— That was the sound of the gold price falling US$100 overnight. Michael Pascoe is probably penning an article on the bursting gold bubble as we write. We hope he is. It would encourage us to buy more.
— This is what a bull market does. It moves up relentlessly, dragging in all sorts of new converts. It makes long-time bulls feel good about themselves. So good they stop thinking as much as they used to and only see prices continuing to rise.
— But good bull markets twist and turn. The bull shakes investors and speculators off its back, preferring to take only the ‘strong hands’ along for the next upward leg, whenever that may be.
— The gold market has been just about the only game in town recently. While the equity market fell over the past few months, gold soared. That attracted speculators. They didn’t care for the argument that gold is money. Or that gold is once again becoming an international store of value and pre-eminent global currency.
— No. They just saw some momentum and jumped in. But here’s an important distinction. They jumped into the futures market. On margin. Speculators don’t buy physical bullion. They buy paper gold. To do so they are only required to put down a small percentage of cash to gain a very large exposure to moves in the gold price. It’s all about leverage to price moves. It’s not about owning physical gold as a wealth protector.
— Now, if you’re wondering why the gold price dropped a rather large US$100 overnight, here’s the answer, or at least part of it:
— The CME Group, who owns and runs the COMEX gold futures market, just announced a margin increase of 27 per cent, effective from close of business on 25 August.
— That is a hefty increase and comes after a 22 per cent increase announced two weeks ago.
— So if you’re a gold futures speculator and want to buy 100 contracts of COMEX gold futures (1 contract = 100 ounces), yesterday it cost US$742,500 to establish the position. On Friday, the same position will soak up US$945,000 of your cash.
— Importantly, the CME also hiked the maintenance margin by 27 per cent. Therefore, to maintain current positions going into Friday’s trade, speculators will have to stump up more cash…or sell.
— BTW, at a $1,800 gold price, this initial outlay gets you exposure to $18,000,000 in paper gold. So you can see the huge leverage available to the speculators. And you can now see why they bailed en masse last night.
— The requirement for more cash was the starting point. And then selling begat selling.
— Of course, there is a political element involved. The COMEX is run by, let’s put it nicely, the ‘establishment’. They are on the side on the bankers and the government. They have an uncanny knack of raising margins right at the point where they can inflict as much downside pain as possible. They did it with silver a few months ago.
— This time, with the gold price sending warning signals about the woeful monetary management of the global economy, the CME raises margins to take effect on the very day Ben Bernanke is due to speak at the Jackson Hole central bankers gathering. Coincidence?
— And let’s face it, the margin hikes were guaranteed to result in a sharp sell-off, given the ‘overbought’ nature of the gold price. Gold had risen for weeks on end and a natural correction was due.
— In an email update to our paying subscribers yesterday, we wrote:
‘…gold “should” correct so don’t be surprised to see it retreat back to around the $1,500 to $1,600 level. Despite this, I’m not considering selling any gold…
‘One of the hardest things to do is sit through a bull market and not be tempted to take profits. By taking profits, you feel good in the short term. But you also trigger a tax liability and then wonder whether and when to get back in. I’d prefer to sit and ride the bull market higher.
‘While I think we have reached a short-term peak, I don’t think the bull market is over by a long shot.
‘The only caveat I would make to the above recommendation is if you have made good gains in gold and feel you have too much exposure, take profits to cut back a little bit.’
— The point is, markets correct. But also understand the CME is amplifying this correction through highly selective timing of margin increases. Don’t get us wrong. Margins should increase as the underlying metal price increases. This ensures leverage doesn’t get out of control.
— The way it is done though is highly suspect. Why anyone chooses to play in the COMEX futures market is beyond us. Obviously it’s the lure of leverage. But at certain points the odds are stacked against you. Still, the speculators keep coming back for more. After this latest beating, you can be sure a new bunch will be back again.
— We would guess that gold is now in for a few months of correction/consolidation. But unless the world’s major central bankers commit to bring real (inflation adjusted) interest rates back into positive territory, gold will continue to march higher. You can make up your own mind whether you think that will happen.
— So if you own physical gold you have little to worry about. Simply use this golden waterfall to buy more.
— We were going to write about BHP’s massive profit today. But when we saw the gold price decline we spilt our coffee over BHP’s report and binned it. We’ll get to it tomorrow and discuss why such a heavy reliance on China poses such a short-term risk to companies like BHP and Australia itself.
for The Daily Reckoning Australia
Publisher’s note: Market set to move on Bernanke’s Friday speech – but which way? Find out what our ‘scarily accurate’ trader thinks will happen – for FREE – here.
We know world markets move whenever US Fed Chairman Ben Bernanke opens his mouth… but which way will they go after his Friday speech? Up or down?
Slipstream Trader Murray Dawes has been watching how other traders are preparing. Some are ‘short covering’… some are buying ahead of the speech in the hope that “The Bernank” announces QE3…
Murray has a different view. And it might disappoint some investors hoping to see a rally…
Whatever happens when this key speech is over, you’re going to want to know two things: what key level on the ASX Murray has targeted for action And what action to take if that level is breached.
Find out the answers to both these questions – for FREE – in Murray’s latest YouTube market update. Watch it here.