PRATA - Ted Butler's weekly commentary

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WEEKLY COMMENTARY

February 8, 2005


Break On Through To The Other Side

By Theodore Butler



First, a few words about the latest Commitment of Traders Report (COT). In silver, there were no surprises, and the market structure continues to improve. All told, the dealers' net short position has declined (improved) by some 42,000 futures contracts (210 million ounces) since the top in early December. I wish there were another way, but improvement in the market structure entails lower prices and tech fund selling. You'll never get a market bottom with good price action and everyone feeling great.

Gold's market structure also remains positive and has gotten better. Some were disappointed with the small improvement in the latest weekly gold report, considering the large decline in total open interest. What many have overlooked was the automatic and mechanical reduction in open interest as a result of heavy deliveries on the first two days of the Feb COMEX gold contract and the reduction in spread positions.

Also, there were some very obvious reporting errors by the CFTC in the last two gold COT reports, in which they botched categories between large reporting and small non-reporting traders. I made a big deal about this last year and got the CFTC to amend a similar error in silver, but I'm not going to bother this time. Been there and done that. Besides, bottom-line is that it doesn't matter much this time, as it does not alter the fact that almost 12 million ounces of gold (120,000 net futures contracts) have been aggressively sold by the tech funds.

We have hit new lows in gold, exceeding the January lows by several dollars, while silver has held those lows, so far, as more tech funds have been lured into selling. The last remaining significant moving average in gold (the 200-day) is under assault, accompanied by dollar currency strength, that while painful, actually fortifies the market structure in the metals. In addition, it has clearly been technical fund buying of the dollar that is the prime price mover in that market. This reinforces the selling in the metals and becomes a self-fulfilling mechanism.

Once the tech funds have completed their dollar buying and gold and silver selling, a large move the other way, namely, a dollar fall and metals rally is all but certain. In fact, what we are really attempting to measure is just how brain-dead the brain-dead technical funds really are. They always go too far. Two months ago, they were loaded to the gills long gold and silver, and short the dollar. That argued for caution and a change in trend, which we got in spades. Now, most of those long tech fund metal positions have been sold and their dollar shorts have been bought back. It is precisely this tech fund selling in the metals that caused the price decline.

It is important to put things in perspective. Two to three months ago, I was worried about the tech funds' extreme long/dealer short position in the metals, even to the point of writing about a real "thumper" to the downside. We got that thumper. Now the market is no longer structured for another such drubbing. If anything, the market is structured for an upside surprise. Maybe a very big surprise. While the last $10 of a $50 gold decline, or the last 20 to 30 cents of a $1.50 silver decline always feels the worst, that's because of human emotion. The first $10 down in gold, or the first 30 cents down in silver is always taken in stride. The last $10 or 30 cents is the killer. It always feels terrible at market bottoms.

In reality, we should be focused on something else entirely, namely, what the dealers will do when, not if, we break to the upside. Sooner or later, we will cross above the moving averages that we are now below, and when that occurs, the same brain dead tech funds will be buying just as aggressively and recklessly as they have been selling. When we "break through to the other side" the question will be how the dealers will react. Will they short sell into this coming tech fund buying and cap the price rally (as usual), or will they stand aside and let the price zoom?

While no one knows the answer to that question, what I do know is that it should be played like the dealers won't sell. If the dealers do sell, there will be time to adjust to that. If they don't sell, then we explode and it will be very hard to get aboard the long side then. You have to play it, in my opinion, like they won't sell and we will explode.

One thing that I have noticed is the extent to which the COTs have been included in more and more analytical commentary. This is as it should be, in my opinion, because this approach has been remarkably reliable and it is natural for more folks to pick up on it. In other words, more people everyday realize that the main short-term price driver in many markets, certainly including gold and silver, is the ongoing battle between the tech funds and the dealers on the COMEX. As this realization grows, what becomes even more remarkable is the refusal of the silver miners (notably PAAS, CDE, HL and SIL) to recognize the obvious. Speculative trading is setting the price of their main product, contrary to the main intent of commodity law, and these companies continue to look the other way. It's just amazing.

There has been renewed talk about a coming silver EFT (Exchange Traded Fund), modeled after the gold ETFs already introduced. In these ETFs, actual metal is deposited and stored for each share created according to a specific formula. In the three gold ETFs successfully introduced by the World Gold Council (WGC), some 8 million ounces of gold has been secured and deposited, creating shares worth some $3.5 billion.

Some have questioned how the price of gold could have declined with some 5 million ounces being taken off the market since the introduction of the US version in November.

The answer is relatively simple. While the price of gold did increase for a couple of weeks after that introduction, the reason the gold price declined thereafter is because of the aggressive selling of the equivalent of some 12 million gold ounces on the COMEX by the tech funds. The math is simple – aggressive selling of 12 million ounces of futures equivalent gold trumps 5 million ounces created in a gold ETF. The good news, of course, is that the 12 million ounces sold is completed and its market impact is in the past.

As far as a silver ETF is concerned, I still have my doubts, as I wrote back at the time of the US introduction of the gold ETF. There just isn't enough real silver to back a legitimate ETF. Three and a half billion dollars is more than three times all the known silver bullion in the world. According to the WGC, there are 5 billion ounces of gold in the world, so the 8 million ounces that back their 3 ETFs, even though it carries a price tag of $3.5 billion, is little more than one-tenth of one percent of total gold stock.

That's the main difference between gold and silver. Because there is so much more gold in the world than silver, and because the price of gold is more than 60 times the price of silver, $3.5 billion worth of gold hardly impacts the price at all, while that same amount of money would be impossible to be put into silver south of $100/oz.

Common sense should tell you that while there is clearly enough gold in the world to back many ETFs, there is not close to enough silver to back a single ETF. Just because a large financial firm predicts otherwise (in this case, Barclay's), don't hold your breath. I remember a few months back, there was much talk about how the new Chicago Board of Trade electronic contracts on gold and silver would break the COMEX's grip and be a big deal. I remember writing that it would be no big deal. After many months of trading, the CBOT's contracts have open contracts of maybe 1% that of the COMEX, in spite of an aggressive marketing campaign. My point is that you should rely on your own common sense and not wishful thinking and self-serving announcements by those with an agenda.

While I doubt a silver ETF will ever come to fruition, I would much prefer to be proven wrong in this. It actually is a very good idea, even more logical than a gold ETF, because storage is a problem in silver in that you get such an incredible amount of material for your money.

The important point is that you don't have to wait to for someone else to bring out a silver ETF, or bring out a silver ETF at much higher than current prices. You can set up your own equivalent silver ETF, as many thousands of investors have done already. A "personalized silver ETF" is nothing more than bonded and insured storage of 1000 oz silver bars, with documentation as to serial numbers and bar weights and the specific authorization of ability to receive actual possession at your demand. You can accomplish this through a reputable dealer or via futures delivery today. Or wait for silver ETF that may never come, or come at a much higher future price.

Finally, just a quick note on the latest metals controversy – the possible IMF gold sale. Since there is no objective way to determine what will actually occur, I will not attempt to handicap it, other than to say I doubt it will happen. I think the gold price is bottoming, or has bottomed, and a powerful rally will emerge soon. But I would like to make a different point, namely, this is one more reason to consider silver in lieu of gold. Regardless of whether the IMF actually sells gold or not, this will not be the last time a governmental authority publicly threatens to sell gold. Those public threats just do not exist in silver.