Yesterday will undoubtedly go down as one of the worst days in the history of commodities. Everything from crude oil to silver to wheat suffered huge losses, and the great question is: why?
In picking up the pieces and deciding what to do from here, we believe the commodity bull market is still intact. We'll begin by discussing yesterday's action, and then turn to longer term fundamentals.
What Caused the Selling?
As is usually the case with an event like yesterday, there were many factors conspiring to produce such a large drop in commodity prices. First, there were far too many speculators long crude oil and gold (this is a point we have been making in our commodity newsletter). Admittedly we are (and remain) very long gold, but the speculative interest on gold was very high, leaving it susceptible to a pullback. Specifically, the speculative long interest in crude oil as of Tuesday of last week was in 98.6th percentile of readings going back to 2007, and gold was in the 85.6th percentile.
Secondly, the euro fell huge yesterday, settling down a full 2% against the U.S. dollar. With bearishness against the U.S. dollar at a fever pitch, a U.S. dollar rally was bound to happen. The U.S. dollar had lost significant ground to the euro and yen lately, with the yen rallying the last 18 of 21 days even with commodities and stocks performing well, a seemingly "risk-on" stance. The massive bearishness on the DXY Index (the index that tracks the U.S. dollar) was primed to reverse, as speculators were stretched too high, and volume was fading as the euro and yen rallied.
The combination of speculative liquidation and U.S. dollar rallying was too much to bear for commodities, and many went into absolute free-fall. However, delving into the market internals yields an interesting picture of just who was doing the selling.
Who Was Doing All That Selling?
With crude down almost 10% in a single day (largest drop since the bubble burst in 2008), and every other commodity getting destroyed, I myself wondered: who is doing all this selling? In viewing yesterday's action through the lens of commodity ETFs vs. commodity futures, it appears that retail investors bailed en masse yesterday from commodities. Comparing the commodity ETFs to futures is a worthwhile comparison because retail investors are almost always exposed to commodities via ETFs, whereas hedge funds and commodity funds far prefer the leverage of the futures market.
Posted below are charts of gold futures, the GLD, and PHYS with yesterday's volume on each highlighted in a green box.
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To make these numbers easy, we have posted a table below:
| 50 Day Avg. Volume | Yesterday's Volume | % of Average | |
| Gold futures (front month) | 155k | 310k | 200% |
| GLD | 15.656mm | 51.224mm | 327% |
| PHYS | 1.415mm | 4.098mm | 289% |
The point of this exercise is to show that both the GLD and PHYS traded significantly more shares than did gold futures. Since the GLD and PHYS are much more favored by retail investors, it stands to reason that retail investors sold feverishly yesterday, and much more aggressively than futures traders.
The crude oil market is even more astounding. Posted below are the same format charts on crude oil futures and the USO.
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As can be seen, crude futures traded about 2.3x daily average, whereas the USO traded 4.44x the daily average volume. Due to the problems with USO as a product (it holds futures contracts rather than physical crude oil), very few true commodity investors would ever hold it, unless they were arbitraging it against the futures contracts. USO is predominantly held by individuals, and the massive selling of USO yesterday compared to crude oil futures contracts was indicative of retails investors bailing out of long commodity trades.
Also interesting in crude oil was the generally falling volumes as crude rallied recently, another point we made in our commodity newsletter. The combination of weak, momentum retail buyers leaving the long commodity trade as well as the cascading effect of selling left crude with its largest loss in 3 years.
The most striking example of yesterday's retail selling came from SLV. Posted below are charts of silver futures, the SLV, and the PSLV.
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Silver futures traded about 2.14x daily average, whereas the SLV traded 4.5x daily average volume. The PSLV traded 2.79x daily volume. The massive volume on SLV coupled with yesterday's large drop indicates that silver's fall was largely caused by retail investors hitting the panic button.
Additionally, silver speculators were actually at a relatively low level of net long speculation as of last, at the 51.5th percentile of their net long readings over the last 4 years. The fact that Managed Money had been cutting their silver exposure so drastically over the past few weeks, coupled with the insanely high volume recently on the SLV indicates that it was largely silver retail holders doing the selling yesterday, and not futures speculators.
Commodity Fundamentals: What Changed?
The answer is: largely, nothing. The events that conspired to cause yesterday's commodity drop were a perfect storm of margin hikes, excess speculation, and unexpected U.S. dollar strength. Commodities needed a breather anyway, and yesterday took plenty of air out of the bag.
Ironically, the even that caused the U.S. dollar to strengthen, Trichet's dovish statements about not raising rates in the Eurozone aggressively, are actually bullish for commodities going forward. Trichet knows that he cannot raise rates too much, unless he wants half the Eurozone to default on their debt and spark a global recession. He therefore must live with abnormally high inflation, which he hates to his core, but he has no ability to stop. Easy monetary policy in Europe will have the effect of inflating commodity prices further.
The same problem that Trichet has in Europe is multiplied greatly here in the U.S. Bernanke has no ability to raise interest rates because our economic recovery is already shaky as is and rates are the lowest they can go. As such, funds will continue to flow into hard assets such as commodities. Furthermore, the debt problems of the U.S., Europe, and every other industrialized nation are not going away. For now, there has been no real effect felt of European bailouts, or even the U.S. banking system bailout, in the sense that no inflation has been reflected in the CPI. However, as banks start to lend again, and the economic recovery becomes more firmly entrenched, inflation, as well as interest rates, will rise. It is then and only then that the true commodity "bubble" will form. These drops along the way are reminiscent of a bull market, in which pullbacks are sudden and severe, but prices grind up slowly again. Our belief is that we are still in the beginning stages of the commodity bull market, and continuing loss of faith in paper currencies and their purveyors will cause precious metals to only become more sought after.
Trade Recommendation
We recommend purchasing gold futures. Gold has pulled back $100 an ounce in three days, and fundamentals for the metal remain extremely strong going forward. The recent pullback should have the effect of washing out weak long holders, and this consolidation will prove healthy to the gold market. Unless you think inflation has peaked, or that government debt problems will somehow be solved through a combination of extraordinary growth and unprecedented financial discipline, you should own gold.
Silver is also beginning to look attractive, although we would be cautious at these levels, and happier purchasing closer to the $30 level. As such, the sale of put options at the $30 level would be an appropriate strategy, as $30 will prove to be an excellent long-term entry price. Furthermore, recent downward action has made put options expensive, and as such, selling put options is a favorable strategy.
Disclosure: I am long SLW. Long silver futures, long gold futures, short silver futures put options, short WTI crude futures. Additional disclosure: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.
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