-- Posted Monday, 12 July 2010 | | Source: GoldSeek.com
Written by Justice Litle, Editorial Director, Taipan Publishing Group
Gold kicked off the third quarter with a major sell-off – but the reasons behind it are not as bearish as one might think.
Gold took a major hit the week before last. On July 1, the yellow metal cratered by a whopping $40 an ounce – its largest single-day move in quite a while.
Not a very auspicious start to the quarter one might think…
By the chart alone, there is reason for concern – especially given that the drop came on significant volume. It’s rarely positive to see a trend line broken in such violent fashion.
As is often the case, however, there is more than meets the eye with this move… and it’s important to understand what is happening behind the scenes with gold. There are at least three key factors that led to the gold sell-off on July 1:
· Swap news from the Bank of International Settlements may have unsettled the market.
· Gold was, at least temporarily, a “crowded trade” in a holiday trading environment.
· One or more large hedge funds were forced to liquidate sizable positions.
Swap Jitters
The first point relates to the BIS picking up 349 metric tons of gold via “swaps” with commercial banks. (The WSJ originally reported the swaps as conducted with central banks, not commercial, but then updated and corrected the report.)
In layman’s terms, a swap is basically a “cash for gold” transaction with a time limit attached. The players who “swapped” their gold (349 metric tons worth) to the Bank of International Settlements in exchange for liquid funds are obligated to buy the gold back later.
The swap news is short-term bearish because it increases the possibility of gold being dumped on the open market… but it is longer-term bullish for the same reason that short-selling campaigns are bullish when carried out against a fundamentally sound stock. When the shorts are ultimately forced to cover, their desperation buying just shoots the price even higher than it would have gone otherwise.
At this point, efforts to manipulate gold lower are likely doomed to failure because of the powerful floor under the market. The various fiat-currency-exposed central banks of the world are desperate to get their hands on more gold – a LOT more, to beef up their miniscule holdings as a percentage of reserves – and are thus delighted to buy more gold at a discount when such discounts become available. (These patient accumulators are not anxious to buy gold at new highs, but they love meaningful pullbacks.)
Gold may be in the news, but it's not the only thing moving the market right now.
A Crowded Trade
It is also important to understand that, while the long-term fundamentals for gold are exceptionally bullish, in the short term gold can be viewed as a “crowded trade.”
When a trade gets crowded, it means a large number of market participants have piled in on the same side. These “crowded” conditions can fuel near-term reversals to shake out the weak hands. Then, when the weak hands are gone, it is mostly the strong hands who are left… and the trend can reestablish itself once again.
Crowded trades can be especially susceptible to shakeouts in light volume trading conditions. Heading into July’s holiday heat, hedge funds on the whole were long gold, long the dollar and short the euro, making each trade “crowded” to one degree or another. Gold’s decline was part of a broad liquidation as popular positions reversed.
The Big Dog Gets Burned
To further confirm this idea, one of the very biggest players in the gold market saw a bloodletting in June.
John Paulson is the hedge fund manager who pulled off the “greatest trade ever” in 2007. Paulson – no relation to Hank – made billions for himself and billions more for clients buying credit default swaps in the subprime mortgage meltdown.
As a result of his huge success in 2007, and another round of success shorting the major banks in 2008, Paulson’s total assets under management swelled to as much as $35 billion. Paulson deployed this capital in a rough “barbell” strategy, betting a large chunk on economic recovery and another very large chunk on gold and gold stocks.
A big hedgie trades in big size. Paulson’s gold and gold stock bets grew so big, in fact, that at one point they accounted for a whopping 30% of assets. This multibillion-dollar bet became vulnerable to forced redemption selling, as we shall see in a moment.
The Paulson Advantage Plus Fund reportedly dropped 6.9% in June, taking the total return to a first-half loss on the year of 8.8%. One of Paulson’s smaller funds, the Recovery fund – a “pure play” on economic growth – reportedly fell 12% in June, an even worse performance. On top of all this, Paulson faces the possibility of further questioning from the SEC in relation to Goldman Sachs mortgage deals.
As the hedge fund monitoring service Absolute Return Alpha reports, all this led to “roughly $2 billion in redemptions at the end of June, an amount some investors found surprisingly low…”
Now we see that the July 1 sell-off date for gold was not a coincidence. Paulson, the big dog, saw $2 billion in capital rushing for the exits at June’s end. This meant he had to hunker down and sell – quickly – to meet those investor redemptions. (Bank of America, another major Paulson holding, also fell sharply and in size on July 1.)
Not Fundamental
In respect to gold, the thing to take note of is that short-term price drivers are not always fundamentally based. In fact, sometimes they have little or nothing to do with the fundamentals at all.
In fact, in the case of “crowded trades,” sometimes a market will experience a surprising (and prolonged) reversal in spite of the fundamentals, simply because too many players got caught leaning long (or short) in size.
The true drivers for gold at this point are the long-term buying patterns of central banks, the inevitability of fiat currency erosion as the Austrian endgame comes to pass, and the generally insatiable appetite for gold on the whole.
On the technical side, it also helps to check in with the longer-term charts.
On the weekly chart, the Paulson sell-off hardly registered for gold, with the 18-month trend line (in place since January 2009) still intact. Also, given the buying patterns of the central banks, the odds remain good that support will rematerialize around the weekly trend levels, if not sooner.
From a trading perspective it’s important to be aware of – and sometimes take advantage of – the short-term machinations created by shifts in hedge fund positioning. From an investment perspective, however, it’s perhaps more useful to look beyond such cat and mouse games.
Don't forget to follow us on Facebook and Twitter for the latest in financial market news, investment commentary and exclusive special promotions.
Article brought to you by Taipan Publishing Group. Additional valuable content can be syndicated via our News RSS feed. www.taipanpublishinggroup.com.
Justice Litle is the Editorial Director of Taipan Publishing Group, Editor of Justice Litle’s Macro Trader, and Managing Editor to the free investing and trading e-letter Taipan Daily. His articles have been featured in Futures magazine, he has been quoted in The Wall Street Journal and has even contributed regular market commentary to Reuters and Dow Jones.
-- Posted Monday, 12 July 2010 | Digg This Article
| Source: GoldSeek.com
