Tactile Trade: Shorting Gold

Since the Financial Crisis, knee-jerk reactions to the latest FOMC statement, Fed Chairman testimony, or US data point have become even more prevalent.

Last Friday was no different, as market participants were quick to read the tea leaves of the latest US monthly labor data and reallocate assets accordingly. It's our job to determine whether these knee-jerk reactions are temporary and should be exploited to align ourselves with the prevailing trends or whether these reactions represent a regime shift for various asset classes.

My take: Last Friday was a knee jerk reaction and not a regime shift. I used the market’s over reaction to initiate a tactical SHORT trade in gold.

For clarification, a tactical trade is a trade, in the direction of my bias for a particular market, which I believe I can close profitably sometime in the next 10 trading days. This as compared to a strategic trade, which I might hold from several weeks to several months.

Whether it's tactical or strategic, I always trade in the direction of my bias for a particular market. As for gold, I’ve maintained a SHORT or NEUTRAL bias on gold for 77% of the weeks since I began publishing TWR in December 2012.

My bias for a particular market or stock is made up of 3 components: fundamental perspective, quantitative analysis and behavioral finance. When all 3 components are aligned in one direction, that is when a directional bias is issued for that market. When they aren’t aligned, the market maintains a NEUTRAL bias. I’ve had a constant SHORT bias on gold in TWR since June 29.


The Big Fundamental

Gold is an interesting market because it doesn’t have any direct fundamentals, like equities, currencies, fixed incomes or other commodities. The price of gold is dictated by US yields and the US Dollar.

Anyone who wants to argue this point can simply look at the past. Whenever US yields are elevated or rising, especially in conjunction with a strong USD, gold can't compete for investor assets and is unable to sustain any upward momentum.

Take the current gold bear market as an example. The USD hit an intermediate low in April 2011 and has rallied 32% since then. Gold hit an all-time high and peaked just 5 months later, and has since declined over 40%.

US 10-year yields bottomed in July 2012 and have increased from just under 1.4% to 2% today. Strong Dollar, strong yields, weak gold. Wash, rinse, repeat.

So, to ascertain the fundamental picture for gold we need to look at the fundamental backdrop for US yields and the USD.

As long as there's a strong US dollar and low rates, vs the rest of the world markets, the fundamental outlook for gold is decisively bearish. Keep in mind, that the Fed doesn’t even need to raise rates for this trade to continue to work against gold bulls.

As long as a prospective rate hike remains on the table then the US is diverging from the monetary policy of the rest of the world. As long as US policy remains bullish for yields and the USD, or at a minimum not outright negative for those markets, then gold is a clear SHORT, fundamentally speaking.

And while the prospect of another round of easing here in the US will surely get the gold bulls salivating, I wouldn’t be so quick to assume that gold will have a sustained run higher in that environment either.

It's true that gold had a massive run during the initial round of quantitative easing, rallying just over 35%. However, gold mustered only an 11% gain in round 2, hit its all-time peak just a few months after that round ended and has been declining ever since.

Not even the third round of easing could move gold; it declined 35% during that time period. Another round of domestic easing is surely bearish for USD and yields but a monster gold rally is far from a forgone conclusion.


The Behavior

When it comes to evaluating the sentiment of a particular market we look at number of factors covering the buy side, the sell side and the insiders, if we're evaluating a specific stock. Trading gold is no different.

One of the factor we look at, which is readily available to everyone is the bi-weekly commitment of traders data for the futures market. The data is divided into 3 categories: commercial investors (hedgers), large investors (professional money managers, aka “smart money,” and the small investors, aka “dumb money.”

I am a contrarian by nature, so from a positioning standpoint, I like to see extremely long positioning in a market that I want to short. Commercial long positions in gold are at a 5-year high. Check.

Large investors, or smart money, have been steadily increasing long positions since December 2013 and have decreased short positions by 30% in just the last 2 months. Check.

The one segment of this evaluation that was a red flag was the small investor positioning, or the dumb money. Small investor short positions are within 10% of all-time highs while long positions are at the lowest in a decade. I don’t make it a habit to align myself with the dumb money, however, this one behavioral data point was outweighed by a number of other behavioral criteria, outside of the commitment of traders report.


The Math

The fundamentals and the behavior are conducive for a SHORT gold trade but what about the quantitative characteristics of gold?

At my asset management firm, we know that extraordinary returns can only be earned through non-consensus perspective that leads to non-consensus behavior.

If you’re looking at the same information as everyone else in the same way, how can you expect to earn any returns that are above average?

As such, we have developed a quantitative process for evaluating the price, volume and volatility data of a given market differently than other market participants. Does this proprietary process make us right 100% of the time? Of course not, we are generally right about 40-45% of the time.

But our process heavily skews the probability of a winning trade in our favor and over time if the odds are repeatedly skewed in your favor you can earn out sized returns. Anyone can look at a chart of gold and see that it's been in and remains in a 4-year old bear market. And unless you are trying to play the role of Captain Bottom Picker, then you are actively looking for optimal prices to enter SHORT gold trades.

Our quantitative process for looking at price, volume and volatility screamed that gold’s rally on Friday was not to be trusted and in fact, should be faded.

Finding the right entry prices in a market that has already declined as much as gold has can be tricky. How do you know if a rally like the one this past Friday is fake or the beginning of an extended move? The truth is you don’t know with absolute certainty. But our understanding of the fundamental back drop, the way investors have been positioning themselves in the futures markets, coupled with our quantitative process, led me to believe that shorting gold is a high probability trade for a profit sometime in the next 10 trading days.