April 25, 2013

Sprott: Did Last Week’s Gold Sell-off Mark the Bottom?

Guest post by Henry Bonner (hbonner@sprottglobal.com)

Sprott Global Resource Investments Ltd.

Last week gold fell profoundly from $1,580 to $1,350 in a few short days, rattling many investors. This week we are seeing a determined rebound and many are searching for the cause of such a dramatic price action. I asked Investment Executive Eric Angeli at Sprott Global Resource Investments Ltd. for his outlook on the yellow metal.

“My outlook remains bullish,” he begins, “no one knows if the price of gold will come back tomorrow, if it will take months or even longer, but I think those who remain long the trade and especially those with the courage to add to the trade will be greatly rewarded when these markets come back. I see nothing in the collective policies of global officials to suggest precious metals have lost their luster as a store of value in these uncertain times.”

What are the reasons for the biggest one-day drop in 30 years?

“On the morning of April 12th, the futures markets were flooded by two unprecedentedly large trades – 100 tons hit the market and an hour later, another 300 tons hit. Who has that much gold to sell? ”
Why is this such an abnormal event?

“Traders typically spread large sell orders over time. That way, they avoid flooding the market all at once and causing the price to decline. An experienced trader would know that a sell order of that magnitude would be likely to crush the price; unless, of course, that was the objective.” He adds that the massive 400 ton trade was likely made on leverage, meaning that the trader who made it had only put up enough money to cover between 5-15% of the order. “In highly leveraged markets like futures exchanges, individuals can cause large price movements with relatively little net exposure.”

As Eric explains, the morning after a massive drop is when margin calls are sent out requiring those who are investing with leverage to post more cash to meet the cash call. “This will amplify the drop as selling has a tendency to beget more selling in a bear market. When the value of the assets that traders buy on margin declines beyond a certain level, they are forced to sell off some of those assets in order to cover their margins. We witnessed compounded selling in nearly every equity space, and gold and other commodities were no exceptions.”

Gold’s increasing role as collateral for foreign banks adds to the snowball effect, says Eric. While he believes this further validates gold’s role as money in the international community, the price drop meant that the value of the gold collateral declined enough to drive a cash call – which often results in these banks having to sell off some of their gold.

In addition, the Shanghai Gold Exchange recently announced it is increasing its margin requirements to 12% for gold and 15% for silver[1]. The Chicago Mercantile Exchange announced last week that it would increase margin requirements for gold and silver contracts by 19% and 18% respectively[2]. This is important because “traders have to put up more cash to make the same sized trade, and many will have to sell to meet those margin requirements, or at least reduce their investing ability overall.”

Finally, this type of selling is often to be expected in the later phases of a down period: “Right now is the time when weak investors exit the market – when sentiment is at its lowest. I believe that precious metals’ fundamental strength remains intact as much now as ever before. Successful investors are defined not by what they do in a bull market but by their boldness in bear markets. The successful investors of tomorrow will be those that seize the opportunities of today.”

Eric Angeli has been with Sprott since 2006, when he moved from major Wall Street firms Morgan Stanley and Bear Stearns to work under the tutelage of Rick Rule in the natural resource space. Eric takes a concerted interest in the education of his clients and is an avid proponent of the value-based investing strategies of Benjamin Graham. Eric holds a double major in finance and international business from New York University’s Stern School of Business. To contact Eric, e-mail him at eangeli@sprottglobal.com or call 1.800.477.7853.