Gold, the
COT and Paper Money
The following is an extract from
commentary that was posted at www.speculative-investor.com on 10th February
2002.
What do
the Commitments' of Traders (COT) Reports tell us?
A common misconception is that the
commercial traders in the futures markets (typically, those who use the
futures markets to hedge their dealings in the cash markets) are usually
right and, therefore, that the speculators are usually wrong. This misconception
leads to the incorrect conclusion that the traders' commitments are bullish
for a commodity when the commercials are net-long and bearish when the
commercials are net-short.
As we've explained on many occasions
in the past, the commercials tend to be right at important turning points
and tend to be wrong the remainder of the time. Speculators, on the other
hand, usually follow the price trend and therefore tend to be right as
long as the trend remains intact, but will be wrong when a trend change
occurs. Those who claim that the commercials are usually right simply because
they tend to be on the right side of the market when a trend change eventually
occurs are effectively making the argument that a downward trend is bullish
because it will eventually be followed by an upward trend (or that an upward
trend is bearish because it will eventually be followed by a downward trend).
The 1993 gold rally provides an excellent
example of how the commercial traders tend to be right at the important
turning points and wrong while the market is trending. Below is a chart
(courtesy of www.kitco.com) showing
the gold price during 1993. As we've noted on the chart, the commercials
were (correctly) net-long gold futures at the beginning of the rally, but
after only a $10 rise in the gold price they had reversed their position
and had become net-short. The commercial net-short position continued to
increase as the gold price rallied, peaking at 113,000 contracts in early-August.
At this point, of course, the commercials were once again right because
the gold price then embarked on a sharp correction. However, 85% of the
increase in the gold price from its March-1993 low to its August-1993 high
occurred with the commercials being net-short.
Most of the time the COT reports do
not provide any information that helps us with our forecasts since there
is no telling how net-long or net-short the commercials will become before
a trend change occurs. As illustrated by the above example of the gold
market in 1993, the commercials can remain on the wrong side of the market
for an inordinately-long time. However, we have found the COT information
useful when our work has already led us to the conclusion that an important
trend change is imminent. For example, over the past few months we've argued
that the Dollar would remain firm throughout the first quarter of 2002,
after which a major decline would likely begin. The recent COT data support
this view in that the commercials have built-up substantial net-long positions
in some of the Dollar's main fiat-currency competitors such as the Swiss
Franc and the British Pound. The sizes of the commercial net-long positions
in the SF and the Pound do not preclude further short-term Dollar strength
(in fact, we still expect the Dollar Index to move to a new multi-year
high over the coming 1-2 months), but are consistent with the onset of
an important peak.
Just cut-up a newspaper
and call it money
Several weeks ago the Argentine Government
floated the idea of keeping the Peso pegged to the US$ while introducing
a second local currency, to be called the Argentino, that would not be
pegged to anything and would therefore have no objective limitations on
its supply. The Argentine people were understandably not impressed with
the potential introduction of this new free-floating currency (a currency
that could be inflated ad infinitum). An Argentine housewife neatly encapsulated
the prevailing sentiment towards the proposed new currency when she was
quoted at the time as saying something along the lines of "they may as
well just cut a newspaper into pieces and call it money". She was, of course,
correct in this assessment, but what she and the vast majority of people
didn't understand was that the "Argentino" would have been no different,
in most respects, to the US$ or any other fiat currency. The pieces of
paper spewing out of the US Federal Reserve's printing presses have no
more intrinsic value than pieces of old newspaper. The only difference
between the Federal Reserve's paper and the Argentino would have been that
the Federal Reserve has far more credibility than the Argentine central
bank.
Any paper money, or electronic money,
is fine until people start to lose confidence in the money. It is not really
money, after all, but it functions as such because governments tell us
that we must accept it in exchange for our goods and services. What governments
can't tell us, at least not without severely distorting the supply of goods
and services, is how much money should be exchanged during each transaction.
Rising prices are always one of the first signs that confidence in the
currency-of-the-realm is beginning to wane and the gold price is typically
one of the first prices to rise.
The gold price, in terms of every major
currency except the US$, has been trending higher for more than 2 years.
In terms of the US$ it has been trending higher for almost 1 year. Is the
performance of the gold price over the past few years an early warning
sign that confidence in the fiat currencies of the world has peaked and
reversed lower? It sure looks that way to us.
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and
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