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Protective Put Buying Fuels Rally

By: Captain Hook | Tuesday, February 26, 2013

The following is commentary that originally appeared at Treasure Chests for the benefit of subscribers on Tuesday, February 12th, 2013.

Just give me another reason to short the stock market and I'll do it. That appears to be the operating mechanics of what is going on in the stock market right now, which accounts for the continued firmness in the tape. Whether it's the Sequester, renewed trouble in Europe, seasonal timing considerations, or just the fact stocks are both over-bought and over-valued, both hedgers and naked speculators (but mostly hedgers) alike are buying protective puts like wild-men right now. For the hedgers, the idea here is with the future so bright for stocks (January Barometer, QE, etc.), what's the use of selling stocks that are destined to go higher, especially with the moral retards on the Beltway looking like they will fold on everything from the Sequester to the debt ceiling. The mob is demanding this, and they will get their way or Caesar (Obama and his lot) will meet his demise as the Ides of March come upon us.

So again, instead of selling, long positions are being hedged with puts, which is fuelling yet another grand perpetual short squeeze of the broad stock market(s). Here, good news is naturally good; but bad news is even better, because it means more money printing. And the bad news just keeps coming because, ironically, it doesn't need to be manufactured, which in turn fuels and ever-increasingly euphoric mania in stocks. And the fun and games will get ever more jubilant until all the squeezing is over, which could come as early as this month if a Bradley Model Top is being traced out at present. As mentioned last week, the last thing bulls want to see is continued strength in stocks running into February, because this would mean the shorts (hedgers) are getting squeezed out right away, and they won't be back again after the impetus is gone. (i.e. think Sequester, etc.)

Side Note: The upshot of what new highs here in February means for the future is unfortunately bad news for the bulls from a sentiment and mechanics perspective. Because once stocks begin to fall, hedges will be lifted and the dip bought (think using calls, which will drive open interest put / call ratios lower), which is exactly the opposite dynamic that exists in a late stage short squeeze, as we have now. (i.e. predicated on squeezing hedgers out at the top.) Please note also that the idiots who are putting these hedges on are likely borrowing the money to do so, which is what makes them prone to cover, and again, fuels the squeeze.

What happens in terms of market dynamics is once the hedgers become exhausted and stop buying protective puts, the stock market will indeed top, and then begin falling. Along the way, once these same hedgers think stocks have fallen sufficiently to engender a resumption of the 'bull market', they subsequently lift their hedges and go long with any remaining capital they may have; but remember, for all intents and purposes they are already 'all in' (we know this with margin on the New York Stock Exchange above 2008 levels as can be seen in the attached above), meaning buying power will be weak. What's worse, with no puts (and shorts) to squeeze out even though prices have fallen (because the consensus is still bullish), prices keep falling - where in fact they begin cascading lower as the deer in the headlights syndrome hits unwary bulls, along with the realization the pretence(s) given on bubble vision were 'bull sh*t', and they collectively begin to realize they must sell. This is when the stock market will fall hard.

What could trigger such a fall at this point? Answer: How about Europe. It could be the trigger for a global move to 'risk off'.

Because sooner or later this hedging will exhaust itself, along with the larger degree squeeze in stocks. (i.e. because actual short positions are quite low.) And again, it's important to distinguish hedging is the reason stocks remain buoyant despite compelling technicals calling for lower prices, where the combination of this and the money printing become new fuel for the machine, which is detected instantaneously. The power of the machine(s) (computers) in controlling the stock market today is truly remarkable. High Frequency Trading (HFT) and the algo's that control this activity make it almost impossible for a trader grounded in logic to make money anymore. Only the fastest and most powerful machines trading seemingly bottomless accounts funded by our fiat masters (the Fed) make money on a consistent basis these days.

And the money printing - it's just as important in the big picture. Did you ever ask yourself why the Fed's use QE now to print money? Did you know it's because the money goes directly to the Fed's chartered (money center) banks so they can dish it out as they see fit. This way, only the 'table scraps' reach a now brain dead public (increasing numbers are happy to stay at home and watch TV where the stock market has been made into just another game show) in order to keep these operations 'semi-sterilized' (as price inflation neutral as possible), because they know the money printing lifecycle has a 'limited life' (a degree of hyperinflation will erupt at some point - like next year), and they want to keep it contained as long as possible. So, the Fed prints the money; the banks and brokers buy their favorite stocks and bonds; their commodities accounts are used to suppress input costs and real money alternatives; and, they pay themselves huge salaries and bonuses every year. Life is great as a high level banker in case you didn't know - it's Animal Farm at its best.

What's more, they pull it off by using Houdini like tactics (creating diversion), where their bought and paid for politicians hold official behind closed-door meetings and press-conferences designed to distract the sheeple (and hopefully ratings agencies) that US credit is still good. (i.e. but in reality it's getting worse quickly.) But like the days of Bread and Circuses in Rome, this too shall pass in spite of best efforts on the part of the bureaucracy to scare ratings agencies into compliance with the insanity. They have been working hard in this regard of late because they know the balloons must keep inflating or it's all over for their fragile fiat currency economies. So, with the prospect of debt ceiling restrictions being eliminated entirely in May, the ratings agencies had to be neutered - mission accomplished. Certainly it's this prospect, along with the other embroils authorities have manufactured (so they can be supposedly solved), which continues to provide the staged backdrop to fuel the short squeeze in stocks - which is close to all time extremes I might add. (See Figure 1)

Figure 1

Side Note: It should be noted another good day for tech stocks would see the Fibonacci target in the above plot met, where although higher trajectories may be in the cards later on, it's difficult envisioning much progress here (especially with all the insider selling) without some sort of correction. I expect this target, and possibly intermediate degree highs, to be achieved this week going into the G-20 meeting on the weekend.

Unfortunately, the rest of us, and to stay on topic, more specifically, precious metals shares, do not fall within the 'privileged' category of being a favored largesse recipient. No, no, no. In fact, they are on top of the banker's 'sh*t list', under the category of 'real money alternatives' discussed above, along with gold and silver bullion of course. So, right now they (bankers) are winning, big time, where they can increase money printing for their own accounts (which they use to keep precious metals controlled), while handing precious metals shares their worst monthly close in three-years last month. Again, this is a big win for the powers that be - aided by greedy and aggressive speculators in the sector - driving open interest put / call ratios to all time lows across the precious metals sector. (See previous open interest put / call ratio analysis for further explanation.)

Analysts will come up with legitimate reasons why gold stocks are so hated. But in my books gold stocks are actually doing quite well considering they have doubled their floats since 2001, meaning they would be trading at far higher prices today in the absence of such activity. Why did this happen? Is it because precious metal producer managers are so lousy, as is increasingly being bandied about these days? Answer: Perhaps to some degree in some instances; however, the primary reason for this in my books is because of the artificially managed low commodity prices that can't keep up to runaway costs, which are not so closely managed, especially on the wage front. Gold and silver prices have been held down by paper market related pricing constraints for over 20-years now, where this past week's margin reductions in Comex Gold and Silver is just another instance of price managers attempting to suck the unsuspecting and greedy leverage junkies in again, so that that they can be flushed later on when market conditions become excited.

So, when will precious metals rally? Answer: When it's perceived the need for speed in currency debasement rates is back in vogue. When will that be? In terms of the cyclical bounce we are expecting to materialize, the answer to that question is soon (like beginning next week post options expiry), if this assessment is correct. Of course there is the initial deflation scare sell-off to deal with if stocks turn lower in tandem, however precious metals are already sold down, so any further weakness should be muted, and conforming to the patterning discussed here. You will remember we are expecting a cyclical bounce to emerge soon, followed by one more bout of weakness extending into next year. The timing of all this could be compressed because of the finagling in the markets these days, however I have little doubt we will need to work through an a - b - c corrective sequence in the HUI (Amex Gold Bugs Index) / SPX (S&P 500) Ratio, with both the b and c waves still ahead. (See Figure 2)

Figure 2

With options expiry this week however, and the influence of all those newly acquired puts to prop the stock market up at their highest, despite increasingly glaring divergences across the broader spectrum, prices could remain firm; again, bringing the possible specter of a Bradley Model top into view (a Three Peaks and Domed House top would call for a drop in stocks in excess of 20%.), along with setting the bottom in precious metals. (i.e. because of the spread trade extreme between stocks and precious metals stocks being reached, discussed above.) And again, we have the G-20 this week, and it's a long weekend in the States coming, along with Chinese New Year (so their markets are closed), which are all reasons why stocks could be higher - and precious metals lower (it's perceived without the Chinese buying precious metal prices will fall), in order to finish the move(s) in the above mentioned (and pictured) ratio. To confirm this thinking, we will also be looking hard at the Franco Nevada / HUI Ratio for a top, where as you can see below, we have redrawn the Fibonacci resonance related target to an achievable fit for such a short time span. This was done because the HUI / SPX Ratio is very likely to hit a bottom this week, implying the less aggressive target in the below is the correct one. (See Figure 3)

Figure 3

Once this occurs it will be up and away for precious metals and down for the stock market in counter-trend moves, which again, should begin next week - post options expiry. We know these moves will be cyclical (counter-trend) in nature because of the count in the HUI / SPX Ratio (see above), which undoubtedly has another 5-wave sequence lower (after this counter-trend rebound) to finish the larger degree corrective (cyclical) move that began back in 2011, as discussed above. And again, this next leg of the larger degree correction lower in the HUI / SPX Ratio should run into next year once it begins (think some time in late summer or fall), and it should play hard on precious metals in stocks are falling at the same time, so make sure you have your portfolios properly diversified (or hedged) for such a possibility. This next rally should give you the opportunity to lighten up, looking to re-deploy cash in latter 2014 when the larger degree cyclical low for the sector is anticipated.

Precious metals shares will be cheap then, ripe for the picking. The Boys From Brazil who live in New York will take freshly printed money from the Fed and buy them all up with most precious metals investors happy to give them away at blow-out prices. (i.e. right before the bull market completes its secular move into the 2020 [think a Fibonacci 21-year cycle] area.) I am thinking of calling this bull market the 'dumbbell bull market', where because of the idiocy of its market participants, buying up all the paper alternatives (think ETF's) handed to them by the boys from New York, the vast majority of the gains in precious metals shares are compressed into the first three and last three years of the larger degree secular move, which could in fact run past 2020 for the shares if it stretches a full Fibonacci 21-years. (i.e. it could run into late 2021 or early 2022.) Both the market participation propensities (except for the New York boys buying up the cheap shares next year) and gains distribution would be 'dumbbell like' if this were to occur you see.

The question then arises, 'why will precious metals shares begin to outperform again in 2015 if ETF's are still available?' The answer is two sided. First, I expect bullion sales to be restricted to the public by then, leaving paper alternatives as the only means available for your average village idiot to participate. (i.e. meaning don't be a village idiot and get your bullion now before it's too late.) And second, bullion prices should be rising faster than input costs as a result of newfound scarcity for precious metals. Such conditions should work like a charm to get people's attention because they want what they can't have the most, which will do wonders for the market from a psychological perspective.

So, don't worry about all the so called 'experts' running around telling you precious metals are going to crash now, because this is not going to happen. In fact, even though the ratios (think HUI / Gold, HUI / SPX, etc.) are only to have counter-trend moves higher in coming months, this does not mean the commodities themselves cannot go to new highs. Again, watch gold at $1800 and silver at $34. Once these thresholds are surpassed, new highs should not be too far behind.

Good investing all.


Author: Captain Hook

Captain Hook

Treasure Chests is a market timing service specializing in value-based position trading in the precious metals and equity markets with an orientation geared to identifying intermediate-term swing trading opportunities. Specific opportunities are identified utilizing a combination of fundamental, technical, and inter-market analysis. This style of investing has proven very successful for wealthy and sophisticated investors, as it reduces risk and enhances returns when the methodology is applied effectively. Those interested in discovering more about how the strategies described above can enhance your wealth should visit our web site at Treasure Chests.

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