February 13, 2007

Ted Butler: Time frames

Silver market analyst Ted Butler analyzes the commitment of traders report for the gold and silver futures markets and gets the feeling that the dealers, who are short, are again about to scalp the technical funds, which are long, sending gold and silver spiking down to wonderful new buy points in their steady ascents:

Time Frames

By: Theodore Butler

Investment cycles, like all things in life, run in both short-term and long-term time frames. I’ll define short term as days, weeks and months, and long term as years and decades. For the average investor, the best hope for success lies with a long-approach. Contrary to TV infomercials and other hype, short-term trading won’t and can’t make the masses rich. That’s why I have always counseled a long-term approach to silver and intend to do that again today.

But when you study the markets closely, there are times when the risk of a short-term sell-off becomes more likely than at other times. This does not mean a sell-off must occur, just that the odds may be greater for that to occur than at other times. Most importantly, it is imperative to understand the reasons behind such a potential sell-off, and to determine if those short-term reasons negate the reasoning behind the long-term bullish case for silver. This is important because the biggest mistake an investor can make is to lose a long-term investment for short-term considerations.

In fact, I have increasingly attempted to ignore the short-term situation in my public silver analysis, precisely to prevent long-term silver investors from fretting about the short term. But it is possible to be increasingly bullish about the long term, but to be concerned about risk and volatility in the near term. Even if those concerns are not realized, and the long-term fundamentals of silver overpower the short-term considerations, which can and will happen someday, it would be analytically dishonest to not acknowledge such concerns. At the very least, such an acknowledgement might better prepare one emotionally in the event of a sell-off. At the very best, it might assist in positioning for the long-term bull market in silver.

The Short Term

Long-time readers know that my speculation for near term price change is based upon the futures market structure as depicted in the Commitment of Traders Report (COT). It is the current market structure that is the basis for my concern about near term risk. As a way of explanation for newer readers, I’ll offer a brief overview of the COT, but first I must clearly state that this has little importance in the long term. Long-term investment decisions should not be made based upon the COTs, simply because the COTs change much more frequently than do long term supply/demand fundamentals, which I’ll discuss shortly.


The COT is a weekly report, issued by the Commodity Futures Trading Commission (CFTC), on just about all major futures and options contracts traded on US commodity futures markets. As such, it is one of the most dependable and timely of information data sources available. The report breaks down, in great detail, the long and short positions held by certain categories of market participants, including by size of trader and the level of concentration of the largest traders.

The COT is an objective and comprehensive snapshot of the positions different types of traders are holding at any point. That objective data is studied to help predict future price movements. The trick lies in the interpretation of the data, which, by definition, is subjective. Ask ten analysts who study the COT for their opinion and chances are you may get ten different opinions.

Many analysts, including me, who study the COT as it pertains to gold and silver, focus on the interplay between two main categories of traders, the large commercial and non-commercial traders. Usually, the commercials are money-center banks and brokerages and non-commercials are technical futures trading funds, a specific type of hedge fund. The tech funds buy and sell on price signals, buying as prices go up and selling as prices go down, hoping to capture significant price trends and limiting risk. Generally, the commercials, or dealers, take the opposite side of whatever the funds buy or sell.

Whenever the tech funds have established their maximum long or short total position, we have arrived at the "moment of truth", from which point either the tech funds or dealers will have to aggressively liquidate positions. In essence, the dealers have never panicked as a group and liquidated in a disorderly manner. It has always been the tech funds that have liquidated in a panic. That is not to say that it is not possible for the dealers to liquidate in a panic, just that they never have in gold or silver, to my knowledge. This can be seen in the basic chart patterns for the life of the gold and silver bull markets so far. Prices climb over longer periods of time, as trend-following tech funds establish positions, compared to sell-offs, which occur abruptly and feature urgent tech fund selling to limit losses. That’s why we go down faster than we go up.

The key to accurately determining the "moment of truth" is in trying to guess when the tech funds have built up their maximum position and are likely to begin to liquidate. This maximum position is, admittedly, a moving and variable target that can only be known for sure in hindsight. Sometimes the funds put many more contracts on than they have put on before, sometimes less. But there is little practical good in waiting for the benefit of hindsight. After the tech funds establish a maximum long position and have begun to liquidate in earnest, the top in price has come and gone. Therefore, one is forced to guess before the liquidation process has begun, even though you risk looking dumb for a while.

I’m guessing that we are at or very close to the tech funds having a maximum long position in gold and silver futures contracts. We are at, or above, recent high water extremes in tech fund long/dealer short positions in gold and silver, which have resulted in significant sell-offs in the past, even though we are not near the all-time historical maximum levels currently. So the question becomes how likely are we to move from the recent extremes to the all-time historical extremes of a year and a half ago? That question is important because a move from here to the all-time maximum tech fund long position would necessarily involve higher prices. While that can certainly occur, my sense is that it won’t. Let me explain my reasoning.

Many factors go into how much of a position the tech funds can build up to. Price action, margin requirements, volatility, and the perceived risk on a trade (how close are the moving averages) all play an important role in determining the tech funds’ full position. Of basic concern is the actual amount of assets that the funds are controlling. More assets under management equal more of a potential position, all things being equal. Fewer assets indicate a smaller position. It is this basic concern that troubles me at this time. Using the John Henry & Company (www.jwh.com) as a proxy for the tech fund sector, at the time of the historical maximum gold and silver long position in Sep–Dec 2005, the tech funds held more assets under management than at any other time. Since that time, principally due to trading performance (but also due to investor withdrawals), assets under management are down close to 45%. If the assets under management in the tech fund sector mirror those of Henry, this would argue against a much bigger position than currently held.

Since the second week of January, the price of gold has risen more than $60. Using the most recent COT data and extrapolating from Tuesday’s cut-off, the net tech fund long/dealer short futures position on the COMEX and the CBOT has risen by more than 80,000 contracts, in my opinion. That’s the equivalent of 8 million ounces of gold, or 250 tons. (Silver has gone up by almost 15,000 net contracts, or 75 million ounces, as prices rose by $1.50.) This is one of the largest 5-week increases in net gold contracts in history, especially considering the tech funds’ reduced assets under management. It appears obvious to me that gold rose by $60, in that period, precisely because the funds and other speculators bought 8 million ounces of futures contracts. In contrast, during that same period of time, the big gold ETF, GLD, added less than 10 tons, or around 300,000 ounces of gold.

If I am correct and the tech fund buying was the reason gold went up over the past 5 weeks, the market could be at risk of a significant decline if those positions are liquidated. Further, I get the feeling that the tech funds were intentionally lured onto the long side in a big way by the dealers, whose plan it is to trigger a big tech fund long liquidation to enable the dealers to buy back large numbers of gold and silver short positions. If and when this liquidation does occur, it should present a phenomenal buy point once that liquidation is complete. As always, don’t even think about liquidating long-term silver positions because of a one or two dollar temporary sell-off that might not occur, or might occur from higher levels.

If I am wrong about anything, it is likely to be on short-term prognosis. It is entirely possible that the dealers could get over-run or for the tech funds to put more longs on at higher prices before liquidating, or even that the buying was not by tech funds, but some other entity. But if I am not going to report on negative readings in the COT when they occur, I would not consider myself to be objective.