Thursday, December 19, 2013

Watch the Volume At the Top- S&P 500 Price/Volume Heat Map Dec. 18

Yesterday's move in equities probably gave Bernanke a boost to his machismo, as it apparently validated the Fed's whole QE efforts. Following the fed announcement for a cut of $10 billion/month in QE, equity prices exploded, ultimately culminating in a total gain of about 1.7% in the S&P 500.

Yesterday's gain came on wide price spread and accelerated volume, in of itself suggesting that equity prices still have life in them. In another case of you probably do not need to look, the price/volume heat map reflects the price strength with demand higher across the board.

Looking ahead, I will be watching today's price action closely. Not only did the S&P 500 close near the highs of the day, a positive signal, but it also closed pretty much near/at the all-time high. This would mark the third time the S&P 500 retested the high water mark. If equity prices cannot push through this level it would suggest major selling resistance at this level. More so, the inability of equity prices to push through the high may be a tell in of itself. Additionally, I am unsure if yesterday's was wholly a bullish signal. Yes, the tapering action removed uncertainty, which traders abhor, but yesterday's action also looks like a regressive action. Remember,  the removal of the tapering uncertainty followed a trading environment where equity prices fell in the last four days out of five. We were bound for a snap-back and why not now. You should also note that the sector with the largest percentage gain was healthcare, gaining 2.5%. Healthcare stocks had taken it on the chin in the recent, shallow, four day pullback, and the large price gain in sector lends itself to the conclusion that yesterday's actions were a regressive move. Definitely a lot to watch in today's trading.

Wednesday, December 18, 2013

Inflation Is Like Sun Burn

Volume Off the High- Dec. 17 Trading Day Edition

So what happened to the Dec. 16 Volume Off the High post? Well, no names hit the screens I follow or passed any smell taste, hence no Dec. 16th post. This is the first time this has occurred in a while. However, I would not read anything into it, per se. Turning to the most recently ended trading day, one name of interest is FDS. The financial services company reported earnings that were light of estimate and traders bashed the shares. It appears that stock has broken the support at about the $109 level. This portends that the stock may test price levels below $100 per share.

High Volume High- Dec. 17 Trading Day Edition

I was going over the list from yesterday's trading and was trying to pick out at least one name that holds some level of interest. I failed. The best company fitting the bill in my mind was CFX, which held its analysts day yesterday and gained on increased investor interest. That said, KFN gained after the announcement it was being acquired KKR, an acquisition that has garnered some debate considering KFN essentially controlled KFN. May be something of interest here (on the long or short side) but I do not know enough to saying anything even partially intelligent.

All That Glitters, Is Not Gold- Housing Market Setting Up for Another Crash

The below blogpost by Economatters highlights the many looming risks that many are disregarding in the latest stabilization in the housing market. One area not addressed, how much of the at-the-margin demand from investors for real estate has been driven by Fed-induced low interest rates? What will happen if and when rates turn and cap rates go against this group? 

By Economatters

All that Glitters, is not Gold

The housing market appears to be in better shape than it really is and investors should be wary regarding investing in Housing stocks, investing in property not as a primary residence, and should conduct a thorough analysis of their own financial obligations with regards to their primary residence.

In many parts of the world real estate prices have risen quite substantially due to several factors, one is foreign buyers trying to move money out of their home countries for security purposes. Another is institutional investors hoping to buy low and sell high in an investment strategy, and then there are the small to medium size professional flippers who buy properties, make some cosmetic changes, and hope to sell these properties into an improving market because supply is artificially tighter, and the broader economy is better than when they originally purchased the properties. 
Macro Headwinds
However, there are a couple of macro dynamics that are going to provide significant headwinds for the housing market. One is taxes, and all the financial obligations that are rolled up into property taxes. As governments continue to spend more and more, local as well as state, jurisdictional, and federal the fundamental result is that property taxes continue to rise on real estate.
The property taxes are the real killers in real estate because a homeowner can even diligently pay off their mortgage and owe nothing on their home (which is becoming rarer these days), but still even in these best of circumstances the future property tax obligations are going to catch up to the homeowners as their income shrinks once they retire. 
Subsequently these individuals incomes shrink drastically, but the property taxes continue to escalate as these local and state jurisdictions need to get more money to support poor fiscal spending policies, and eventually homeowners have to sell their homes because they cannot afford a decade`s worth of property taxes. 
Fortunes Acquired Elsewhere Often Get Lost in Real Estate Market Crashes
The more expensive the real estate the higher the taxes which when the tide goes out in the economy, and people become overextended, then they have to start dumping real estate, and inevitably there is a huge margin call that runs through all financial assets, and hits real estate especially hard. 
Many multi-millionaires have lost most of their net worth mainly due to an overextension on real estate when times are good to find that the haircut on these properties when they need to sell via a fire sale just cripples them financially. 
The dynamic is as follows: They need to sell, but there are many people in this boat, the few buyers out there get spooked, prices fall sharply, but they still need to sell, so these sellers are forced to take 50 to 60% losses on these properties. There goes all the stored wealth like a vanishing mirage that the investors were trying to protect by investing in hard assets – it is really a vicious, pernicious cycle that repeats itself over and over in the real estate market.
Foreigners Not Exempt
This applies to foreign buyers as well, when they need the money during a reset in other financial areas, they are not going to be able to afford the property taxes on these properties, and local jurisdictions constantly needing more money, and effectively raising these property taxes every year, only makes the problem worse, and sets up the future drivers for the inevitable crash in real estate. Ironically, this results in the local jurisdictions not collecting any taxes at all on the properties for substantial time periods. 
Therefore, many foreigners who think that real estate in first world countries are safe and secure wealth storage vehicles when they buy at the top of the market with these offshoring strategies can lose 60% and more of their net worth in a market crash. 
This is one of the downfalls of all cash transactions when buying real estate at elevated market levels. Investors can walk away from mortgages like they did in 2007, but with 20 and 30% down payments to secure loans these days from banks; it is still a substantial loss for investors on any market re-set.
Foreigners all hiding money away in these properties are in for a rude surprise when they calculate their future tax obligations over just a ten year period. These people may or may not be able to afford the real estate on a long-term basis, but most of these people will definitely not be able to afford the property taxes on these purchases on a long-term basis without a consistent, perpetual revenue stream.
Likewise, since many of these financial resources were acquired in less than legitimate ways, these revenue streams are not consistently perpetual in nature which is required to meet perpetually consistent tax obligations at elevated levels on expensive real estate. 
Affordability Issues
The other problem is that property prices in several parts of the country are too high relative to incomes, think in terms of the two coasts, but there are many other areas as well. This means consumers are paying too high a percentage of their disposable income on housing. 
This always means that the market will eventually have to reset, or be forced to reset because any small change in the local labor market causes disproportionate reverberations in the real estate values, and substantially increases the likelihood of add-on contagion which severally makes these markets susceptible to large price drops in value for these expensive real estate markets. In short, you get a market crash in real estate values like we had in 2007. 
 Demographic Shifts 
The final worry is that with the large population of baby boomers now retiring, many of these individuals will soon realize that they don’t have the nest egg they thought they had once their incomes are reduced because they are no longer working full time.  
 Once they start factoring in property taxes for 15 years on higher appraised values for their homes, and they always go up for tax purposes, and the fact that comps are artificially high because home owners have to make major investments in their homes to market these properties, thereby raising taxable obligations on all homeowners in the process even though most homes haven`t been upgraded. Many of these baby boomers are going to be forced to sell their homes, and turn to the rental market so that they can live off the home equity that they have built up over the years. 
This dynamic and macro driver would be very bearish for the real estate market, more supply means market saturation, and this leads to lower prices, which just reinforces the deflationary cycle causing other deflationary outcomes in the overall local economy. The baby boomer demographics are not favorable for the housing market, and this is a negative for the industry as a whole.
Final Thoughts
There are opportunities in the real estate market, but unfortunately most people don`t understand the importance of having cash on the sidelines waiting for these inevitable market crashes to buy at fire sale prices. Most investors get tied up in investments trying to get a return that they get stuck, and when the market crashes and properties are 70% off of their highs; this is the time to buy real estate. 
However, the trick is have the cash available, and not tied up in other illiquid investments. And investments can be illiquid for a myriad of reasons, such as usually liquid investments being heavily underwater due to the same market forces that are causing the housing market to crash. 
Cash truly on the sidelines is an undervalued investment principle, and one of the hardest long-term investment strategies to learn. Investors are always thinking about returns on an annual basis instead of sitting on cash and being in the position to buy when there are no buyers in markets.
Investors need to factor in the value of market timing in an investment strategy that focuses on long-term returns over a 10-year time period. Investors are so worried about 5% returns on their portfolios and beating inflation that they miss the 70% returns in 16 months type investments because they had no cash on the sidelines available for these market crash opportunities.

Sprott Money News With David Morgan- All Fiat Currencies Fail

Mirror, Mirror- S&P 500 Price/Volume Heat Map Dec. 17

I am unsure if we need a lot of rhetoric and details here. For one, volume and activity is beginning to slow, partially as a result of the approaching Christmas holiday. Second, many if not most traders, investors, and the markets as a whole sit on their proverbial hands awaiting the 'results' of the Fed's December meeting. This leaves us with a lot churn, but in the end signifying noise.

Just look at the price/volume heat map in regards to last Friday's (Dec 13th) heat map. In a way, they are largely reflections of each other. On Friday, the market gained with a lack of demand support, and yesterday the market fell on an overall lack of supply. That said, potentially Earth moving faults may be ready to slip under the proverbial crust of the market of here. So far Q4, negative preannouncements outpace positive guidance by a factor of about 11-to-1. This while we see warnings concerning medium term earnings growth (see Hussman's latest commentary) all the while the economic growth remains tepid at best.

If You Have Children, You Need To See These Numbers

By Simon Black of the Sovereign Man Blog

According to a recent survey by the Pew Research Center, just 33% of Americans think their children will have a better life than they did. On the other hand, 62% believe their children will be worse off.
They’re likely to be right.  The typical American family has seen its real income (adjusted for inflation) fall for 5 consecutive years now, and it earns less in real terms that it did in 1989.
According to the Census Bureau, median household income fell in 2012, and it languishes 8.3% below the pre-crisis peak in 2007. 
The Brookings Institution, meanwhile, calculates that real incomes for working-age men in the US have fallen by 19 per cent since 1970.
(Of course, if you’re fortunate enough to be a member of the super-rich who, thanks in large part to central bankers driving up asset prices, saw their real incomes rocket by 20% in 2012.)
In Europe things look even more dire.  Just 28% of Germans think their children will be better off than they were.  In the UK it’s 17%, in Italy 14%, and in France just 9%. 
In Britain, research by the Financial Times shows that those born in 1985 are the first cohort to suffer a living standard worse than those born 10 years before them. 
Contrast this gloomy picture with China, where 82% think their kids will have it better than they did. In Nigeria, the number is 65%. In India, 59%. 
It’s blatantly obvious that the West is in decline. And most people seem to understand this.
But this isn’t a bad news story. Wealth and power has constantly shifted throughout history. Five hundred years ago, it was the West that was rising and Asia in decline. Today it’s the exact opposite.
As Jim Rogers has said so many times before, if you were smart in the 1700s, you went to France. If you were smart in the 1800s, you went to England. And in the 1900s, you went to the US.
Today, it’s the developing world. That’s where the long-term opportunity is-- Asia, Africa, and South America.
What’s happening in the developing world is nothing short of remarkable. One billion people are being pulled from the depths of poverty into the middle class... bringing with them untold possibilities for business, employment, and investment.
That’s one of the reasons why I travel so much, and why I spend so much time in Chile. I’m constantly amazed at the tremendous opportunities I come across in this country (which is still largely off the radar of most people).
It’s also what I encourage my students to do each summer at our entrepreneurship camps—seek out opportunities in countries that are rising suns, not setting suns.
If you have children, this is a great direction to influence them. Encourage them to learn another language, travel, and apply what they want to do to how the world is going to be in the future.
As Wayne Gretzky said, skate to where the puck is going to be.

Why Government Data is Useless- The Continuing Conversation Between Biderman and Bianco

Many of the issues brought up by the pair are well known, if you have been looking and have been paying attention. However, you should be in awe of how vast the problem really is. And many say Chinese economic statistics are lower quality.

Tuesday, December 17, 2013

How the Paper Money Experiment Will End

By Philipp Bagus and origninally posted to

A paper currency system contains the seeds of its own destruction. The temptation for the monopolist money producer to increase the money supply is almost irresistible. In such a system with a constantly increasing money supply and, as a consequence, constantly increasing prices, it does not make much sense to save in cash to purchase assets later. A better strategy, given this senario, is to go into debt to purchase assets and pay back the debts later with a devalued currency. Moreover, it makes sense to purchase assets that can later be pledged as collateral to obtain further bank loans. A paper money system leads to excessive debt.
This is especially true of players that can expect that they will be bailed out with newly produced money such as big businesses, banks, and the government.

We are now in a situation that looks like a dead end for the paper money system. After the last cycle, governments have bailed out malinvestments in the private sector and boosted their public welfare spending. Deficits and debts skyrocketed. Central banks printed money to buy public debts (or accept them as collateral in loans to the banking system) in unprecedented amounts. Interest rates were cut close to zero. Deficits remain large. No substantial real growth is in sight. At the same time banking systems and other financial players sit on large piles of public debt. A public default would immediately trigger the bankruptcy of the banking sector. Raising interest rates to more realistic levels or selling the assets purchased by the central bank would put into jeopardy the solvency of the banking sector, highly indebted companies, and the government. It looks like even the slowing down of money printing (now called “QE tapering”) could trigger a bankruptcy spiral. A drastic reduction of government spending and deficits does not seem very likely either, given the incentives for politicians in democracies.

So will money printing be a constant with interest rates close to zero until people lose their confidence in the paper currencies? Can the paper money system be maintained or will we necessarily get a hyperinflation sooner or later?

There are at least seven possibilities:

1. Inflate. Governments and central banks can simply proceed on the path of inflation and print all the money necessary to bail out the banking system, governments, and other over-indebted agents. This will further increase moral hazard. This option ultimately leads into hyperinflation, thereby eradicating debts. Debtors profit, savers lose. The paper wealth that people have saved over their life time will not be able to assure such a high standard of living as envisioned.

2. Default on Entitlements. Governments can improve their financial positions by simply not fulfilling their promises. Governments may, for instance, drastically cut public pensions, social security and unemployment benefits to eliminate deficits and pay down accumulated debts. Many entitlements, that people have planned upon, will prove to be worthless.

3. Repudiate Debt. Governments can also default outright on their debts. This leads to losses for banks and insurance companies that have invested the savings of their clients in government bonds. The people see the value of their mutual funds, investment funds, and insurance plummet thereby revealing the already-occurred losses. The default of the government could lead to the collapse of the banking system. The bankruptcy spiral of overindebted agents would be an economic Armageddon. Therefore, politicians until now have done everything to prevent this option from happening.

4. Financial Repression. Another way to get out of the debt trap is financial repression. Financial repression is a way of channeling more funds to the government thereby facilitating public debt liquidation. Financial repression may consist of legislation making investment alternatives less attractive or more directly in regulation inducing investors to buy government bonds. Together with real growth and spending cuts, financial repression may work to actually reduce government debt loads.

5. Pay Off Debt. The problem of overindebtedness can also be solved through fiscal measures. The idea is to eliminate debts of governments and recapitalize banks through taxation. By reducing overindebtedness, the need for the central bank to keep interest low and to continue printing money is alleviated. The currency could be put on a sounder base again. To achieve this purpose, the government expropriates wealth on a massive scale to pay back government debts. The government simply increases existing tax rates or may employ one-time confiscatory expropriations of wealth. It uses these receipts to pay down its debts and recapitalize banks. Indeed the IMF has recently proposed a one-time 10-percent wealth tax in Europe in order to reduce the high levels of public debts. Large scale cuts in spending could also be employed to pay off debts. After WWII, the US managed to reduce its debt-to-GDP ratio from 130 percent in 1946 to 80 percent in 1952. However, it seems unlikely that such a debt reduction through spending cuts could work again. This time the US does not stand at the end of a successful war. Government spending was cut in half from $118 billion in 1945 to $58 billion in 1947, mostly through cuts in military spending. Similar spending cuts today do not seem likely without leading to massive political resistance and bankruptcies of overindebted agents depending on government spending.

6. Currency Reform. There is the option of a full-fledged currency reform including a (partial) default on government debt. This option is also very attractive if one wants to eliminate overindebtedness without engaging in a strong price inflation. It is like pressing the reset button and continuing with a paper money regime. Such a reform worked in Germany after the WWII (after the last war financial repression was not an option) when the old paper money, the Reichsmark, was substituted by a new paper money, the Deutsche Mark. In this case, savers who hold large amounts of the old currency are heavily expropriated, but debt loads for many people will decline.

7. Bail-in. There could be a bail-in amounting to a half-way currency reform. In a bail-in, such as occurred in Cyprus, bank creditors (savers) are converted into bank shareholders. Bank debts decrease and equity increases. The money supply is reduced. A bail-in recapitalizes the banking system, and eliminates bad debts at the same time. Equity may increase so much, that a partial default on government bonds would not threaten the stability of the banking system. Savers will suffer losses. For instance, people that invested in life insurances that in turn bought bank liabilities or government bonds will assume losses. As a result the overindebtedness of banks and governments is reduced.

Any of the seven options, or combinations of two or more options, may lie ahead. In any case they will reveal the losses incurred in and end the wealth illusion. Basically, taxpayers, savers, or currency users are exploited to reduce debts and put the currency on a more stable basis. A one-time wealth tax, a currency reform or a bail-in are not very popular policy options as they make losses brutally apparent at once. The first option of inflation is much more popular with governments as it hides the costs of the bail out of overindebted agents. However, there is the danger that the inflation at some point gets out of control. And the monopolist money producer does not want to spoil his privilege by a monetary meltdown. Before it gets to the point of a runaway inflation, governments will increasingly ponder the other options as these alternatives could enable a reset of the system.

High Volume High- Dec 16th Trading Day Edition

A number of acquisition related names on the latest high volume high list. One non-acquisition related name though is XOM, which caught an upgrade from the Street. XOM's upgrade probably had a lot to do with the overall gains in the energy sector and the market as a whole. Although and I pointed out in the latest price/volume heat map report, there was not a tremendous amount of depth in the energy sector gains.

A Turn In the Silver and Gold Markets- What To look For

An interview with David Morgan.

Divergences, Divergences- S&P 500 Price/Volume Heat Map Dec. 16

In yesterday's trading, the S&P 500 gained roughly 60 basis points, primarily on gains in the tech industry and industrials.

Looking at the price/volume heat map, however, does not give such a sanguine picture of trading. At least as total demand across the market is concerned. Of the ten sector groups, only four posted overall strongly positive demand on the trading day, with strong demand defined as stock with strong volume and price gains occurring concurrently. The four sector groups were financials, tech, industrials, and utilities. So why the stronger gains, my take it was a lack of selling pressure, as the supply-side of coin looked weak. More so, some of the stronger sector groups on a price basis, were not necessarily supported by broad demand. These groups include discretionary and energy names. Lastly, I would note that total volume contracted significantly on the trading day. To me, this all suggests the current rally has no underlying strength.

Faber- The Fed Will Never End QE

Fed Inflated Hall of Mirrors- Grant

The environment just feels more and more like 2007/2008.

QE Tapering- A Historical Perspective (Repost)

With taper talk once again building..... I thought this historical perspective should not be forgotten. 

Back in 1999, Alan Greenspan floated $40 billion in monetary supply for the sole purpose of providing extra liquidity to avert any problems potentially associated with the change in the calendar to the year 2000, or Y2k. Below you will find the chart of the year-over-year change in the monetary base versus the similar perspective for the NASDAQ for the period between January 1999 through late-2000.

See a pattern here. An overheated market whose upward acceleration was goosed by extraordinary monetary stimulus subsequently crashes after that stimulus is removed. More appropriately, just $40 billion is removed. I would not be as bold as to predict an impending market crash here and now, as no one is predicting an outright reduction in the monetary base. However, if a $40 billion reduction in monetary base led to a 10%+ crash in the NASDAQ, what sort of volatility could one expect with $10 billion to $15 billion a month reduction in QE?

Taper Talk With Biderman and Bianco

A great conversation. Soak it in a think about what a tapering means. And as I have shown, money coming out of or not expanding the Fed's balance sheet will hit asset prices.

Monday, December 16, 2013

Let's Get Physical- Tocqueville's Hathaway

Money printing by world central banks, it would seem, has propelled the prices of all things rare. The list includes fine art, vintage wines and antique sports cars. It is front page news that the flood of paper money has enhanced the quotation of almost any tangible asset perceived to be in scarce supply. In a 11/23/13 article, The Economist reports: “Evermore wealth is being parked in fancy storage facilities….The goods they stash in freeports range from paintings, fine wine and precious metals to tapestries and even classic cars.” The article observes that a key factor fuelling “this buying binge…is growing distrust of financial assets.” It doesn’t hurt that the prices of most of these items have trended steadily higher in price over the past decade.

Most intriguing in this array of ascendant alternative assets, however, is the crypto currency known as Bitcoin, whose advocates offer a rationale that is striking in its parallel to that for holding gold bullion. Bitcoin, as almost everyone knows, is a liquid transactional medium of strictly limited supply. The parallel breaks down, of course, when it comes to price behavior of these two otherwise similar alternative currencies. The price of a Bitcoin has increased to $975/coin (Mt. Gox 12/10/13) from less than $25 in May 2011. At the end of May 2011, bullion traded near $1500/oz, and is quoted today at a price that is 17% lower.

The supply of gold has increased over the past two years by 180 million ounces. As an increment to the existing stock of above ground gold, the percentage works out to about 1.5%/year. In the meantime, the US monetary base increased 14%, or an annual rate of 6.7%.

The supply of Bitcoins is fixed at 21 million. There are 11.5 million in circulation. Mining new Bitcoins requires incrementally more massive upgrades in computing power. According to Raoul Pal’s Global Macro Newsletter of 1/11/13 as seen on Zero Hedge, Bitcoin’s success is due to the fact that “the man in the street understands that central banks and governments are going to take their money via confiscation or default or devaluation and it (Bitcoin) is their way of voting against it and them.”

The man in the street has apparently overlooked the similarities between gold and Bitcoin. The future supply of newly mined gold would seem to be in jeopardy if current pricing holds. The same cannot be said for US dollars. While mine output may continue for a year or two at the current pace, production post 2015 seems set to decline and perhaps sharply. Discovery of new gold bearing ore bodies is down sharply. Miners are challenged by declining grades, poor investment returns, worsening access to capital, and increasing risks due to political instability in gold producing countries, rising tax burdens and growing permitting challenges. At current prices, most gold mining companies are barely breaking even on an “all-in” cost accounting basis.

The Bitcoin-gold incongruity is explained by the fact that financial engineers have not yet discovered a way to collateralize bitcoins for leveraged trades. There is (as yet) no Bitcoin futures exchange, no Bitcoin derivatives, no Bitcoin hypothecation or rehypothecation. In 2000, gold expert Jeff Christian of the CPM Group wrote:

Imagine, if you will, that the (bullion) bank can line up three or more producers and others who want to borrow this gold. All of a sudden, that one ounce of gold is now involved in half a dozen transactions. The physical volume has not changed, but the turnover has multiplied. This is the basic building block of bullion banking.” (Bullion Banking Explained – February 2000). He went on to say that “many banks use factor loadings of 5 to 10 for their bullion, meaning that they will loan or sell 5 to 10 times as much metal as they have either purchased or committed to buy. One dealer we know uses a leverage factor of 40.
The buying and selling of paper gold is the traditional business of bullion banking. It is the core of how business is conducted in the world of gold. Gold miners mine and concentrate gold ore. They send concentrates from the mine site to refiners who purify the ore into bars that are 99.99% gold. Refiners remit cash to the mining companies crediting them for gold content in the ore minus impurities. Refiners sell their gold bars, typically to bullion banks in London, where the physical gold is received for deposit in allocated or unallocated pools and held for distribution to users such as the jewelry trade, industry or mints. The physical gold that remains in London as unallocated bars is the foundation for leveraged paper gold trades. This chain of events is perfectly ordinary and in keeping with time honored custom.

What is interesting, and perhaps not surprising, is the way in which a solid business model has been perverted by extraordinary leverage into an important, unregulated trading profit center for large banks and hedge funds wholly unrelated to the needs of miners, jewelry manufacturers, and other industrial users. In its 2013 study related to gold, the Reserve Bank of India (RBI) commented: “In the Financial Markets, the traded amount of “paper linked to gold” exceeds by far the actual supply of physical gold: the volume on the London Bullion Market Association (LBMA of which the RBI is a member) OTC market and the other major Futures and Options Exchanges was over 92 times that of the underlying Physical Market.”

The LBMA reported that average daily volume of gold cleared in June 2013 was 29 million ounces, a new record. The LBMA estimated in 2011 that trading was 10x clearing volume. Assuming this ratio has held over the past two years, trading volume is the equivalent of 9000 metric tons of gold on a daily basis, compared to annual mine production of 2800 metric tons.

Compliant and unwitting central banks leave much of their gold on deposit in London, to be “managed” by the Bank of England, presumably to produce earnings on an otherwise dormant asset. For example, the central banks of Finland and Sweden announced last month that approximately half of their gold was somewhere in London earning something. Reassuring language from the Bank of Finland suggested that “the risks associated with gold investments are controlled using limits, investment diversification and limitations regarding run times.”

It would not be surprising if “run times” on leasing arrangements of central bank gold span decades. 1970’s documents recently declassified or otherwise unearthed contain extensive discussions among high level policy makers including Volcker, Kissinger, Arthur Burns and others expressing various concerns over the implications of a rising gold price. The policy objective in those days was to establish the SDR and the US dollar as the foundation of a “durable, stable (international financial) system”, an objective which was deemed “incompatible with a continued important role for gold as a reserve asset.” It was therefore resolved to “encourage and facilitate the eventual demonetization of gold …and (to) encourage the gradual disposition of monetary gold through sales in the private market.” (from a 1974 memo written by Sidney Weintraub, Deputy Assistant Secretary of State for International Finance and Development to Paul Volcker, Under Secretary of the Treasury for Monetary Affairs).

At the November, 2013 Metals and Mining Conference in San Francisco, keynote speaker Ron Paul and former lawyer to Governor Ronald Reagan, Art Costamagna, reminisced about their service together for the 1981-1982 Reagan Gold Commission. They noted that the Commission was not allowed to initiate an audit of the Fort Knox gold depository. Paul stated from the podium that no member of Congress has any real information on the status of that gold. He believed that the gold was still physically located at Fort Knox but most likely encumbered by complex derivative transactions.

Several observers have noted the difficulty Germany has encountered in requesting the repatriation of its gold held on deposit at the New York Fed. A return of physical gold that could be easily accomplished in two trans-Atlantic cargo flights must be stretched out over seven years, Germany was informed by the custodian of their gold, the New York Fed. However, the Germans were cordially invited to view their gold bars in the meantime. The reasons for the stretched out delivery schedule are not given by government officials, but we surmise that the difficulty relates to the unwinding of a web of leasing arrangements in which specific bars have been re-hypothecated, perhaps hundreds of times, over many decades. Who knows what counter parties were involved, not to mention their obligations or responsibilities?

One wonders whether the German request was the beginning of a run on the institutional arrangements that govern global depositories of unallocated physical gold. For those of us who have cheered the withdrawl of physical collateral from the system because of its potential tightening effect on derivative transactions, the short term effect may have been to depress the price of paper gold because there is less physical to support the frenetic trading of paper reported in the financial media. The shrinkage of collateral availability may be analogous to a contraction of credit which in a general sense drives down asset prices. At the end of credit liquidation cycles, however, collateral seems to wind up in the strongest hands. While most of the trading in paper gold nominally takes place on Comex, there is a parallel and much larger over the counter and derivatives market based in London where physical trades are also settled. The LBMA vets refiners, dealers, bar purity and other technical matters. It is a trade organization consisting of 143 members ranging from bullion banks, central banks, fabricators, refiners, and brokers who have some participation in the settlement of physical and paper trades. LBMA reports the results of the two daily London Gold Fixes but otherwise has no substantive input, supervisory or regulatory. According to a 11/26/13 Bloomberg dispatch, the fix is controlled by London Gold Market Fixing Ltd, an entity owned by five bullion banks. While the process is unregulated, one of the member banks went on the record for Bloomberg stating that the company has a “deeply rooted compliance culture and a drive to continually look toward ways to improve our existing processes and practices.”

From a regulatory point of view, the City of London is an entity unto itself, with a peculiar and special status, incorporated separately from greater London. It is the birthplace of the offshore banking industry and, as described by Nicholas Shaxson, author of Treasure Islands, the city “provides endless loopholes for U.S. financial corporations and many U.S. banking catastrophes can be traced substantially to those companies’ London Offices.” A July, 2010 Working Paper titled “The (sizable) Role of Rehypothecation in the Shadow Banking System” asserts that in the UK, an “unlimited amount of the customer’s assets can be rehypothecated and there are no customer protection rules.” (Rehypothecation occurs when the collateral posted by a prime brokerage client (e.g., hedge fund) to its prime broker is used as collateral also by the prime broker for its own purposes.) The London offices of AIG, JP Morgan, MF Global and others took advantage of the local “regulation lite” to fund off balance sheet ventures that would ultimately impair corporate and customer credit. It would be hard to imagine that the culture of the City did not extend to gold. In fact, the intersection of the shadow banking system and the pool of unallocated bullion does much to explain the proliferation of paper gold supply.

For the moment, the primary function of the paper gold market appears to be to enable macro hedge fund traders to express bets on the likelihood and timing of tapering the pace of quantitative easing. Made possible by lax oversight, weak accounting systems and otherwise dubious connections to underlying physical, the paper gold market offers substantial capacity for money flows wishing to take a stance on the expected shift in Fed policy. Unlike the physical gold market, which is not amenable to absorbing large capital flows, the paper market through nearly infinite rehypothecation is ideal for hyperactive trading activity, especially in conjunction with related bets on FX, equity indices, and interest rates.

Are high frequency and algorithmic traders that account for over 90% of the futures volume currently having a field day with this worn out trade paying any attention to the steady drain of physical gold on which their speculations are based? As is usually the case in a temporarily successful momentum trade where almost the entire universe is aboard, the answer is probably not. The precipitous 2013 drop in Comex warehouse stocks and ETP holdings has been widely reported. It is also well known that physical gold is showing up in record amounts in China. The manager of one of the largest Swiss refiners stated (12/10/13-In Gold We Trust website) that after almost doubling capacity this year, “they put on three shifts, they’re working 24 hours a day,….and every time (we) think it’s going to slow down, (we) get more orders…..70% of their kilo bar fabrication is going to China.” In his 37 years in the business, he has never experienced this degree of difficulty in sourcing physical metal. In some cases, they are recasting good delivery bars from the 1960’s. He added that there is no evidence of any return of these massive import flows back into Western hands.

China appears to be bent on becoming a dominant force in the physical gold market. There are eight refineries in mainland China converting 400 oz. London good delivery bars into Kilo bars, the preferred format in Asia. An increasing flow of physical is bypassing London and going straight to China. China has not shown its hand in the official sector. At last report (five years ago), China holds only 1000 tonnes of gold in official reserves. Current market weakness certainly benefits large buyers of physical as well as their fiscal agents in Western financial markets. China may be attempting to help their cause by understating import levels and by overstating domestic production. The CEO of a major Canadian mining company, whose research group has done due diligence on every existing producing mine of significance in the world, including China (over 2000 properties globally) believes that domestic Chinese production is less than half of what is reported officially. We have also heard credible stories from other mining executives to the effect that short reserve lives will mean a significant decline in future domestic production. Also uncaptured in Hong Kong import numbers are direct shipments from Russian production, which are said to be conveyed by the Chinese military. The Chinese government continues to encourage its citizens to buy physical gold, but why? Our guess is that Chinese policy makerss take a different view of the future price than Western hedge funds, and we suspect they have a superior grasp of where the gold price is headed.

Rising demand for physical is not simply an Asian phenomenon. The December 3, 2013 U.S. Commodity Futures Trading Commission report shows that commercials, the category which includes bullion banks, have substantially reduced their massive short exposure over the past year while the short exposure of large traders, mainly hedge funds have approached record highs for 2013. The CFTC bank participation report which includes 20 banks shows a swing from a net short position in December 2012 of 106,400 contracts to a net long position of 57,400 contracts for December 2013. Long contracts held by bullion banks are being used to claim physical gold stored at Comex warehouses. JP Morgan accounted for more than 90% of December deliveries. The category of registered bars which must be delivered upon notice stands at a two year low and is not far from a ten year low.

 It seems to us that the physical flows we have outlined cannot be supported by new mine supply or scrap only. In our view, these flows could only be accommodated by a significant amount of destocking, the prime source of which would appear to be vaults of unallocated gold in London. While it appears that Western traders don’t seem to mind if their paper claims have a credible backing by physical, we can think of three reasons why this may change and lead to an epic short squeeze: regulatory scrutiny, suspect bookkeeping, and the realization that cash (in the bank) may no longer be king.

1.   The limits to leverage are unknown as are the potential flashpoints to collapse the pyramid. The disappearance of collateral may have depressed gold prices in the short term, assuming there is any integrity to the requirements for collateral backing. It is only our speculation, but we believe that increased regulatory scrutiny could provide a major splash of cold water. Such scrutiny could lead, among others things, tighter standards for collateral, rules on rehypothecation, etc. This could well lead to a scramble for physical.
On 11/19/13, the UK Financial Conduct Authority announced that it is reviewing gold benchmarks as part of their wider probe on how global rates are set. Why should the gold market be excluded from review when many of the bullion banks have already been found guilty and paid fines for the manipulation of Libor, energy, biofuels, and aluminum prices or benchmarks? On November 27th, the German financial watchdog, BaFin, announced it was looking into allegations of possible manipulation by banks in gold and silver price-fixing. A WSJ 11/29/13 article began with the innocuous headline: “UBS to Restructure Foreign-Exchange Unit.” The bank is rolling its foreign-exchange and precious metals business into another unit, with the co-head of the unit stepping down to explore “other opportunities in the bank.” In addition to other actions, the bank has also “clamped down on the use of electronic chat rooms by its staff. Chat rooms face scrutiny from regulators as venues for potential collusion and market manipulation.”
On December 5th, Deutsche Bank announced that it would cease trading energy, agriculture, base metals, coal, and iron ore, while retaining precious metals and a limited number of financial derivatives traders. It cited mounting regulatory pressure.” It is more than curious that a similar announcement from JP Morgan in July of 2013 noted that the bank’s exit from commodities trading did not include an exit from precious metals. The exclusion of gold from the newly enacted Volcker rule is the reason these banks are able to retain their precious metals proprietary trading activities.  It appears that in the eyes of Washington policy makers, all commodities are not created equal.
In the US, regulators including the US Federal Energy Regulatory Commission are “aggressively targeting uneconomic trading in a crackdown on potential market manipulation” according to Shaun Ledgerwood, senior consultant at the Brattle Group. From his June 2013 white paper, Uneconomic trading, market manipulation and baseball: “A key common feature …is that trades used to trigger the alleged schemes were designed to lose money on a stand-alone basis, while benefiting related physical or financial positions.”
The CFTC is examining position limits on spot trades for gold and other precious metals. CFTC Commissioner Gensler’s deadline for a resolution of the issue is Q1 2014. Among the issues to be settled is how to account for entry of orders by affiliated entities, an area of suspected potential abuse. In question also is whether new Comex position limits, should they be imposed, apply to trades settled in London. The CFTC board is in transition due to the departure of Gensler and two other vacancies on the five member body. Therefore, it remains to be seen when the Commission will act on this issue. Nevertheless, we think that the discussion surrounding the surfacing of this issue is constructive and that the potential enactment of more restrictive rules on limits could be positive development in the direction of more orderly trading. It should come as no surprise that bullion banks are lobbying hard against position limits.
The cumulative discrepancy since 1970 between paper markets in the West and physical markets in the East is displayed in the chart below. It is difficult to fathom how such a discrepancy can exist in the same asset. It is a mystery that we expect might be of interest to the appropriate regulators.

Where scrutiny and possible new regulation leads and what it means for the gold market is only a speculation at this stage. However, we speculate that it will result in a big win for those of us who remain bullish on the future price. In the words of former Supreme Court Justice Louis Brandeis, “sunlight is the best disinfectant.”
2.   The intermediation arrangements between the physical and paper gold markets may come under scrutiny for reasons other than regulatory oversight. The LBMA, Comex, and even gold backed ETFs depend on market trust in the ability of owners of paper claims to exchange those claims for physical gold. For unallocated bars vaulted in London, the complexity of cross ownership claims and entitlements to the underlying physical must be bewildering in light of the amount of re-hypothecation necessary to support the kind of frantic trading activity reported by the LBMA. It would not seem out of order to ask whether there are parties asleep at the switch on both sides of the trade – the central banks who lease gold into the pool, and the bullion bank back offices in charge of record keeping. Cutting corners in procedures to protect the chain of ownership of physical to speed transactions to support a pyramid of leverage is not an unreasonable nightmare to awaken central bank custodians whose principal charge is asset protection. Does anyone in bullion banking recall robo mortgage signing?
The pool of unallocated gold bullion in London is the center of the bullion banking system. The gold is vaulted at multiple locations in the hands of separate institutions. Disclosure is minimal and to our knowledge there has never been a comprehensive audit of the bullion and, more important, the systems on which the clearing process is dependent. We have heard instances of where private requests for delivery of allocated gold have been refused. While it is a simple matter for an owner of allocated gold bars to view the metal and check bar numbers against a statement of ownership, it is an entirely different matter to prove solitary unencumbered ownership. It is a matter of trust.
We believe that the very real possibility of an indecipherable web of multiple claims on the same bar of gold should concern both central bank owners, grass roots constituents of politicians in Europe and elsewhere pushing for repatriation, and private investors who hold paper claims against the metal. The potential for slipshod book keeping is a legitimate issue that could lead to a significant decrease in the amount of central bank gold available for lease.
3.   The risk of holding a significant portion of personal wealth within the framework of conventional banking and securities arrangements is on the increase. Simon Mikhailovich of Eidesis Capital LLC states in the November 15 issue of Grant’s: “In the old framework, cash was a risk-free asset. In the new paradigm of systemic risks, no asset (even cash) is risk-free so long as it is in custody of a financial institution. Investors and depositors no longer have clear title to their own assets if they are held in financial accounts. There is now a body of law (including Dodd-Frank) that allows custodial assets to be swept into the bankruptcy estate and be subordinated to senior claims.” Hand in hand with the evolution of the banking laws is the subtle but pernicious evolution of the practice of banking: “Various rules and practices have made it almost impossible to use cash and securities. Go try to make large cash withdrawal or cash deposit and see what paperwork you would be forced to complete.”
Should we worry about cash in the bank? Never mind that policy makers and respected private economists are openly campaigning to debase paper currency. “In Fed and Out, Many Now Think Inflation Helps” was the headline for a New York Times article on 10/26/13. “(Fed) critics, including Professor Rogoff, say the Fed is being much too meek. He says that inflation should be pushed as high as 6% a year for a few years.” In addition, there are calls for outright taxes on wealth and movement towards a cashless society in which all money would be electronic. In his recent speech before the IMF, Lawrence Summers stated that electronic money would “make it impossible to hoard money outside the bank, allowing the Fed to cut interest rates to below zero, spurring people to spend more.” Cash and securities within banking and securities institutions are visible forms of wealth. Liquid private wealth captured in electronic form offers endless possibilities for wealth redistribution and other social engineering schemes. Tangible assets that are not securitized or digitized are less visible and therefore less vulnerable to broad edicts targeting private wealth.
The same Mr. Mikhailovich notes that during the financial crisis of 2008, public policy was mostly an ad hoc reaction to a cascade of emergencies. Since then, policy makers have had plenty of time to plan orchestrated responses to circumstances similar or worse. In a series of steps, many small and some large, almost always cloaked in complexity and obscurity, and always in the name of public interest or national security, policy makers have constructed mechanisms that are substantially and substantively unfriendly to private wealth:
Source: TBR

Western investors seem to view gold only as a directional bet based on considerations ranging from micro economic (supply and demand) to macroeconomic (money debasement, fiscal disorder etc.) In our opinion, this view only partially explains what drives long term gold demand. We have always thought that the larger and more encompassing driver was wealth preservation. Gold is insurance against unforeseen events. It is the one tangible asset that is both truly liquid and that can most reliably provide buying power during times of crisis. In this context, the idea of selling it for a “profit” seems absurd. Physical gold is a reserve of liquidity, and it seems inappropriate to think of it as a way to buy a container of milk or a gallon of gas under emergency conditions. For notional apocalyptic purposes, a carton of Marlboros or case of Glenfiddich is better suited than ingots or coins to pacify the hordes of barbarians at one’s doorstep. However, for preservation of large scale wealth over generations there is no substitute. Gold does what expensive homes, crates of Picassos, safe deposit boxes packed with Rolexes, or a garage full of Aston Martin DB 7’s cannot…..morph quickly and easily into liquid buying power, with no haircut, when it matters the most.

Paper claims on gold will always serve well for trading/ gambling purposes. For those who wish to make directional bets on the future gold price, bullish or otherwise, futures contracts, ETP’s, or other paper derivatives, there is no need to hold physical gold. In fact, one could categorically state that physical gold is not for traders. However, time and again throughout history, usually over a weekend, paper claims have been rendered non-functional, useless or worthless. Banks may shut down, securities exchanges may stop trading, wire transfers may be blocked, arrangements may be suspended, or laws may change. The rhyming of history is not limited to far away places such as Cyprus, Poland, or Ireland. Recall the words of President Nixon (Sunday, August 15, 1971):

In recent weeks, the speculators have been waging an all-out war on the American dollar….I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold….Let me lay to rest the bugaboo of what is called devaluation.
An article in The Wall Street Journal Op Ed piece on 11/29/13, Romain Hatchuel wrote: “From New York to London, Paris and beyond, powerful economic players are deciding that with an ever-deteriorating global fiscal outlook, conventional levels and methods of taxation will no longer suffice. That makes weapons of mass wealth destruction—such as the IMF’s one-off capital levy, Cyprus’s bank deposit confiscation, or outright sovereign defaults—likelier by the day.” The two year long decline in the gold price has been largely explained in terms of the likelihood of Fed tapering and by inference the return to normal economic conditions for the global economy. Nothing could be further off the mark, in our opinion. It seems to us that the decline, initially a reaction to an overbought spike hyped by headlines of a government shutdown in August of 2011, gained momentum as macro traders saw selling and shorting gold as a vehicle to express views on tapering, Fed policy, jobs reports, and the health of the US economy. It makes perfect sense that confidence in the restoration of normalcy in monetary policy would be bad for gold. It appears to us that the pressure on gold is part of a vast macro trade involving the dollar, interest rates and stocks, with a script that seems to rely in part on encouragement from the official sector and in part on pure fantasy. As the short game gathered momentum, vested interests in lower gold prices have become powerful and entrenched.

The money printing thesis has been supportive of almost every tangible asset deemed to be of limited supply except for gold, a glaring exception. The explanation for the incongruity, in our opinion, is warp speed rehypothecation via the shadow banking system of the murky pool of London’s unallocated gold to create artificial supply of this scarce asset. The murky pool which is the foundation for this trade is draining, perhaps quickly, while the party goes on for the gold bears. The set up for a short squeeze of this overcrowded trade and market reversal seems compelling. Catalysts are awaited and as yet unknown, but in our opinion, it will not take much of a spark to inflict serious damage. A reversal will lift not only the gold price but that of the beleaguered gold mining sector where substantive and positive change has been occurring unnoticed by most investors.

In the financial markets, a person that is one step ahead of the crowd is considered a genius, but two steps ahead, a crackpot. Call us the latter, or just resolute, but we hereby go on record as downgrading the sovereign debt of all democracies to junk status. It seems to us that restoration of sustainable fiscal order remains a long shot and that money printing, thought by most to be only an emergency measure, will become the norm. Our negative view on the prospects for fiat currency has not been invalidated by the steep two year decline in gold price. When the market reverses, the diminished physical anchor to paper claims, concerns over title and encumbrances on central bank bullion, and worries over the drift of public policy will drive liquid capital into gold. However, this time around, it seems to us that the major recipient of flows will be the physical metal itself. Holders of paper claims to gold will receive polite and apologetic letters from intermediaries offering to settle in cash at prices well below the physical market. To those who wish to hold their wealth exclusively in paper assets, implicitly trusting the policy elites to resurrect normally functioning capital markets and economic conditions, we say good luck. For those who harbor doubts on such an outcome, we say get physical.

Under the Surface.... With Treasuries

Roughly two months ago, I had treasuries were ripe for a rally. And they did, but ever so briefly, as treasury prices once again retested the lows of 2013. That said, treasury prices have failed to push through the 2013 lows. 

More so, the volume on the TLT (or the Ishares 20+ year treasury bond ETF and which I use here as a proxy for treasury prices) since mid-October has been generally decelerating. A pullback on decelerating volume which fails to push through the lows suggests to me something stirring under the surface here. For instance, the RSI, MACD, and stochastic have also failed to push lower. In fact, the RSI and stochastic have diverged somewhat from the price trend.

Most noteworthy is the money flow statistics, shown in the second to the last panel in the second chart. Does this mean we will see higher treasury prices soon? Lower interest rates? The risk/return seems weighted towards going long here.  

How Austrians 'Do' Economics

Here We Go Again- Denninger

Karl Denninger picks out some noteworthy machinations going on in the late hour trading (late hour US time) for S&P 500 futures. As Denninger writes at his blog.....

Anyone remember this crap from early 2008?

That's over 12,000 /ES futures contracts in the /ESH4 contract (March 2014); there were another 7,000 traded in /ESH3 (expiring Friday.)  That makes roughly 20,000 on that one-minute move (yes, it was all in one minute.)

It took price from roughly 1765 to 1754, or ~10 handles, instantly.  Which doesn't sound like all that much until you realize that for each contract that was $50/point, or $500/contract.  That is, about $10 million changed hands on an instant basis in the middle of the evening.

There's nothing on the wire to suggest a reason for this.

It'll probably be explained as a "fat finger" mistake, as these often are.  But the market is not recovering from this "fat-finger"; it is instead staying down, and looks like it wants to head back toward 1754.
Who knows whether it will.

What I do know is that in very late 2007 and early 2008 I saw a bunch of these moves in the middle of the night, and more than once I got gapped over and stopped out at a horrific loss that shouldn't have otherwise happened.  Such are the risks of remaining in a futures position overnight when liquidity is for crap and the hunters are out looking for you.

The point of this post is not to put forward the fact that a channel that had held through the last two trading days was just decisively blown up to the downside, or that if you had a long position on with a stop you probably got a bad fill and were nailed for a few hundred bucks per contract on the stop.

No, it's that this kind of move happens when systemic instability is running very high, not when all is well.
And while this doesn't necessarily mean that a crash is around the corner, it does mean that if you're not adequately protected, particularly if you're long some of the high-flyers out there that are trading on near-zero earnings (or worse, negative earnings) and sky-high pie-in-the-sky multiples you're taking a terrible risk.

Incidentally, in 2008 most of the time by the next morning all of those midnight dumps were recovered, which of course led many people to remove the safeties from their financial weapons of mass destruction (that is, their stops.)

That turned out to be an utterly disastrous mistake in the months that followed.

There seems to be some underlying moves themes percolating just under the surface that would seem to indicate that all is not well in the state of Denmark. But more on this later.....