-- Posted Monday, 4 August 2008 | com

by Howard S. Katz

8-4-08

          We are now in a period of great opportunity for gold and the other commodities markets.  And perhaps the best way to approach this is via John Maynard Keynes’ statement that the markets are moved by fear and greed.  That is, Keynes was saying that the markets were irrational and moved by emotions.

          Now human beings do have emotions, but these emotions do not hinder us from getting our jobs done in the real world.  The crops are harvested; the buses run; and the widgets come off the assembly line.  It is true that all the people doing these things have emotions, but still the jobs get done.  For example, the bus driver loves his wife; but still he shows up for work and puts in his good 8 hours.  Indeed, his emotion of love for his wife is motivating him to show up for work and earn his paycheck; it is not preventing it.

          Then why should the fact that human beings have emotions prevent the financial markets from doing their job of correctly evaluating goods (as Keynes claimed)?  Let us take a simple example.  Anyone who follows the cyclical stocks knows that they top out and sport low P:E ratios as the stock market approaches a top.  Isn’t this peculiar?  If stock market tops are caused by irrational greed, then why aren’t speculators just as irrational in the cyclicals as in most other stocks?

          The answer is that in this, as in most things, Keynes was wrong.  Markets are moved by government interference with the values of goods.  The financial markets, whose job it is to recognize those values, then move to respond to chances in government policy.  Take a simple example.  Interest rates in 1981 were 15% on the long bond.  They are now less than 5%.  It was the easing of Volcker and Greenspan which put long rates down.  Since stock earnings yields are competitive with (real) bond yields, this caused stock prices to move explosively higher.  It was not greed which did this; it was government.  At the same time, the easy credit policy made it easy for commodity producers to expand production.  They over-produced, and from 1980 to 1999 commodity prices fell both in nominal and in real terms.

          In fact, Keynes himself was instrumental in taking the world off of the gold standard and giving the various central banks the power to ease credit far more aggressively than before.  This world easing has caused the massive rise in prices since the days of Keynes, and it has caused the wild swings in bonds, stocks and commodities which are common in our age (but were unknown in the day of Keynes).  So it is much more accurate to say that cycles in the markets are caused by government (based on a rationale by Keynes) and not by fear and greed.

          Speculators in the gold market can take comfort in this.  We look back at the double bottom in gold in 1999 and 2001, and we know that this was a period of intense under-valuation, under-valuation caused by Alan Greenspan.  This under-valuation was real.  It was not caused by emotion.  Indeed, the valuation of the CRB index in 1999 was half of what it was in 1971.  And history tells us that ’71 was a period of under-valuation so extreme that to correct it the CRB had to triple.  So now that we have double the under-valuation a good case can be made for a sextuple in the CRB from its turn of the century low.  (183 x 6 = 1098)

          But there is a small place for emotions in the markets.  If one studies the Commitment of Traders Reports, one finds that it is the large traders who are moving the markets.  It is not the commercials or the small traders.  The commodity runs up, and, lo and behold, there was a large increase in the net large trader position during that period.  On the other hand, during that same run-up the commercials were selling.  It is as though the large traders got an idea in their minds and moved aggressively to act on that idea.  While the commercials were just thinking, “Hey, it’s a little high.  I’d better sell.”

          It must also be kept in mind that the large traders are basically the commodity funds.  Remember, a person who puts his money in a fund is saying, “Let the expert do it for me.  I don’t want to think for myself.”  Then the “expert” says, “If I buy according to the conventional wisdom and prove wrong, they won’t fire me.  But if I violate the conventional wisdom and prove wrong, I go to the chopping block.”  With both the customer and the “expert” trying to avoid thinking for themselves, there is ample room for emotion.  Let us look at the large trader short position in the U.S. dollar since last summer.

          Above we have 7 turning points in the large trader short position, and labeled are the corresponding turning points in the U.S. dollar index.  (For this purpose, since the COT positions are reported as of Tuesday close, I chart the dollar index weekly on its Tuesday close.)  Note how the large trader shorts are clearly wrong on 6 of them.  The 7^th was the dollar bottom of last Thanksgiving, and evidence points to the fact that an FOMC member leaked Bernanke’s decision to ease (of early Sept. ’07).  With this kind of inside information, the funds piled in short between Sept. 4 and Sept. 18 and managed to make some money

          With this exception, the fund managers look like a bunch of Sad Sacks.  When the dollar peaked on June 12, 2007 at 82.89, the large trader shorts held only 15,000 contracts, and they were down to 10,000 a week later.  Then, as the dollar fell, they scrambled to get aboard.  By July 24, their short position was over 38,000 contracts – just as the dollar hit a bottom at 79.93.  Then came the sub-prime crisis, and the shorts were caught at another dollar peak (Aug. 21) with only 15,000 contracts.  Note the big run-up in shorts from 17,000 on Sept. 4 to 30,000 on Sept. 18.  This is the way a market behaves when there is big news.

          After doing OK in the autumn, the funds got back on the losing side in the winter of ’07-’08.  At the Dec. 24, 2007 dollar peak of 77.56, they were down to a short position of 5,000 contracts – just when they should have been shorting the stuffings out of the dollar if they were half as smart as the papers tell us.  Of course, you remember this past March.  Gold, and many other commodities were making spike tops as the dollar made its low at 71.30.  But the large traders were shorting heavily, right at the bottom.  That must have hurt.

          On June 10, 2008, the dollar index hit a high of 74.16, and a week later large trader shorts got down to 7,000 contracts.  This 5,000 to 15,000 range has been a good sign of a dollar top.  And this latest week the shorts are down to 10,000 again.

          Where is the buying going to come from in the U.S. dollar?  It does not look like it will come from the large trader longs.  They recently hit their highest position (25,000 contracts) in over 2 years.  They are a group of timid souls and trust big daddy Bernanke (when he says he wants a strong dollar).  Barring some very dramatic news item these people are not going to act in a forceful manner.  What about the commercials?  Well, the commercials are always passive.  If a price is cheap, they may build inventory.  If a price runs up, then may back off and consume inventory.  They do not make moves.  They react to them.

          The only people who are likely to move the U.S. dollar are the large trader shorts.  (The small traders are too diverse and act at cross purposes to each other.)  And as the above chart shows, the large traders can’t hardly cover much more than they already have.  The only thing they can do is to come in and short some more.  And when they do this, the dollar will go down (probably to new lows) and gold and the other commodities will go up.

          If you remember the sub-prime crisis of last August, it was very painful to live through, but what a buying opportunity was there my fellow gold bug.  The exact same action which puts you through H___ as you follow it day-by-day looks entirely different when you look back on it from a distance on the weekly chart.

          This is one of the things I try to do at the One-handed Economist, to help you keep your emotions in check and give you that long term outlook which allows you to apply reason to the problem of figuring out the market.  I also discuss specific stocks.  And a special bulletin was put out on July 31 after some very revealing action on the 30^th.