The Battle for Money
By James J Puplava CFP, September 15, 2003
Today there is a battle going on in the futures pit. This isn't a battle over the major indexes or the price of stocks. It is a battle that will determine the future price of silver and the price of gold. Like so many commodities, the price of silver has languished over the last two decades mired in a bear market. While financial assets such as stocks and bonds have risen over a multi-decade period, the price of most commodities from oil to gold have fallen. That is... until recently.
Since 2001 commodity prices have begun to climb and very few investors are paying attention. Financial assets are up this year for the first time in three years, so investors once again are chasing paper assets bidding their prices back up into bubble territory. While investors focus on the run up this year in paper assets, they are ignoring the more important trend in the rise of hard assets. The global financial markets are transitioning from a period of dominance of paper assets to one dominated by hard assets.
The financial press is totally absorbed by the gains in paper assets this year such as the NASDAQ. The high flying tech index is in the midst of a mini-bubble and very few investors are heeding the warning. There is not a day that goes by where more evidence surfaces that the financial markets are back in dangerous territory. All of the evidence that the markets are behaving in bubble-like fashion are being ignored. Investors will have none of it. They insist that they have learned their lesson this time. This suggests to me that at the first sign of trouble, they will bolt and head for the exit gates. Margin debt is rising, mutual fund inflows are increasing each month and day traders and individual investors have retuned to the markets.
As I have written in recent Storm Updates, it appears that all is going well for the economy and the financial markets. Yet, underneath this apparent new-found prosperity, there is a lingering doubt that something is wrong. If this is a recovery, there is no sign of it in the job market. If the economy is recovering, CEOs are reluctant to invest in it. If indeed we are in prosperous times, it isn't reflected in business and consumer confidence. Investors are the only ones showing confidence by their willingness to plunge headfirst into high priced stocks. This morning's Wall Street Journal featured a story about some of this year's high tech flyers, which appear to be floating on "thin air." While it appears that once reluctant and hesitant investors have become born again, raging bull contrarians should view that as a caution flag. Insiders or anyone else at the top of the company ladder who know more about their companies' future prospects are bailing out and dumping their shares. There is a definite contrast between giddy investors who have developed an insatiable appetite for buying stocks and company insiders who have developed an equal propensity for selling those very same shares. Technicians refer to this as "distribution," a transfer of the ownership of shares from strong hands to weak hands.
While optimism in the financial markets and in the U.S. economy has returned, there is a financial barometer that everyone is ignoring to their own detriment. This financial barometer is flashing warning signs that a major storm may be approaching. The general public may be familiar with the possible dangers posed by the approaching hurricane Isabel to the East coast. They remain totally oblivious to the approaching storm coming to the financial markets and the global economy, especially the U.S. The barometer that is issuing a warning of this approaching storm is the rise in gold and now silver. Since it reached its lows at nearly $250 a ounce in early April 2001, gold has been relentless in its rise. Gold has risen three consecutive years along with gold and silver equities.
The Rise in Gold Signals Storms Ahead
The rise in prices over the last three years is sufficient in size and duration to signal that the long-bear market in gold that lasted for two decades is now over. A few have noticed its gains, but few have understood what it signifies. To most the rise in gold was simply a defensive reaction to the fall in equities over the previous three years. Very few believe that gold's rise has any long-term significance. Misunderstood are gold's importance as a barometer of monetary conditions and its historical role as a monetary asset. When gold rises relentlessly as is has in the last three years, it is signaling approaching monetary storms. In this regard gold's rise stands in sharp contrast to the general bullishness over economic prospects and a further continuance of rising equity prices. Only one of these trends can be true; either the bull market in paper is real or the rise in gold is temporary. Or maybe it is the other way around; the rise in gold is real and the rise in equity prices is temporary.
I believe that the latter reflects the true importance of gold's rise. You can not have a run away monetary policy as we now have in the U.S. under the Greenspan Fed without consequences. That consequence is going to be a fall in the value of the dollar and a concomitant rise in interest rates. We have gotten a taste of both recently, but nothing in comparison to what is coming. The graphs below of M-3 show a major jump over the last few years.
While the supply of money and credit has expanded, the velocity of money has fallen. This indicates that monetary policy is becoming less effective in achieving its desired goal. It may be the main reason why Fed officials sound less upbeat these days. They are running out of traditional monetary tools and may soon have to resort to extraordinary means, if they desire to keep the U.S. economy and financial markets out recession and decline.
Yet, the rise in gold and now silver is calling that policy into question. Gold and silver act as a check on monetary policy. The precious metal is the nemesis to all central banker machinations. No one is more aware of this than Mr. Greenspan himself who was a one-time believer in the precious metal. Having written about the subject in a major paper back in 1966, the maestro expressed the problem that gold poses to the machinations of central bankers and government policy makers hoping to get something for nothing by printing and expanding credit.
"In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves."
The rise in gold therefore may be signaling problems for the bubble economy and financial markets. It may also indicate that Fed policy has been far too inflationary. Gold's rise acts as a check on expansionary monetary policy. Its current rise can not be welcomed by the central planners at the Fed and in Washington. In the past, with the strong dollar policy of the Rubin Treasury under Clinton, the rise in the supply of money and credit were never checked by gold's rise because direct policy actions by the government and other central bankers kept gold from rising. Beginning in 1994 central banks and governments initiated a policy of suppressing gold through actual gold sales and lending additional gold to short sellers at favorable rates. The amount of gold leasing is estimated to far have exceeded actual direct sales by central banks. This policy of keeping gold prices in check allowed central bankers to inflate the financial system without any adverse consequences. By keeping gold suppressed, central bankers were able to inflate the financial system and keep gold from acting and as a financial barometer warning the markets of impending problems. This contributed to the excesses of the 90's stock market mania. The consequences were that when troubles began, investors had very little warning. With a limitation put on gold sales in September of 1999, it has been more difficult to keep the price of gold suppressed. When Mr. Greenspan began to put his foot to the monetary pedal in 2001, the gold barometer began to rise. It has kept on rising ever sense.
Since the vaults of central banks are now half empty of gold, central bankers are having a harder problem in keeping the price of gold suppressed. The main way prices are capped these days is through paper gold and silver, otherwise known as derivative contracts. This is nowhere more obvious than what is going on with the COMEX in silver. Recently the price of silver has broken out of its long-term downtrend and consolidation pattern as reflected in the chart of silver above. While the price of gold has risen for three consecutive years, until recently the price of silver has failed to confirm gold's move. That is until recently when the price of silver has broken above its top line resistance channel at $5. For well over a decade now, shorting silver has been a one-way trade. Silver has been kept within a narrow channel of $4-$5 an ounce. Despite the fact that silver supply has not been able to keep up with demand for 14 years now, the price of silver has languished. Silver markets have been in deficits for 14 years. That deficit shows no sign of improving soon. No amount of price increase will be able to increase the supply in the short-term, outside existing owners of silver bringing their coins, silverware and jewelry to market an event that is unlikely unless prices explode to the upside. The simple fact that silver is a by-product of other mining limits its supply. Gold, copper, lead, and zinc supplies will have to increase before the supply of silver increases. At the moment there is no visible sign of that happening outside a major breakout in base metal prices.
Given the fact that silver is in short supply and is a monetary metal, it is surprising that its price has been kept so low. You will find this oddity in no other commodity except the price of gold during the mid-90's when central banks were dumping the precious metal. The fact that the financial markets and investors can so readily accept this oddity is surprising. In an era when speculative capital dominates the global financial markets looking to arbitrage and exploit discrepancies, this is one discrepancy that has gone largely unnoticed. The silver/gold imbalance and the gold/Dow imbalance is one of the best opportunities in the financial markets, especially when you consider the vulnerable position of the silver markets.
The recent breakout in silver prices has brought into play large short positions by commercial players on the COMEX. Like clockwork the commercials have gone short as the price of silver has risen. This is a game they are accustomed to playing and winning. For the last decade they have played this game and won. However, things aren't going as planned for the commercial short players. Despite the largest short position in silver in over a decade, the price of silver has not fallen, but in fact has risen and broken out of its long-term trend channel.
The Short Sellers Achilles Heel
The silver market has awoken out of its decade-long slumber much to the consternation of the short sellers who now remain extremely vulnerable to a short squeeze, if the trading funds and the small trader ever awaken to their own strategic advantage. The simple fact remains that the commercial shorts don't have the silver to back up their short position. I'll say that again. They don't have the silver to back up their short positions. The short position is so huge now that all it would take to initiate a squeeze is for small traders to begin demanding delivery or for the trading funds to stand for delivery. Things have become so desperate for the commercials, it became necessary for the commercials to take out more short contracts last week and bring their short positions to a decade-long record. Last week alone, commercials went short a net 8,235 contracts, equal to 41,175,000 ounces of silver. The amount of registered silver in the COMEX warehouse is only 43,732,784 ounces of silver. In other words, in one week alone the commercial short sellers have gone short almost the entire amount of silver ready for delivery on the COMEX.
It gets worse and more intriguing when you consider that their entire net short position is 81,755 contracts representing 408,775,000 ounces short. That is almost 10 times the amount of silver that is registered and available for delivery. It is also close to 4 times the entire amount of silver held as inventory on the COMEX. At a time when the officials of exchanges are coming under close public scrutiny for their actions and behavior, one can only wonder if the officials that run the COMEX are asleep or in bed with the short sellers. What is known is that the short sellers represent big financial interests and not commodity producers. This makes their position that much more perilous. Unlike a farmer who is a producer of a commodity, a financial firm can only honor their contract by having possession of the metal. What we have here is a very speculative position that can only end in default if the holders of long possessions press their demand or take delivery. The real value or price of a derivative is that it in a real sense is not an option on the right to buy or sell something. In reality, it represents the right to default in a forward. This is exactly the position of the commercial short sellers today.
Plain and simple, the commercial shorts don't have the silver to back up their short position. All they can do to keep from defaulting is to increase their paper short position in the hopes they can drive the price down low enough to cover their short position. It has become a game of nerves. The commercials are hoping the technical trading funds will retreat "along with the little guy" so that they may get out of their desperate situation. They have played this game numerous times before and always walked away as winners. The game is working out much differently this time. Perhaps the technical trading firms and the little guy see that the financial beast as been wounded and smell blood. At least for the moment they are standing up to the commercials who have always won this game. Maybe it is revenge for all of the money the commercials have taken away from the fund traders and small specs. Or perhaps it is the sense that a new trend has begun a transition from a bull market in paper to a bull market in hard assets.
As a reader and observer of military history, it is fascinating to observe the apparent weakness and vulnerability of the commercial short sellers. Battles are sometimes won by an unexpected event, a sudden change in tactics or the loss of morale and spirit of one of the armed combatants. Perhaps that is what the commercial short seller is waiting for. It has been a tactic that has always been used in the past to win the short seller game. Eventually, the other side's resolve is weakened and the longs abandon the battle. What the longs may not realize and what is becoming the commercial's worst fear is that if the longs awaken to the fact that the battle is theirs for the taking. All it would take to end this battle with overwhelming force is if longs switch their position to the nearest month contract and start taking delivery. The battle would be over instantly. In military terms, the commercials don't have the troop strength to back up their bluff. In this case, it means they don't have the silver to cover their short position. Not unless they have discovered a secret unknown hoard of silver such as the Lost Dutchman's mine, they simply can’tcover their position. They are relying on what they have always relied on which is the ignorance of longs and their inability to exploit their own strength and the weakness of the commercials. Sometimes Goliath looks bigger and stronger than he really is. Goliath was brought down by a stone. In the case of the commercials, all it would take is delivery.
Back at the casino, markets had difficulty today despite better than expected economic news. The East Coast is bracing for the possible arrival of Hurricane Isabel. The hurricane is the strongest storm to surface in years. The storm is aiming directly for the East Coast packing winds of up to 160 miles an hour. Such a storm of this magnitude could wreak havoc and damage to property that would be costly for property insurers. The shares of leading property underwriters fell as investors dumped shares ahead of the storm's arrival.
The major indexes all finished down for the day with minor losses. The next bit of news for the markets to digest is pre-announcements by companies that may not meet their earnings targets for the coming quarter. On the economic front today, industrial production rose an anemic 0.1 percent and a separate report out by the New York Fed showed that manufacturing picked up in the Empire State. But the economic news has already been factored into this perfect market. Either the economic news improves beyond expectations, or the very same with earnings, or else this market will be giving back some of its gains. The markets will focus their attention on tomorrow's meeting of the Federal Reserve. Nobody expects any policy change to emerge from that meeting other than the normal psycho babble that the economy remains strong but is vulnerable to setbacks and that there is no inflation or deflation but they remain vigilant towards the appearance of both.
Volume levels receded on Monday with only 1.13 billion shares exchanging hands on the NYSE and 1.46 billion on the NASDAQ. Declining issues beat out advancing issues by 18-15 on the Big Board and by 17-15 on the NASDAQ as momentum begins to fade from the markets. The VIX was unchanged at 20.25 and the VXN edged up a notch by .25 to close at 32.93.
Chart courtesy: www.stockcharts.com
* FULL DISCLOSURE * The author, James J. Puplava, owns silver and gold bullion & equities for client and personal accounts.
© 2003 James Puplava