Market Commentary

By: Leonard Kaplan | Mon, Apr 26, 2004
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For markets of April 26th

Based upon 30 day maturities
JUNE GOLD $395.70 GOLD .00/.50%
MAY SILVER $6.163 SILVER .50/2.00%
JULY PLATINUM $942.50 PLAT 3.00/8.00%
JUNE PALLADIUM $280.85    

General Comments:

WHOOSH! The sound of air escaping highly inflated, speculatively induced, market bubbles was the overriding theme last week in the precious metals. As notably forewarned in this commentary over the past several weeks, historical precedent ONCE AGAIN was resurrected. The devastation was truly impressive in all the white metals, while gold, for very good reasons, held its ground near its 200 day moving average.

Silver fell by almost a Dollar last week, and has fallen $2.50 in value in just 13 trading days. As noted in previous commentaries, every 5 to 10 years silver lures enough speculators, both large and small; to believe the "urban legends" of massive shortages, potential short squeezes, and improving fundamentals, to propel prices to truly silly levels, only to have the price completely devastated in short order. Let's add the recent rally in silver, and the subsequent devastation, to the long historical record of price action for this commodity. And, in looking at the Commitments of Traders reports, there could be significantly more downside, as we will see later. As an aside, I took rather considerable abuse from the silver bulls when cautioning my readers about this market and its potential for a catastrophic sell-off, and in one conversation the gentleman told me that "this time it will be different". Every time I hear that phrase, I know in my heart of hearts that it won't be.

Platinum and palladium were not spared the rod either, with platinum falling in price some $76 week over week, and $104 in a three day period. Palladium fell by $33 for the week, and the price action in both metals was a debacle of mammoth proportions. The gold market did considerably better, down only about $5 for the week, even though the other precious metals were obliterated and the USD continued to make recent highs.

In order to understand what happened, it is imperative to understand two major phenomenons in the commodities markets. One, which has often been trumpeted by this commentary, is just how important the large commodity funds are in setting both the trend and the current price, and their methodology in trading. First, most large speculative commodity funds are not run by humans, their decisions are generated by computer systems (black box) which DO NOT take into consideration any fundamental supply/demand considerations or external stimuli. These computer systems trade the PRICE, and nothing else. Secondly, most of these systems are strictly trend-following or momentum driven, and these black box systems almost universally add to positions if the price goes in their favor. As an example, if they buy, and prices rise, they buy more. If prices still continue to rise, they buy more. So, by definition, they have their very largest position at the very top of the market, a most foolish way of trading. Next, after driving a market to totally unreasonable levels and then deciding to sell, they find that there is no one to sell to, and prices completely plummet amidst devastating market conditions. This, ladies and gentlemen, is how the world operates in the ruff and tumble commodity markets these days.

Taking the recent silver market as an example, any rational trader would clearly see that the risks of being long silver at $8.00+ are noticeably higher that the risks of being long silver at $6.00, and would lighten his positions or leave the market altogether. Not so the large computer-driven funds who add to their long positions when "magic" technical numbers are surpassed on the upside. They trade against all logic, all rationale, and all risk-based portfolio theory, and the last week in the precious metals was a superb example of what always happens. And please note, it isn't just the precious metals, I have seen the exact same thing in many other commodity markets.

The gold market was a noticeable exception last week, with prices lower but stable at or near important technical support levels. As noted in previous commentaries, I expected gold to remain relatively strong due to the improving fundamental picture, and reports of truly superb physical demand at these levels from India and the commercial/industrial crowd. Gold is also drawing quite a "safe haven" bid in the markets as violence and terrorism continue to plague our world. While gold may indeed go a bit lower, pulled down by the other precious metals and the excellent probability that the USD may continue higher, any such decline should be rather minimal and would represent buying opportunities.

It would seem that the news reports indicate the Germany is closer to selling some of its gold reserves under the newly resigned Washington Accord. Gerhard Schroeder was quoted by Reuter's as offering tacit backing to a plan to use the proceeds of such sales to create a foundation for research and development in Germany. Of course, the government wants to just take the money raised and pay down the deficit, but the Bundesbank vehemently objects.

Quite surprisingly, news arose this week that at least two major gold producers continue to be very aggressive in the paring down of their hedge books. Barrick dropped 800,000 ounces from its books by delivering into previously sold forward commitments, while Buenaventura was a buyer of 120,000 ounces. As shareholders continue to demand a "hedge-free" environment, the gold producers continue to abstain from new hedges and continue to work to diminish their hedge books. This is unquestionably a very major support for the gold price as their purchases far outweigh all investor interest over the last two years.

Things are not going all that well for the South African precious metals producers, having to engage in one battle after the next. The rise of the South African Rand has significantly hurt their earnings and the government continues to seek one new tax after another. Now, their battle against the Mineworker unions seems another obstacle, with the mines unable to retrench workers without strikes and other difficulties. I continue to look for a much depleted yearly production from South Africa under the current trend long-term.

I am always delighted by the financial markets as they seem to "grab" onto one theme, only with the exclusion of much more important information. The Producer Price Index in the USA is rocketing higher, with this week's promulgation showing a .5% rise in prices. The markets see this as a NEGATIVE for gold, taking the perspective that higher inflation rates will cause the Fed to raise rates quicker, thus strengthening the USD, thus hurting gold. The markets are not considering that, historically, gold should rally mightily as inflation begins to surge but are " spinning" the story in an altogether different story. I sense that it will be a while until the correct thought patterns are resurrected, but it is clear that inflation is coming with a vengeance, and eventually gold will benefit. Just maybe, perhaps, this is one reason why the gold market has been supported of late.

I was going to write how Japanese gold demand continues, month after month, to completely disappoint and how total gold imports into that nation fell almost 70% in March to only a bit over 2 tons, but I decided not to beat a dead horse. But, it seems now, that the rallying cry for the gold bulls has finally dismissed any promise of Japanese demand and is now centered on Chinese demand. I can just hear that little voice, in the back of my head, from some rabid gold bull whispering, "This time it will be different". Yeah, sure.

Overall, I still remain bearish on the precious metals for the very short term, as the technical picture clearly shows that the USD is in its ascendancy. As long the Dollar rallies, the precious metals are going to continue to be pressured. As the Dollar rallies, and as the funds continue to liquidate, the path of least resistance appears to be lower. Gold must be considered the notable exception, with any prices in the $380-$385 range being seen as buying opportunities. I would not consider buying silver, platinum, or palladium even if you put a gun to my head. There is absolutely no certain indication that the devastation is over yet. Look to the USD for clues as to what may occur, but the trend is your friend.

The Commitment of Traders reports, as of April 20th, for both futures and options:

Long Speculative Short Speculative Long Commercial Short Commercial Small Long Spec Small Short Spec
109,227 21,102 127,144 271,576 75,905 19,598
-69,020 +5,460 +6,932 -69,976 -4,781 -2,353

During the reporting period, gold fell by about $2 in value as total open interest plunged by over 66,000 contracts. The large speculators were massive sellers as the commercials were equally massive buyers. The statistics above clearly demonstrate that the physical market has reawakened, and with a vengeance, and that demand has rocketed at these price levels. Please understand that the overwhelming majority of the short commercials are dealers, market-makers, and they only buy back futures when a client buys physicals, or forwards, or the like, from them. There can be no more bullish signal than the data above.

Gold remains exceedingly well supported at current price levels but I remain a bit pessimistic about its short-term prospects IF the USD remains strong, and if the other precious metals continue in their liquidation processes. All I know is that gold is not going much lower with such strong underlying upward pressures. I would be a seller of short-term gold puts and a buyer of futures on dips. Recommendations to follow.

Long Speculative Short Speculative Long Commercial Short Commercial Small Long Spec Small Short Spec
52,660 1,477 20,164 106,193 47,176 12,330
-10,476 -419 +1,809 -6,711 -5,046 -6,582

During the relevant period, silver fell in price by about 50 cents and open interest dropped by about 10%. Amazingly, even though silver ended $1.50 off its recent highs, it appears that VERY FEW speculators, both large and small, exited the market. As of April 20th, they still held almost 100,000 contracts (500 Million ounces) in long positions. While it is uncertain what has exactly occurred since, I sense that there is still the potential for continuing liquidation. The ratio of long specs to short specs is over 7 to 1, a dangerous recipe.

While we may get a bounce off the $6.00 price level, as some bargain hunters emerge, I still see this market as very dangerous, with the risks firmly planted on the downside. From my contacts on the floor of the exchange, there are stacks of stop loss sell orders just under the $6.00 price level (just below recent lows), and I suspect that these orders represent just too tempting a target to ignore. The statistics above clearly demonstrate that the speculative liquidation is probably not completed. Recommendations to follow.

Expected trading range: $390 to $404

This market is a screaming buy if external conditions and stimuli change. If the USD begins to falter, and if the Bond Market starts to rally, gold will rise smartly. As technical analysis of the markets rather precludes such events, look for gold to remain very well supported in the $388 to $391 price levels and rallies should be limited to the very low $400's. Short term traders should be buying dips near support and looking to sell as the price approaches the top of the range. I see gold as a trading range for the very short term, with very little risk to the downside.

With adequate evidence that the gold market is VERY well supported at lower levels, selling out of the money puts seems most prudent at this time. I really like the June 390 puts, and would be rather aggressive selling these options. Call our offices for specific recommendations for your account.

Expected trading range: $5.80 to $6.50

The speculators are STILL very long this market and my experience screams that there could be more trouble coming. Aggressive traders should be selling rallies near the $6.25 to $6.30 with very small positions and close stops. I look for continuing liquidation to perhaps the $5.50 price level. There is no reason on earth to think that the carnage is over.

Things are way too dangerous in this market for the average trader. Please call our offices for more specific information as conditions are rapidly changing in this market. Sorry, but nothing looks good from the option side.

Expected trading range: $780 to $850

We have seen total devastation to this market as prices are now down over $100 in just a few days time. There is no reason to believe that the long liquidation by the funds is over. I would be a seller on sharp rallies into the $860's, with a stop at $880 close only. But, this trade is only for those with a strong heart, as market conditions are totally raucous.


Leonard Kaplan

Author: Leonard Kaplan

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

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