Category: Commodities

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The Last Post on Gold

I go on way too much about gold. It’s starting to annoy even me.

So, I’m just going to lay out the cyclical and secular arguments against gold one last time. After that, you do you. If you want more on the cyclical framework, go here.

Cyclical weighs heavy

  • Higher real interest rates. Except for extreme moments, the correlation between gold and real interest rates plots pretty high. And real rates are going higher. You don’t have to believe they are going a lot higher, but you do kind of have to believe the sign is positive. Europe and Japan are next, even if it’s early days and they’re likely to proceed slowly.

  • Unwind of residual disaster myopia. Risk aversion from the GFC and fear of disruptive QE inflation fed a big run in gold 2009-2011. It was a bubble created by investors looking for safe haven from bubbles. The bubble popped in 2012, and is still slowly leaking today. Yeah, inflation is more likely to pick up than not, but we’re not talking about the kind of rampant, de-stabilizing inflation that was almost consensus back in 2009-10. And, sure, some people still fear systemic risk too. But synchronized global growth & better banking regulation/capitalization have been reducing this fear, not increasing it.

Bottom line: If you think the global economy is in synchronized upswing, and also you think major global CBs are going to be reducing exceptional accommodation over the next few years, it’s pretty hard to make the case that the cyclical pressures on precious metals are for higher prices and not lower.

Insidious secular forces

  • Gold is losing monetary relevance. It’s moving further from the center of the global monetary system with every passing day. Nixon closed the gold window on August 15th, 1971. That was the day gold’s utility started to die. No one is going back to the gold standard. Each new generation sees less utility in it than the one before. Much in the way science progresses one funeral at a time, gold’s perceived utility fades one funeral at a time.
  • Digital technology is accelerating this process. The rapid evolution of digital payments and assets is further reducing gold’s utility, and now, thanks to the visibility of bitcoin, at an accelerated rate. Technology is taking us further and further from the gold standard. Even central banks are starting to rethink payment and settlement systems. And this would still be true if bitcoin were officially banned tomorrow.

Where does it end? It’s always made sense to me that gold should revert to pre-bubble levels and maybe overshoot, but really I don’t know. What I do know is that as long as I believe gold’s perceived utility is declining, both cyclically and secularly, I want to be structurally bearish.

Yes, if gold falls to 500 I’m sure I won’t be able to resist coming out and taking victory laps. But, other than that, consider gold-posting done.

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The Anatomy of a Trade: Copper

Late Friday, I tweeted out a chart of copper (HG_F), commenting that the pattern looks like it’s flagging and ready for downside, after a great run. Given that the backdrop is USD strength that looks likely to continue, a selloff in copper seems that much more probable.

But in this business you never know if you’re going to get the direction right–however much ex-ante factors seemed lined up in your favor. This is why I prefer relying on setting up attractive payoff structures to counting on a high ‘batting average’. Obviously, you work to get your batting average as high as possible as well. But in my experience, in trading, relying on your batting average is not the path of least resistance.

Here’s how I’d approach the trade:

Start with the chart of copper.

You can see that it broke down about a week ago and has been creeping back up into significant resistance (note to top-tails on the candles). On Friday, copper took on the look of starting another leg down. Again, no guarantees that it does so, but the odds of a move lower increased.

Now we look at the broader dollar backdrop. Both the euro and the BBDXY (trade and financial flow-weighted dollar index) suggest more dollar strength ahead.

Euro:

Looks like it’s rolling over pretty hard, and the head and shoulder formation that so many technicians like is clear.

BBDXY:

Similar pattern, same basic story: the world is focusing right now on the strength of the US economy, an upcoming tax package, and a new Fed chair who is arguably, at the margin, more hawkish and more sympathetic to reducing regulatory burden. Yes, the global economy is in good shape, which tends to be supportive of copper, but after the run copper has had, it seems that much of this is already in the price. Again, the extent to which you and I agree with this story doesn’t matter, what matters is getting a read on the prevailing story in the market and whether it is waxing or waning.

Next, I look at speculative positioning in copper contracts:

Speculative positioning is high. It’s important to point out that positioning in and of itself is not dispositive, but helpful when it’s supportive of other observations.

Then I think about sizing the trade. The first thing I do is look for a natural stop in the pattern.

Drawing a line at overhead resistance and you come in around 317, versus a current price of 311.5. Now, copper is fairly volatile asset, approximately three or four times as volatile these days as the S&P 500. Plus, it is subject to a lot of intraday noise, so there is some risk with a stop 1.75% away that price noise could bounce you out. But you can reduce this risk if you use a closing break instead of an intraday breach–and then hope your read of the pattern is a good one.

You’d then want to compare the 1.75% downside with potential upside. Again, you need to rely on a read of the pattern, so it’s impossible to get away from subjectivity. But you try to be sober and realistic and even a little conservative when you come up with a target area.

In this case, it seems to me that if the strong dollar/spec unwind thesis materializes, copper could realistically and conservatively retrace to 290, the bottom of the saddle from 5-6 weeks ago.  This would give you 21.5 points of lower versus 5.5 points higher, a payoff asymmetry of about 4:1 (a little less when you build in execution slippage to your stop). That’s pretty decent, implying that if you’re right 1 time out of 4 you break even. 3:1 is usually the minimum I look for.

Then you have to think about how much of your NAV you are willing to lose. This is highly personal and mandate specific. Some of it has to do with the confidence you have in the trade and the embedded degree of asymmetry. Some of it has to do with being able to sleep at night, since the best way to combat emotion is reducing position size. Lastly, you have to consider how long you’re expecting the trade to run. Counter-intuitively, the longer/farther you expect to have a trade on, ceteris paribus, the smaller you want your position to be. Counter trend moves where you give back chunks of performance have induced many a trader to close out long term winners far too early. This often overlooked consideration is one of the most costly errors a trader can make, and one, frankly, I still struggle with.

So, if you are willing to lose, for the sake of illustration, 1% of AUM in a trade where the stop is 1.75% away on the close, I’d round the 1.75% up to 2% to allow for slippage, and then divide the 1% by the 2% to get my position size, in this case 50% of NAV

The final trick I would add in this case is a stop roll down. If this pattern materializes to plan, it is highly unlikely to return to the entry point once it breaks down. If it does, it means your thesis is busted. So this is a great candidate for rolling down your stop to around breakeven if the trade starts to work. Based on the pattern, I wouldn’t want to roll down the stop until the front contract price was below, say 305. You have to really careful to not let P&L stinginess bounce you out of a winning trade when rolling stops. Good luck!