Wednesday, February 18, 2009

The Tail Wags the Dog

"Gold is going to $1000"
-- heard endlessly today on CNBC by many "experts"

"Holdings in SPDR Gold Shares, the largest exchange-traded fund backed by gold, reached 935.09 tons, climbing above 900 tons for the first time. That's up more than 40 tons from a day ago, and nearly 150 tons higher than a month ago."
--Wall Street Journal  2/12/09

What if Gold ETFs didn't exist?  Do you think that they're affecting the price of gold?  And what happens if gold prices reverse?  It's clearly a very crowded trade.  Hedge fund Greenlight Capital, the University of Notre Dame endowment, and the Teacher Retirement System of Texas all bought tens or hundreds of millions of dollars worth of GLD in the latest reporting period (Q4 2008) according to the WSJ.

By the way-- if you're long GLD, have you read the prospectus?  I have.  It seems that they do have roughly 1/10 of an ounce of gold for every GLD share according to the latest 10k.  But in this era of Madoff and Stanford, I'd sure rather have that gold in bars or coins in my basement rather than as an electronic entry for a fund held in my Schwab account.  

Here's some interesting quotes from the "Risk Factors"  section of the prospectus:

Investors should be aware that the gradual decline in the amount of gold represented by the Shares will occur regardless of whether the trading price of the Shares rises or falls in response to changes in the price of gold.

There is a risk that part or all of the Trust’s gold could be lost, damaged or stolen. Access to the Trust’s gold
could also be restricted by natural events (such as an earthquake) or human actions (such as a terrorist attack)....The Trust does not insure its gold.

In addition, the Custodian and the Trustee do not require any direct or indirect subcustodians to be
insured or bonded with respect to their custodial activities or in respect of the gold held by them on behalf of
the Trust. Consequently, a loss may be suffered with respect to the Trust’s gold which is not covered by
insurance and for which no person is liable in damages.

So if you're buying GLD as a hedge against the world coming to an end, you'd better hope that all of your gold doesn't get lost or stolen in the Apocalypse.

And Oil is no better.  Oil ETFs, particularly the USO, are also impacting their underlying markets. quotes an analyst who notes that "the extreme contango on the WTI contract is primarily due to market distortions created by the USO."  He calls the ETF "a cancer to the oil market."

And finally, let's talk about Credit Default Swaps.  CDSs are theoretically an instrument which provides insurance in the event of a default on an issuer's bonds.  They're relatively new, having come to prominence in the past five years or so. They're typically one-to-one agreements with a counterparty.  Although they allegedly provide "insurance", in fact they're almost entirely a way for hedge funds and other investors to make bets on changes in the market's perception of an issuer's credit standing.  In many ways, they're similar to a short stock position, but they have advantages like no need to borrow the stock and reduced price transparency.  Do CDS spreads widen because a company is in trouble, or does a company get in trouble because its CDS spreads have widened?

The height of absurdity is CDS on US Government bonds.  "Investors" can buy "protection" against default by the US Government.  The price has been increasing, making it a profitable trade for those who have been bearish.  But tell me this:  if the US Government defaults on its bonds, what are the chances that your counterparty will be able to pay off your bet?  

Remember, it was not very many years ago when CDOs were considered to be an innovative instrument for sophisticated investors.  CDS and ETFs aren't the market-- they're derivative instruments.  

Portfolio Update

It's easy to follow your discipline when it's working.  But the market's performance over the past two weeks has been difficult.  Keep the faith.  We've yet to see any positive market impact from the government stimulus plans, and that rally is on the horizon-- even if it's a bear market rally.  

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