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I
know I have been on a one-track mission recently about the extraordinary development
of the COMEX gold commercials miscalculating in establishing their giant
short position. I know I have been virtually alone in depicting the resultant
commercial short covering as being the prime price driver behind gold’s
$300 run from $1600 in early August. But government data still suggest that
the unprecedented commercial blunder is very much at the core for explaining
the volatile price action we are witnessing. Today, I would like to explore
what this means for the future, even though I am on record as warning that
the correct explanation for something that has occurred can be different from
accurately predicting what may happen next.
Restating
what I feel is the obvious; the dramatic gold rally was caused by aggressive
buying by the group of speculative traders which are classified as
commercials by the CFTC. Many make the mistake of assuming that just because
these traders are classified as commercials that means their trading is
purely for legitimate hedging purposes. Nothing could be further from the
truth, as the bulk of their trading is speculative in nature. Therefore,
while it would be technically correct to say that the gold rally has been
caused by speculative buying, most would assume that meant new buying of long
positions by easily-identified speculators such as hedge funds and momentum
traders. That is definitely not what has transpired in gold recently, as the
“normal” hedge fund and technical fund speculators have been
selling COMEX gold contracts, not buying them. Instead, the big COMEX gold
speculative buyers have been the commercials who were previously heavily
short. Correctly identifying the true speculators driving a market is a
distinction that makes all the difference in the world. That so few see it is
amazing to me.
There
is little doubt that the commercial gold shorts have taken a horrific beating
in buying back their short contracts. My guess is that the collective loss on
the covered gold contracts so far is on the order of $1.5 billion. Such a
loss, even when spread among the roughly 40 traders classified as COMEX
commercial gold shorts, amounts to a hefty per entity average loss of $37.5
million each. And I’m speaking of closed out losses only; there is
still a large number of open gold shorts that the commercials are holding
whose resolution remains to be seen. Those “open” losses run to
an additional $8 billion at current gold prices. It is imperative to
recognize the unprecedented magnitude of these closed out and open gold
losses. It’s not enough to say that these commercials lost big-time;
having never lost before on such a scale, the turnabout for these commercials
must be shocking to them. As such, I’d like to explore what this may
portend in the future.
The
commercial COMEX gold shorts are banks and trading companies, not
individuals. Every commercial trading corporation maintains some financial
controls and is overseen by corporate treasurers and financial risk officers.
The amount of loss generated in this recent gold short debacle dwarfs the
gains recorded in prior years. (Same as with silver earlier in the year).
Because of the suddenness and extent of the commercial gold short losses, it
is not plausible that the corporate risk controls have not kicked in. For
sure, the chief financial officers and corporate risk officials have
restricted the traders responsible for the gold losses. Unlimited margin
money is not being extended; quite the contrary – traders are
undoubtedly being ordered to reduce risk and close out positions. Anything
else would be irresponsible.
If
my analysis as to what has just transpired in gold is close to the mark, what
does this portend in the future for gold and, especially, for silver? The one
result that looks almost certain to me is a severe loss of liquidity or true
market depth. In fact, it looks like the death of true liquidity for COMEX
gold and silver, the signs of which are increasingly evident. I can assure
you that I am very much aware of the recent high volume statistics recorded
on the COMEX and despite what may appear to be high volume and great
liquidity; the real level of actual market depth may be near death. Please
allow me to explain.
The
big reporting COMEX commercials’ modus operandi has always been to
serve as counterparties to almost all other market participants, particularly
the technical funds which buy and sell based upon price signals. In this
role, the commercials served as market makers, providing liquidity to the
market. The tech funds buy and the commercials sell to them and vice versa.
This is the rhythm of the market that I try to analyze in the COT reports.
Since commodity markets are supposed to be open auction type operations and
not a market dominated by specialists, I always thought this market making
function of the commercials was bogus. It is also no secret that I have found
the uniform dealings of the commercials to be collusive and manipulative. My
personal feelings aside, there is no question that the big commercials have
functioned as market makers on the COMEX.
Therein
lies the problem for liquidity; the dominant commercial market makers on the
COMEX just got creamed in the gold price rally and are sharply restricting
their activities. This is what is behind the great price volatility in gold.
The former big sellers of last resort are sellers no more. Concurrent with
the withdrawal of the coordinated selling of the commercials is the rise of
computerized High Frequency Trading. The mindless HFT activity does wildly
increase daily trading volume, but the nature of this super-charged day
trading only adds to price volatility while providing no true depth to the
market. Legitimate hedging, the economic justification behind futures
trading, is ill-served by HFT. In other words, there has been an immense
increase in mindless second -to-second trading which adds little real benefit
to prospective hedgers and a sharp drop off in the actual market making on
which hedgers depend. This is the very worst of both worlds. And this
development was made possible due to the activities of the CME Group, owner
of the COMEX, which is hell-bent on expanding HFT. Thanks a lot, guys.
Just
like commercial short covering was the prime driver of the gold price rally,
it is also behind the increase in volatility. As these commercials withdrew
from the market, not only did it drive gold prices higher, it also created a
void in true liquidity. If the commercials don’t sell on higher prices,
who will? Someone must take their place, as there must be a seller for every
buyer, but it is increasingly obvious that the sellers replacing the
commercials have not sold with the same force and power that the commercials
formerly sold. To date, the noted sellers have been the technical funds and
other long speculators who have cashed in on enormous profits. As a result,
the gold price is subject to sudden spurts in price both up and down, as I
have suggested previously.
On
the one hand, the lack of additional commercial shorting has provided a lift
to gold prices. On the other, the lack of technical fund buying allows for
sharp downdrafts in the price as well. The withdrawal of the commercials and
the cessation of buying for now by the technical funds (as we’re so
much above all technical fund buy signals) have created a market devoid of
real liquidity. Hence, we get great price swings on not much real overnight
buying and selling. Yes, we get high volumes from HFT, but that’s
garbage volume to everyone except the HFT web-bots themselves and the greedy
pigs at the CME who collect on every contract traded, garbage or otherwise.
What
does this all mean to regular investors? It means get used to the volatility,
because it isn’t going away. Surprisingly, I think it means a lot more
to silver investors than it does to gold investors, even though I have been
talking more about gold than I have silver. There’s a reason for that.
What I’ve described is a process that has already occurred in gold and
to a much greater extent than in silver. There may be more commercial short
covering to come in gold and if there is, that will exert continued upward
price pressure. But the process is fairly well advanced and having already
launched the gold price upward, it’s hard for me to predict what
happens next, other than almost nothing would surprise me price-wise for
gold. I see something very different for silver.
I
believe we have also lost true liquidity in silver, as we have in gold. This
can be seen in the volatility of the silver price, same as in gold. Back in
April, the commercials panicked in silver and bought back shorts, causing
prices to explode into the end of that month. Then, a giant manipulative
takedown occurred, starting May 1. Recently, the commercial shorts in silver
haven’t panicked as they have in gold. In fact, JPMorgan, who I believe
to be the largest COMEX silver short, added to short positions in the last
COT, as I reported on Saturday. Considering what has occurred in gold, I
believe it is only a matter of time before the big commercial shorts also
panic in silver. But the panic in silver will be much more profound than it
has been in gold.
The
prime driver in the gold rally was commercial short covering on the COMEX. In
silver, if the commercial shorts panic, it will trip off other powerful
forces as well. That’s due to the basic difference between gold and
silver, namely, that silver is an industrial material in addition to being a
precious metal investment. Gold and silver can go sky-high in price, due to
commercial short covering or investment buying. But since gold in not an
industrial material, it is most unlikely that it could experience a shortage
or a rush to buy by industrial users. How can industrial users panic if there
are no gold industrial users?
In
silver, there are great numbers of industrial users throughout the world, who
are like a vast herd of wildebeests grazing on an African plain. The
wildebeests will panic at the first scent of lions. The scent that will cause
the silver industrial users to panic will be sharply higher price along with
delays in receiving silver deliveries. A commercial short covering on the
COMEX will certainly increase prices, just as it has in gold and previously
in silver. But given the consistently tight signals emanating from the
wholesale physical silver market, it will take little to set off a scramble
for physical material which will cause delays to industrial users. As the
first few silver industrial users panic and buy physical inventory to insure
continued production, this will further tighten supply lines and exacerbate
delays in deliveries, thereby inflaming additional user buying. It’s impossible
to say when such a process will start in silver, but we surely are closer to
that than ever before. This is more a case of inevitability than it is of
timing. It will come when it is least expected, but it will come.
It
is lamentable that real liquidity seems to be dying on the COMEX, but that is
of secondary importance to long term silver investors. Of more importance is
that the death of liquidity will likely also signal the death of the ongoing
silver manipulation. That’s because liquidity and manipulation are
rooted in the big commercial shorts on the COMEX. If there is one thing that
could put the price of silver to the stars, it would be the end of the silver
manipulation. The message from gold is that the commercials are capable of
miscalculating on a massive scale, causing prices and volatility to soar. The
message from silver will be not just that, but also that the inevitable
physical shortage will cause prices and volatility to soar far higher than
any of us can comprehend.
(This article was sent to subscribers on August 31. For subscription
information please go to www.butlerresearch.com)
Theodore Butler
Butlerresearch.com
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Theodore Butler is an independent Silver Analyst who has been
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