The [Recovery] Has No Clothes
By Eric Sprott & David Baker from Sprott Asset Management
"I believe that there have been repeated attempts to influence prices in
the silver markets. There have been fraudulent efforts to persuade and
deviously control that price. Based on what I have been told by members
of the public, and reviewed in publicly available documents, I believe
violations to the Commodity Exchange Act (CEA) have taken place in
silver markets and that any such violation of the law in this regard
should be prosecuted."
- Bart Chilton, Commissioner, U.S. Commodity Futures Trading Commission (CFTC), October 26th, 2010
What
a difference a month makes. Now that Greece has been papered over, the
bulls are back in full force, pumping up the equity markets and
celebrating every passing data point with positive exuberance. Let's not
get ahead of ourselves just yet, however. Very little has actually
changed for the better, and it's certainly too early to start
cheer leading a new bull market.
Take
the latest US unemployment numbers, for example. There was much
excitement about the latest Bureau of Labor Statistics (BLS) report
which announced that US unemployment remained unchanged at 8.3% during
the month of February. The market was particularly enamored by the
BLS's insistence that non-farm payrolls increased by 227,000 during the
month, as well as its upward revision of the December 2011 and January
2012 jobs numbers. Lost in all the excitement was the Gallup
unemployment report released the day before, which had February
unemployment increasing to 9.1% in February from 8.6% in January and
8.5% in December. Granted, the Gallup methodology is slightly different
than that used by the BLS, but even if Gallup had applied the BLS's
seasonal adjustment, they would have still come out with an unemployment
rate of 8.6%, which is considerably higher than that produced by the
BLS. We all know which number the pundits chose to champion, but the
Gallup data may have been closer to the truth.
For
every semi-positive data point the bulls have emphasized since the
market rally began, there's a counter-point that makes us question what
all the fuss is about. The bulls will cite expanding US GDP in late
2011, while the bears can cite US food stamp participation reaching an
all-time record of 46,514,238 in December 2011, up 227,922
participants from the month before, and up 6% year-over-year. The bulls
can praise February's 15.7% year-over-year increase in US auto sales,
while the bears can cite Europe's 9.7% year-over-year decrease in auto
sales, led by a 20.2% slump in France. The bulls can exclaim
somewhat firmer housing starts in February (as if the US needs more new
houses), while the bears can cite the unexpected 100bp drop in the
March consumer confidence index, five consecutive months of
manufacturing contraction in China, and more recently, a 0.9% drop in
US February existing home sales. Give us a half-baked bullish
indicator and we can provide at least two bearish indicators of equal or
greater significance.
It
has become fairly evident over the past several months that most new
jobs created in the US tend to be low-paying, while the jobs lost are
generally higher-paying. This seems to be confirmed by the monthly US
Treasury Tax Receipts, which are lower so far this year despite the
seeming improvement in unemployment. Take February 2012, for example,
where the Treasury reported $103.4 billion in tax receipts, versus
$110.6 billion in February 2011. BLS had unemployment running at 9% in
February 2011, versus 8.3% in February 2012. Barring some major tax
break we've missed, the only way these numbers balance out is if the new
jobs created produce less income to tax, because they're lower paying,
OR, if the unemployment numbers are wrong. The bulls won't dwell on
these details, but they cannot be ignored.
Then
there are the banks, our favorite sector. Needless to say, the latest
Federal Reserve's bank stress test was a great success from a PR
standpoint, convincing the market that the highly over leveraged banking
system is perfectly capable of weathering another 2008 scenario. The
test used an almost apocalyptic hypothetical 2013 scenario defined by
13% unemployment, a 50% decline in stock prices and a further 21%
decline in US home prices. The stress tests tested where major US banks'
Tier 1 capital would be if such a scenario came to pass. Anyone who
still had 5% Tier 1 capital and above was safe, anyone below would fail.
So essentially, in a scenario where the stock market is cut in half,
any bank who had 5 cents supporting their "dollar" worth of assets
(which are not marked-to-market and therefore likely not worth anywhere
close to $1), would somehow survive an otherwise miserable financial
environment. The market clearly doesn't see the ridiculousness of such a
test, and the meaninglessness of having 5 cents of capital support $1
of assets in an environment where that $1 is likely to be almost
completely illiquid.
That
anyone still takes these tests seriously is somewhat of a mystery to
us, and we all remember how Dexia fared a mere three months after it
passed the European "stress tests" last October. There has since been
some good analysis on the weaknesses of the US stress tests, including
an excellent article by Bloomberg's Jonathan Weil that explains the
hypocrisy of the testing process. Weil points out that stress-test
passing Regions Financial Corp. (RF), which has yet to pay back its TARP
bailout money, has a tangible common equity of $7.6 billion, and
admitted in disclosures that its balance sheet was worth $8.1 billion
less than stated on its official balance sheet. An $8.1 billion
write-down plus $7.6 billion in equity equals bankruptcy. But the
Federal Reserve's analysts didn't seem to mind. It came as no surprise
to see that Regions Financial took advantage of its passing "stress
test" grade to raise $900 million in common equity on Wednesday, March
14, which it plans to put toward paying off the $3.5 billion it received
in TARP money. Well played Regions Financial. Well played.
Our
skepticism would be supported if not for one thing - the recent
weakness in gold and silver prices. Given our view of the market, the
recent sell-offs have not made sense given the considerable central bank
intervention we highlighted in February. Although both metals have had a
dismal March, we must point out that they were both performing
extremely well going into February month-end. Gold had posted a return
of 14.1% YTD as of February 28th, while silver had appreciated by 32.5%
over the same period. And then what happened? Leap Day happened.
In
addition to being Leap Day, February 29th also happened to be the day
that the European Central Bank (ECB) completed its second tranche of the
Long-Term Refinancing Operation (LTRO), which amounted to another
€529.5 billion of printed money lent to roughly 800 European banks.
February 29th also happened to be the day that Federal Reserve Chairman
Ben Bernanke delivered his semi-annual Monetary Policy Report to
Congress. Needless to say, during that day gold mysteriously plunged by
over $100 at one point and closed the day down 5%. Silver was dragged
down along with gold, dropping 6%. Any reasonably informed gold investor
must have questioned how gold could drop by 5% on the same day that the
European Central Bank unleashed another €530 billion of printed money
into the EU banking system. But all eyes were on Bernanke, who managed
to convince the market that QE3 was off the table for the indefinite
future by simply not mentioning it explicitly in his Congress speech.
Given that Treasury yields have recently started rising again and that
US federal debt is now officially over $15 trillion, do you think QE3 is
officially off the table? We don't either. Just because Bernanke
signals that the Fed is taking a month off doesn't mean they're done
printing. It doesn't mean they have suddenly become responsible. It's
simply a matter of timing.
Looking
back at the trading data on February 29th, the sell-off in gold and
silver appears to have been an exclusively paper-market affair. We were
surprised, for example, to note that between the hours of 10:30 am and
11:30 am, the volume of the COMEX front month silver futures contracts
equaled the paper equivalent of 173 million ounces of physical silver.
Keep in mind that the world only produces 730 million ounces of physical
silver PER YEAR. The problem from a pricing standpoint is the simple
fact that the parties who were on the selling side of those 173 million
paper ounces couldn't possibly have had the physical silver to back-up
their sell orders. And the way the futures markets are designed, they
don't have to. But if that's the case, how can the silver price be
smashed by sell orders that don't involve any real physical?
Looking
at this issue from a broader perspective, we've discovered that silver
is indeed in a unique situation from a paper-market standpoint. We
compared the daily paper-market futures volume of various commodities
against their estimated daily physical production. We discovered that
silver is disproportionately traded 143 times higher in the paper
markets versus what is produced by mine supply. The next highest paper
market commodity is copper, which is traded at roughly half that of
silver on a paper market volume basis.
We
don't know why the paper market for silver is so huge, but we have our
suspicions. Silver is obviously a much, much smaller market than that
for copper, gold or oil. It could very well be that paper market
participants like silver because they don't need as much capital to push
it around. The prevalence of paper trading in the silver market is what
makes the drastic price declines possible by allowing non-physical
holders to sell massive size into a relatively small market. It's not as
if real owners of 160 million ounces of physical silver dumped it on
the market on February 29th, and yet the futures market allows the
silver spot price to respond as if they had.
Same
goes for gold. Although gold paper-trading isn't as lopsided as
silver's, it too suffers from the same paper-selling issue. Indeed, as
we discovered for February 29th, it appears to be one large seller of
gold that single handedly down ticked the spot price by $40/oz in roughly
ten minutes. The transaction represented approximately 1.8 million
ounces, representing roughly $3 billion dollars' worth of the metal. Who
in their right mind would even contemplate dumping $3 billion of
physical gold in so short a time span? Dennis Gartman's Letter on March
2, 2012, also mentioned an unnamed source who described an order to sell
3 million ounces of gold that same day, with the explicit order to sell
it "in just a few minutes". As the Gartman Letter source states, "No
investor or speculator would 1) handle it this way and 2) do it at the
fixing only... This [has] happened this way three times in the last
year, yesterday being the fourth time. Ben Bernanke had done nothing
yesterday to trigger this the way it happened. I [have done] this now
for 30 years and this was no free market yesterday."
The
following three charts show the price action and volume for the
February, March and April Comex Gold contracts. You'll notice that the
February contract stopped trading on February 27th to allow time for
settlement between the buyers and sellers who intended on closing the
contracts in physical. The March contract had hardly any volume at all,
leaving the majority of gold futures that traded on February 29th taking
place in the April contract. This speaks to our frustration with
futures contracts. The majority of trading that produced the February
29th gold price decline took place in a contract month that won't settle
until April 26th at the earliest, giving plenty of time for the shorts
to cover and exit without having to back their sales with physical
delivery.
All
of this nonsense brings us to the crux of our point. If we are right
about gold and silver as currencies, and if we are right about the
continuation of central bank printing, both gold and silver will
continue to appreciate in various fiat currencies over time. If there is
indeed some sort of manipulation in the futures market that is designed
to suppress the prices for both metals so as to detract from the
mainstream investor's interest in them as alternative currencies, then
both metals are likely trading at suppressed prices today. This means
that there is an opportunity for investors to continue accumulating both
metals at much cheaper nominal prices than they would do otherwise.
While the volatility of the price fluctuations may be unsettling, they
ultimately won't change the underlying fundamental direction of both
metals, which is upwards.
The
equity market rally that began in late December appears to be generated
more by excess government-induced liquidity than it does by any raw
fundamentals. We continue to scour the data for signs of a true recovery
and we are simply not seeing it. Until those signs come through, we
would be very wary of participating in the equity markets without a
strong defensive stance. We would also expect the precious metals
complex to enjoy renewed strength as the year continues. One bad month
does not change a long-term trend that has been building over 10 years.
Gold and silver will both have an important role to play as the central
bank-induced printing continues, and we expect more on that front in
short order.
PS
- if there is any group that can effectively address silver's continued
paper market imbalance, it is the silver miners themselves. Despite the
best efforts of a select few at the CFTC, it is unlikely that there
will be any resolution to the CFTC's investigation announced back in
September 2008.16 Silver miners have the most to lose from the continued
"fraudulent efforts" that Commissioner Bart Chilton refers to in the
opening quote above. They also have the most to gain by confronting the
continued paper charade head-on.
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