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August 24, 2004

Market Commentary
by Leonard Kaplan

For markets of August 23^rd

General Comments:

The gold and silver markets rocketed higher last week as new "themes" or considerations emerged in the financial markets. After dutifully and obediently following the Euro for years, the gold market suddenly was beset by the transitory illusion that gold was suddenly highly correlated to the oil price, and as oil set record highs near $50, gold was forced higher in price by massive buying by the large commodity funds. Gold finished the week higher by $14.30 to approach significant technical resistance at the $415 price level.

While there is indeed a line of reasoning correlating the values of gold and oil, the past years have shown that such a relationship is more of an aberration than the norm. Although there is a rather circular argument that high oil prices cause inflation, which then inflames investors to seek gold as a hedge, this line of reasoning is almost exactly opposite from the reality of current thought in today's financial markets. Yes, I know it is contrary to logical thought, but, at this point in time, the markets believe that higher inflation would cause the Fed to be more aggressive in raising rates, thus aiding the USD, thus hurting the gold price. The sudden shift in temperament of the markets was not only unexpected, but almost certainly false. But, emotions, the enemy of the professional trader, ran high and speculators piled in to this market late last week with reckless abandon. While the metals screamed higher, the USD was actually higher for the week. It was clear that it was mostly irrationality.

Gold and silver prices rallied against all currencies last week, as thin summer market conditions and the outsized buying orders pushed the market to levels that confused most analysts. In fact, CBS Marketwatch reported that the percentage of bullish analysts reached a dangerously high level, and that contrary opinion dictated selling, as again, too many people were on the same side of the boat. Long term readers of my ravings know that I believe that the next leg of the bull market in gold will occur when gold begins to rally in all or most currencies, but that has yet to occur. A two or three day aberration does not negate the many years recently when gold has traded as a currency, following the Euro and the USD in totally slavish fashion. While gold may be taken higher by the large speculative funds, odds are that we go lower as the market is vulnerable should the USD rally or oil prices fall.

As of yet, I see no reason to change my view that the gold market is STILL a trading range, bounded by $375-$380 on the downside to perhaps $420-$430 on the upside. And, as we are closer to the top of the range than the bottom, I would either be selling long positions, considering small short positions, or selling out of the money calls.

There was another justification for the rally in gold, as it become known that the Central Bank of Argentina was a buyer of 42 tons of gold. Now, it has been a really long time that any Central Bank has been a buyer of gold in the open market (as opposed to China and Russia who buy internally produced gold), and as such, hopes skyrocketed that perhaps the USD rich Asian banks may follow their lead and add to their reserves. This hope, and rumors of such, have been percolating through the market for years, but as of yet there is no hard evidence to prove these fairly unreasonable hopes true. Nor is there much rational thought that such purchases are likely. Rampant optimism and enthusiasm remains the province of the gold bugs, and as such, perhaps the gold market last week was encouraged. Until more is known, I would treat the rather small purchase of gold by Argentina (only ½ Billion USD) as a one time occurrence, and not a trend.

However, should other nations begin to add to their gold reserves, shunning the precedents of the past decades, it would most certainly change the entire ball game. Dependent upon the nature of such actions, gold would most certainly move most considerably higher. But, as mentioned, it is highly unlikely that we will see the Asian countries, nor any else, as a buyer of gold for their reserves.

Another very bullish report was published by GFMS showing that demand for gold, for both jewelry and private investment jumped 10.5% in the second quarter of the year over last year. This comparison is taken from Q2 2003, when SARS affected much of the Asian economies. But, please note that the 743 tons of gold purchased is still 4% higher than Q2 2002, even with the gold price averaging $50 higher in value. Retail investment was reported at 79 tons, the highest quarterly number in 5 years. It is becoming clear that retail investment demand is rising, albeit at a rate sharply lower than either expected or hoped. If gold is to continue its secular bull market, the responsibility lays upon the investment world, as the fundamental supply/demand considerations are too finely balanced at present to allow gold to do more than rally quietly and moderately, and move in tandem with the USD. It has to be the outpouring of investment interest that fuels the next move. While the statistics are favorable, they are less than inspiring. This, of course, tends to justify my macro-view that gold is still in a rather well defined trading range.

Another moderately bullish data point was that GFMS noted that outstanding producer hedge positions (gold sold forward in time) were cut by 3.4 million ounces in the 2nd quarter of the year. It is thought that most, if not all, of this reduction was the delivery of gold into previously sold commitments, along with the curtailment of newly originated positions. This leaves the global hedge book at about 64 million ounces, about 77% of global gold production. While it is the lowest number in years, it still remains rather considerable. With gold at or near current levels, the gold producers are really not buyers; they are just no longer sellers. But, truth be told, they should be at these price levels in moderation.

With the monsoon dumping a bit more rain onto India than once thought, with the harvest going rather well, and with the general economic prosperity in that nation, gold demand has remained very strong. Imports into that nation jumped 30% in the 2nd quarter of the year, even with gold prices at higher prices. This data was much better than expected in the market.

The silver market followed the gold higher last week, in rather volatile fashion with prices tracing over a 50 cent range from high to low, ending up by 24 ½ cents. Trading conditions remain VERY thin during these summer vacation months, and action is almost totally dominated by the large speculative funds. Silver's use in photography, which accounts for 25% of total demand, has been falling since 1999 as digital cameras become more widespread, and as regular film sales decline. We have seen a 13% decrease in demand over the years. This is often heralded as a hugely bearish influence on the fundamentals, but in fact, it is most minimal. At the very worst, we are seeing a 13% reduction in a 25% sector of the global demand perspective, about a 3.25% reduction overall in a market that is about 800 million ounces wide, or about 26 million ounces. At current prices that amounts to only $170 million Dollars. Investment interest, or speculative buys in this marketplace can easily gobble such a tidbit.

On October 6th, the Chicago Board of Trade is once again attempting to compete with Comex as they will be offering electronic trading of gold and silver contracts that EXACTLY match the specifications of the Comex in New York. I have lost track of just how many times the CBOT has been thwarted in such ventures, but this attempt is likely to achieve the same rebuff by the financial world. Instead of exploiting the weaknesses of the electronic system run by Comex, instead of updating contract and delivery specifications to meet today's precious metals industry, the CBOT is simply copying Comex. There will be no benefit to trade in Chicago, thus, speculators and the industry will continue where they are most comfortable and assured of superb liquidity, in New York.

On to the Commitment of Traders reports, as of August 17th, both futures and options:

Gold rose by about $4.50 during the reporting period, as open interest rose by a rather sizable amount of 15,000 contracts. And, please note, that on Friday alone, well after this report, open interest rose by 19,000 contracts showing huge fund buying that propelled prices near $415. Looking at the data, it is clear that the only buyers were the large speculative funds, as noted earlier in this commentary, and that the sellers were the commercials. We have seen this a thousand times and it is virtually always certain that the commercials have their way with the speculators sooner or later. I interpret such data quite bearishly, and look for the market to retreat as longs are forced to liquidate their positions. I still adhere to my trading range strategies of buying dips, selling rallies, and selling out of the money puts and calls at advantageous levels.

During the relevant week, silver was just about unchanged and the data above supports just how thin and quiet this market is at this time of year. The big rally in this market occurred after the release of the statistics above and I see little benefit in looking too hard at the numbers above. Nothing of interest occurred during the week.

GOLD RECOMMENDATIONS:
Expected trading range: $395 to $415

In gold, I remain bearish as I see prices over $410 as quite near the top of the trading range. Look to get mildly short if we see ANY weakness in the market, or strength in the USD, or any weakness in the oil price. Also, sell out of the money calls at the $425 price level basis the December contract. These can be done as naked calls, but only in small size as the threat of terrorism still always lurks. I would add to short positions on a close under $407.50, looking to cover some shorts around the $402 price level, and the remainder at $395ish. As a stop, use $416 basis the December contract.

SILVER RECOMMENDATIONS:
Expected trading range: $6.40 to $6.90

Again, we see how this market operates, with the funds driving prices up to unsustainable price levels only to see the physical market disappear, the commercials become sellers, until the inevitable wash-out occurs. With the capriciousness of the large funds, the volatility of this market in thin summer trading conditions, it makes recommendations difficult. Although I remain bearish, I am cognizant that the foolish funds could drive prices well higher before they cascade lower. Selling way out of the money calls is the only sensible trade I can imagine. Call our offices for specific recommendations.

PLATINUM RECOMMENDATIONS:
Expected trading range: $800 to $855

Prices seem rather strong here, and if gold and silver decline, then it is likely that platinum will as well. I really don't want to get short this market, so we will wait for a buying opportunity later. I am still looking for the $780's for purchases.

Leonard Kaplan
Prospector Asset Management
1415 Sherman Ave. #504
Evanston, IL 60201
Ph: (847) 733-8400
Fax: (847) 733-8958

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