WEEKLY COMMENTARY

September 27, 2005

You Can’t Always Get What You Want

By Theodore Butler

(This essay was written by silver analyst Theodore butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

The most recent Commitment of Traders Report (COT) indicated that the tech funds had, effectively, increased their long position in COMEX gold back to a record, while the dealers increased their short position to a reciprocal record. Thus, we are in a high-risk state in the gold market for a sell-off down through the moving averages. Of course, that does not preclude new highs first or tell us much about timing. And it is always possible for the dealers to be overrun, although that is still yet to occur in memory in gold and silver.

Although there is continued increased attention and commentary on COT analysis in gold and silver, I am somewhat taken back by the underlying current of thought that holds that the COT market structure is somehow peripheral to why the market moves short term and the great anticipation (hope?) that the dealers will get slaughtered in a self-induced orgy of short-covering. Don’t misunderstand me, seeing the dealers lose big and thus ending the illegal price dominance of paper trading will be a day of great personal celebration for me and all free market advocates. But it may be premature to dance in the end-zone and slap high-fives. As I have written previously, these dealers are harder to kill than Dracula.

It is important to put the COTs into proper perspective. They are not the underlying force to long-term price movements, but rather are responsible for the $30 to $50 intermediate term moves in gold, in my opinion. While it is true that gold rose more than $200 over the past few years with the dealers consistently net short, a close study of the changes in the dealers net short position reveals they largely escaped loss by virtue of trading against the tech funds. (The long-term rise in gold had more to do with the cessation and reversal of the idiotic and manipulation practice of metal leasing/forward selling.)

The dealers’ trading success (or at least escape from financial damage) has occurred in spite of the funds holding enormous open profits in gold and silver at times, measuring in the hundreds of millions of dollars, only to lose such open profits in sudden price downdrafts. It is easy to prove my assertion. Go to the web site of what is considered to be the largest tech fund, John W. Henry & Co (www.jwh.com) and review the lack of profits in their metals’ trading, in spite of robust gains in metals’ prices these past few years. I’m not saying the tech funds have lost big, but rather that they have let big open profits disappear on several occasions and have nothing to show for all their massive metals trading.

Since the lows in July, when the tech funds held a small long position and the dealers a small short position, the gold price has advanced roughly $50. That price advance was caused, according to my COT-interpretation, by the tech funds’ purchase, of more than 100,000 COMEX gold futures contracts (the equivalent of 10 million oz). Perhaps I am over-simplifying things, but it seems clear to me that this 100,000-contract tech fund purchase is precisely why the gold price rose $50. I say this knowing full well that many other reasons for gold’s rise have been given.

It is this 100,000 contract increase in the tech fund gold long position and dealer short position that creates the risk to the downside, as it could be expected that the tech funds will sell these contracts at lower prices. It is important to state that I don’t know if this will happen, just that it has always ended with tech fund liquidation when the position has been this extreme. Maybe it will play out differently this time. To be sure, the resolution of this extreme market structure, one way or the other, will be precisely what determines the next short term move in gold prices.

My point is simple – the $50 gold price increase came because the tech funds bought 100,000 COMEX contracts, and the price will move from here, up or down, depending upon who blinks at this point; the funds, as is usually the case, or the dealers being overrun for the first time. I don’t claim to know how this will play out and neither does anyone else, but I do know what will determine the outcome. That paper speculators, funds and dealers alike, and not legitimate real metal participants, are clearly setting prices is against basic commodity law.

In silver, there was also deterioration in the market structure, by close to 20,000 contracts (100 million oz). While the silver COTs are nowhere near the historical bearish extreme of gold, it does give one pause for thought on a near term speculative basis, especially considering that extreme gold reading. (Long-term core silver positions and the COTs, like oil and water, don’t mix. The real silver fundamentals are better than ever). But the willingness of the dealers to sell and let the tech funds "off the hook" by 20,000 net contracts does negate a recent speculation of mine that the dealers may be unable or afraid to sell short silver in size and that the big move was imminent because of that. Obviously, I was wrong, even though we did rally by 80 cents, trough to peak, in the past couple of months. Eighty cents was not my idea of the big one.

But I am still struck by something that is nagging at me. While the dealers did sell roughly 20,000 contracts on the so-far modest silver rally this time, my sense is that they are still reluctant to sell short the massive quantities they have sold regularly in the past. There have been times in the recent past when the dealers’ net short position would be as much as 30 to 40 thousand contracts larger than it is currently, or the equivalent of 150 to 250 million ounces more than now. As recently as early June, the dealers held a large 77,000-contract net short silver futures position on the COMEX. In the past two months, however, the largest net short position has been in the 54,000-contract level, both in early August and in the latest COT Report.

Why this seems strange to me is that gold has hit record large dealer short positions in the past two months, which caused the unprecedented extreme between the very high dealer short position in gold and the very small dealer short position in silver. One interpretation of this dichotomy is that the dealers were eager to sell gold short into the tech fund buying over the past few months, sensing they could cause tech fund liquidation eventually, but were very reluctant to sell silver short at all (at least until the two-day 40 cent rally incorporated in the most recent COT.)

Maybe I’m imagining something that isn’t there, and if silver continues to rally and the dealers do buildup to the large short positions they have held in the past, then my imagination was, admittedly, misguided. But if we turn down from current price levels and the dealers buy back the 20,000 contracts of silver they have recently sold, then that next bottom would take on particular significance.

I admit to disappointment that this last rally in silver didn’t explode violently from day one. It could have easily done so, considering the small net short position of the dealers and the large tech fund short commitment. Who knows, it still may. I certainly like it better when the COTs are flashing strong buy signals to compliment the spectacular silver fundamentals. Still, the COTs were and are, once again, in conformance with the price action that transpired in both gold and silver As such, it is hard to disregard the message, at least until that message is wrong. Kind of like a child learning quickly not to touch a hot stove.

As I have written previously, the COTs are not the be-all and end-all in the markets. They were never intended to be. Long-term investors should generally ignore them. Never should anyone dispose of a long term silver position because of a COT reading and never be naked short silver under any circumstances. But the COTs do have their use, particularly for speculative purposes. In my opinion, they have yet to be dead wrong at important market tops and bottoms. That’s not to say they can’t or won’t be wrong, just that I haven’t seen that yet.