The past week saw a resurgence in selling pressure among US stocks, with the panic of last week’s selloffs returning. With the VIX index back comfortably above 40, risk aversion is at a fever pitch. Investors have turned to monetary commodities as a safe haven, bidding up gold seemingly every day for its longest winning streak in years, and increasing prices by almost $150/ounce in the past week. While precious metals have shined even with risk assets getting pummeled in recent weeks, we believe the way forward is becoming rife with risks for all asset classes, including precious metals.The following charts show the CRB Raw Industrial index and the GSCI Total Return index.
(Click charts to enlarge)
From 8/22 Commodity Analyst Newsletter:
As can be seen, the GSCI index appears to be in a full-on bear market, making lower lows and lower highs over the past 4 months. This large drop-off was largely due to the popping of the mini-bubble in oil prices caused by the Middle East unrest earlier this year, an event that we forecast. While fundamentals at the time looked good for commodities in general, crude oil prices had gotten way ahead of themselves, and speculation on higher prices was at an all-time high, never a good thing for a long investor. While this decrease in speculation is actually a good thing for the economy going forward, the CRB Raw Industrial index is also showing weakness, a bad sign for economic fundamentals going forward.
As we stated in last week’s letter, the CRB Raw Industrial index can serve as something of a canary in a coal mine for commodities and the economy in general. In 2008, it peaked a full 2 months before the commodity bubble collapsed in July 2008. As can be seen from today’s chart, the CRB RIND has dropped almost 12% since the highs in April. As the CRB index’s components are not traded across futures exchanges but rather measure prices of commodities traded directly between producers and consumers, the CRB index is a much better gauge of true commodity demand than the GSCI index, and is much less volatile than publicly traded commodities. The fact that the CRB index continues to trend lower is not a good sign for the economy in general, and could signal lower commodity prices across the board, if not an outright recession. We will continue to monitor this index for signs of stabilization, but at this time, the signs are bearish.
At the end of this week, Bernanke will speak at the annual Jackson Hole meeting, the same meeting in which he alluded to the beginning of QE2 one year ago. Judging from the commodity and currency action, investors are largely pricing in, and in fact piling in to investment decisions predicated on a renewed round of quantitative easing. 10-year bond yields touched below 2% for the first time on Thursday, gold is rising parabolically, and the dollar loses value against the euro even on days when Europe looks like it’s in terrible shape. However, trader expectations of quantitative easing may be a bit overblown, and even if they are realized, they may already be priced in to the market.
The most paradoxical of recent commodity action is that industrial commodities are rallying even on days when equities are taking a beating. The overwhelming sentiment on the street is that there is no way to lose with commodities: either the economy improves and industrial demand picks up, or governments around the world continue printing money non-stop and commodities rally as monetary safe havens. The widespread love for commodities as a hedge against the coming slowdown feels very similar to mid-2008, when everyone on earth wanted to buy crude oil, copper, platinum and every other commodity in order to hedge against money-printing. What they soon realized is that when industrial demand falls due to decreased economic activity, no amount of money printing can make people buy them. Such value traps were realized as platinum fell from $2300 to $800, copper fell from $4 to $1.25, and crude oil fell from $140 to $30.
While Bernanke clearly has a quick trigger finger when it comes to Fed policy, we do not believe QE3 will be announced at Friday’s meeting. We know that Bernanke has used equity market prices as justification for policy in the past, and we expect that the recent fall in equities has certainly caught his attention. However, his most recent response, giving a mid-2013 target date to ultra-low interest rates, was met with extremely harsh criticism, and notable dissension within the Fed itself. His ability to embark on a new round of asset purchases just 3 weeks after his last move was so frowned upon is highly limited, and we believe that QE3 will remain on the backburner for some time. In addition, Thursday’s CPI numbers showed that consumer prices continue to spiral upwards, even with commodities undergoing a significant pullback. While it may eventually come to fruition, Bernanke’s lack of political support combined with spiraling inflation will stay his hand for at least a while longer.
However, the most interesting point about QE3 is whether it will even change anything. The following chart shows the CRB RIND over the past 2 years.
from 8/22 Commodity Analyst Newsletter:
As can be seen, the CRB index had already rallied more than 8% off its lows before Bernanke alluded to further quantitative easing at the Jackson Hole meeting on August 27, 2010. What this means is that industrial commodity demand rebounded well before equity markets during the summer 2010 correction. While quantitative easing may have increased business confidence and therefore put a renewed fire underneath industrial commodity prices, raw commodity buyers were already bidding prices up by the time the Fed acted.
When contrasting that situation to today, the CRB RIND continues to make lower lows and lower highs, and is already at its lowest point this year. This means that raw industrial commodity demand continues to slacken. Even during the week after August 8, when the S&P 500 (SPY) rallied impressively, the CRB continued to fall. To us, this indicates that there is more than just a liquidity or confidence issue, there is an actual aggregate demand shortfall, and commodities will not be spared the pain.
The situation seems to be setting up to a very similar outcome as the middle of 2008, when all commodities became a safe haven alternative for equity market and other risk asset investments. However, if demand keeps falling, prices for these commodities could take a huge dive as speculators cut their net long exposure in anticipation of a global recession. While gold could continue to outshine because of its lack of industrial connection, precious metals such as platinum, silver and palladium could lose value as industrial demand for these commodities falls, and traders rotate out of these safe havens.
For these reasons, we are extremely wary of being long commodities such as wheat, corn, platinum group metals, silver, and crude, that have rallied on an implicit expectation of perpetual monetary easing. While we believe monetary policy will remain easy for some time, true aggregate demand is necessary to keep the bull market in commodities alive, and a US recession would not achieve that regardless of the Fed’s activities.
However, until Fed policy becomes more clear, which we hope is a process that begins on Friday, markets will continue to act schizophrenically as they have all summer. For example, Thursday’s beating in the stock market appears to have been motivated by the greater than expected CPI readings. The market was reacting to increased inflation being reflected in goods as a sign that renewed quantitative easing is less likely. As Bernanke’s political justification for QE has been to decrease the likelihood of deflation, the quickening of inflation in July, even with commodity prices having decreased substantially in the last few months, bodes very poorly for the Fed’s deflation-fighting thesis. When viewed in this light, the stock market sell-off makes sense. However, gold rose big on the week, as did the euro against the dollar, as commodity and forex investors continue to price any negative move in the stock market as increased likelihood of QE3, and any positive move in the market as renewed signs of inflation. This lackadaisical attitude toward perpetual dollar devaluation and gold perpetual appreciation is very dangerous, as investors are stacking huge bets on these premises. If their expectations are not realized, prices could move dramatically the other way.
Gold’s recent run has simultaneously surprised us as well as caused us great concern. While we have been a long-time proponent of precious metals as being in a secular bull market, gold’s recent infallibility is not a good sign for its long-term health. In all bull markets, there comes a time when the asset is so coveted that buyers will pay almost any price for it, and the asset takes on a rocket-like trajectory. At this point, it can no longer be bought or sold with any conviction, as the money chasing it can push it up to no end, but the inevitable fall will also be severe. While gold may not be in such a dire situation just yet, it is getting perilously close to such a fate.
The following chart shows the only other bull market gold has experienced, ending in early 1980.
from 8/22 Commodity Analyst Newsletter:
In an eerie similarity to our present market, gold rose roughly in line with the moving averages for much of the early stages of the bull market. However, in late 1979, gold took off from the moving averages, exploding upward by 123% in just 3 months. After the bubble was pierced, gold fell 30% in just 7 days. This is the classic bubble, as those savvy investors got involved in the late 1970s, but then the investing public got wind of it and decided to flood in all at the same time, causing the price of the metal to escalate extremely rapidly. We believe the odds of this large a rise are not great given today’s deeper global market for physical gold and ETFs, but the outcome could be the same. We have always maintained that at some point gold would go absolutely crazy, with buyers bidding it up ever-dizzying heights each day on end, exactly how silver looked in April, and that would most likely mark the end of the gold bull market. We sincerely hope that situation is not what is being played out right now, but we must err to the side of caution.
In viewing gold’s incredible rise, it is helpful to know just who is buying. The following chart shows the Managed Money net long interest in blue and gold’s price in yellow.
from 8/22 Commodity Analyst Newsletter:
As can be seen, while gold Managed Money longs remain near an all-time high, they have actually backed off slightly in the past 2 weeks. This past week, gold Managed Money net longs increased by over 8,000 contracts, or 80,000 ounces, but is still down from the peak of 228k contracts set 2 weeks ago. While it would be convenient if gold futures traders were holding the bulk of the position, it isn’t necessarily bullish that gold is rising while Managed Money net longs are falling. Thinking back to silver, Managed Money net longs hit an all-time high in September 2010, but silver itself did not peak until April 2011. While futures traders scaled back, ETF and physical silver buyers flocked in to the metal en masse, and despite their not being as leveraged as futures traders, silver collapsed magnificently, falling 27% in one week.
Peering into total holdings of gold by ETFs paints a similar picture as to the run-up in silver. The chart below shows total dollar value of gold holdings by ETFs.
from 8/22 Commodity Analyst Newsletter:
Since August 1, ETFs have accumulated more than $23 billion in gold, a staggering amount. In fact, at this point, Managed Money net longs control only about $37 billion of gold in notional value, whereas ETFs hold a combined $135 billion, meaning ETFs are much more influential in the gold market at this point than gold futures traders. At this point, the GLD has a higher market value than the S&P 500 ETF, the SPY, a truly staggering feat. Gold’s status as the premier hedge for every investor on the planet has made it a must-own asset.
The incessant buying of physical and ETF gold is due to the need for investors to find a hedge in the market. While hedge funds were shorting the euro against the Swiss franc as their hedge, driving the euro down 20% from the beginning of the year until the trough on August 9th, the Swiss National Bank’s claim that they could peg the franc to the euro or take other drastic intervention steps caused an exodus out of this trade. Not coincidentally, gold’s rise took an accelerated leg up on the same day, causing gold to rally almost 4% on the day before settling up around 2%. From that date, gold has not fallen below the 1720 level even with an increase in margin requirements because gold has become the hedge of choice for almost every investor on the planet. However, this is an extremely dangerous scenario, as it has become a crowded trade, and could end in tears.
Following the SNB’s verbal intervention with the franc, the franc lost 14% against the euro in a matter of 6 days. For a currency to move that much is a staggering correction and it was caused by hedge funds all rushing to the exits at the same time to take off their hedge. If the trend reverses in gold for some reason, a similar move could easily play itself out, causing gold to fall back to the 50 day moving average, currently at $1615/ounce, 15% lower from here. Nassim Taleb once said that markets tend to hurt the highest number of hedgers, and we believe that scenario will play itself out in the gold market at some point over the next few weeks. Weakness in gold, caused by the disappointment of no renewed quantitative easing or other unexpected event, could cause a mass exodus out of the metal in a short amount of time. Whether it is a good buy for the long-term afterwards depends on how high it goes before correcting now, and how much confidence becomes lost in this latest run-up, but for now, steering clear of gold is a prudent idea.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.