarge)

Now that the price has fallen despite precipitously in 2013 despite Wall Street's year-end 2012 bullish forecasts, Wall Street is now mostly bearish on precious metals- a near complete reversal in sentiment.

By April, those longs had been flushed out of the market (follow the blue line). The short positions are now at extreme levels and offer an excellent buying opportunity. I encourage you to keep an eye on the stampede of funds into trades you are considering whether it is a stock, metal, grain, or anything else where the dynamics could turn to a squeeze.

It is difficult for total hedge fund industry investment in gold to approach zero because there are always funds that commit a percent of capital to gold for diversification purposes, such as hedge fund giants Ray Dalio, David Einhorn, and John Paulson. For net gold investment to approach zero would require huge short positions by other funds. This is essentially the current state of the gold market, from Barchart.com:


(Click to enlarge)

Just one year ago, as analysts were bullish on precious metals, hedge funds were long over 100,000 gold futures with the Large Speculator category long 157,781 gold futures. During the year, holdings were continuously pared and the Producer category was the primary buyer. Now, hedge funds have a miniscule position considering that some funds always retain some exposure to gold for diversification purposes. For more perspective, here is a ten year view of gold from Barchart.com:


(Click to enlarge)

The key point: each time the blue line, representing the Managed Money category, approaches zero has signaled a buying opportunity. Also obvious from the chart is that Producers have accumulated gold all year and now actually hold a net long position which is unprecedented dating back to the start of the data series in 2006.

Giant footprints of hedge funds are showing up in many of the futures markets, and distorting the prices. The structure of commodity futures markets allows for naked selling as long as there are sufficient funds. As the assets of these funds continue to swell, and many of the fund managers pursue similar strategies, it seems to be merely a matter of time before there is a severe dislocation due to a shortage of underlying commodity. Here is a look at copper (NYSEARCA:JJC), for comparison, on Barchart.com:


(Click to enlarge)

Funds accumulated copper during 2009 and 2010, with the peak of investment occurring in December 2010- right near the ultimate top. Funds cut exposure as copper fell and investment then bottomed in November 2011, near the low for that year. More recently, in June 2013, hedge funds amassed the largest short position since the data series began, and that month marked the low for 2013. Despite all of the forecasts for lower copper prices and a surplus next year, copper has trended higher since June.

Conclusion:

Hedge fund compensation leads many fund managers down a trend following path. Positioning for long-term moves can take many months or even years to reap rewards and a fund manager that is not immediately profitable may not be around in a few years to benefit.

Therefore, hedge funds are more likely to apply a trend-following strategy, and in some occasions, they are overwhelming markets that they are treading into. While many analysts look around and cannot find a bubble, this mismatch is a good starting point.

Eventually, the shorts have to cover; but from where? When gold begins trending up, technical traders will pour into leveraged ETFs, gold ETF see net inflows, and gold futures will see net accumulation. Where will that physical metal come from in a world where Asian demand is already sucking up all of the annually mined supply?

Meanwhile, more and more futures contracts are balancing on limited inventories at the COMEX warehouse that currently holds only 7.55 million ounces of gold- leaving over 60 paper claims to each ounce of available gold.

This is an accident waiting to happen. There has not been a dislocation yet in the gold or silver futures markets due to lack of available supply. Many conclude that it cannot happen because it has not happened. The situation reminds me of LTCM and years later the nationwide housing downturn and the warning from Nassim Taleb to Morgan Stanley's risk mangers: "Your models don't work." For more on this subject I highly recommend Nassim Taleb's excellent book, Fooled By Randomness.

Whether or not you believe that a shortage of metal against trillions in paper wealth can occur is irrelevant to the immediate opportunity: gold and silver have been a buy when net fund investment has hit this critical low level.

Source: Hedge Funds Are Handing You Gold On A Silver Platter