Late last week, Zero Hedge pointed out that Goldman Sachs had come out with yet another flip flop piece on gold, having recommended that clients should go long, then short, then long again, pretty much depending on which way the wind blows. We have long been skeptical of Goldman calls on anything, let alone gold, as the firm, just like JPMorgan is very much fundamentally conflicted any time it has a bullish "recommendation" on any precious metal due to the very intimate influence gold and other commodities have on Fed presidents' perception of inflation (and the last thing one would want is for Bernanke's deflation scare tactics to be doubted by more than just Dallas Fed's Fisher, who despite lofty rhetoric has yet to back his words with even one abstaining vote). That said, our skepticism about Goldman's sudden shift in bias has been validated by FMX Connect, which has conducted a forensic analysis of just what Goldman is seeking to achieve with its most recent recommendation. We continue to be far more bullish on any price appreciation prospects for gold, when Goldman (not to mention that other clown on TV), are bearish on gold, than the inverse.
From FMX Connect:
Gold Prices to Hit $1,480: Goldman Advises to buy a Deferred Expiration
We read an interesting sales pitch on the Street.com Friday. Here is an excerpt:
“The investment bank said in a research report Thursday that it expects gold to rally "towards our 3-month price target of $1,480" an ounce. Goldman is recommending investors get long on gold by buying the December 2011 futures contract currently trading at $1,426.10 an ounce.”
“Buy Gold. Buy it in a less liquid, wider bid/ask market contract than April GC or GLD and buy it through and/or from us. Buy a contract whose liquidity will also most likely not be there when you need it most whether you are profitable or losing money.”
Forget the bank’s opinion. We ourselves are bullish. But it is commonly agreed among paranoid yet savvy traders that if Goldman is recommending you to buy, it is because they are already long and are maybe looking for an exit strategy for themselves or a client they favor.
No doubt, sometimes you make money getting long when GS says “Buy”. And that is because GS has uncovered a soft spot and the market will overshoot even their inventory overhang being liquidated. Or because their own client told them to buy. Or perhaps you were an early entrant in their “find the bigger fool” race. But sometimes you don’t make money.
Here is what we want to focus on: The recommendation of buying a deferred expiration future when so many more logical choices are available. Warning: lots of derivative talk ahead. We were on a caffeinated roll when we wrote this and didn’t make the time to translate to normal English.
Why the recommendation is Bad or at least not optimal for most people.
The real poker-tell here for us is how the bank is recommending you to get long.
“…get long on gold by buying the December 2011 futures contract…”
Right off the bat the math is wrong. Using the warped logic that recommends buying deferred expiration futures: A three month target of $1480 translates to an August future at the latest. Why would you tell someone to pay more carry cost than necessary? But let’s look at the implications of any deferred future recommendation as a market taker (i.e. lifting offer/ hitting bid client)
Let us now count the ways that this December purchase is both ridiculous, negligent, and possibly the most obvious tell on earth as to what their position actually is.
1. December futures are less continuously liquid than their front month counterpart, currently the April contract. Which means the implicit fee from the bid/ask spread will be bigger on entry into the long position. Is this added premium worth it? NO. Gold is Gold, and the difference in price between April futures and December futures is the opportunity cost of money. Gold today is gold tomorrow plus the cost of how much interest it would be to borrow money to buy the contract. Note we said continuously liquid. There are times when December will be almost as liquid as April (with a wider bid/ask no doubt), but the real hidden hazard is continuity. Translation: “When you NEED to get out, because of the gold market washing out, the stock market washing out, you kids college tuition due, war, peace, pestilence, or whatever…..that exit liquidity will be AWOL relative to the front month’s liquidity.
2. If there ever were a short squeeze event like in Silver and spreads went backwardated, guess which contract would benefit? April. So as unlikely as it is to happen, buying December takes the whole homerun from physical delivery issues right off the table. You are actually short optionality on a short squeeze. Guess who is long it? Speaking of Silver: how is it that GS didn’t tell their clients Silver would go backwardated? It was the trade of the year and much easier to see than if the market itself would go up or down. Do you think they missed it? We doubt that. We also doubt they would let you in on it until the trade was exhausted. We know of two hedge funds that didn’t miss it, and they told no one anything on their bet. We found out after the fact. When JPM crushed silver spreads and carried out a prominent futures local out on a $10MM stretcher, were their clients in on that one as well? We wonder if GS was caught on the other side of that disaster. Probably not. They probably benefitted. But by all means buy gold because they think it’s going up. Enjoy the crumbs from a TBTF bank’s best trades. It will also come with one of those neat oval stickers you can put on your Land Rover
3. Try getting out when you have to, upon exit especially in a market washout scenario, Murphy’s law applies. The marketmaker of last resort will be Goldman. And guess what he has on his book as your position being, LONG and WRONG. The exit vig will kill you much more than those low-low commissions promised by your benevolent banker.
A Graphic Interlude: What Determines a future contract’s value
These charts are on different scales and not perfect renditions. But you see the point. The difference (for now) in gold future expirations is a function of interest rates, be it treasuries, LIBOR or some other correlated instrument that measures opportunity cost of carry. Futures are just synthetic forwards and vice versa. There is no benefit to buying less liquid instrument unless you are the marketmaker and can make more money in bid/offer fees than you lose in cost of carry arbitrage. There is a reason these curves are similar. Any variation is arbitrage, though not without risks. A future contract in Gold’s value is a mathematical equation.
Spot price x days to expiration divided by 365 x the risk free rate of money for that time period + some storage cost factor= the future price.
There are 2 scenarios that will change that math. When a shortage of physical gold reflects a need to roll futures to spot (unlikely but we can pray!) or when aliens land that eat Dec gold and crap April gold (Moonshot contango)
Also, buying a December future contract does not limit your downside risk NOW as many people think. “It’s Gold in December, not now right?” There is another word for that. It is called a DECEMBER CALL OPTION.
Why the Banks may be legitimately recommending this tactic and why that recommendation assumes you are too stupid to understand the risks of getting long another way:
“You may be holding it for a long time and we are trying to save you the rollover cost execution.”
a. Math is math. Rolling over your long every expiration will cost approximately as much money as the complete contango from April to December right now. Add in the “We know you’re a buyer so we’re gonna back off and raise our Dec. ask price because you are a captive client” and you will most likely get crushed. They can’t fade you in April. They have more competitors there.
b. Even if a. is wrong and they are not fading you, and the monthly rollover carry is a tick or 2 more than just buying and holding the December future, we’d rather pay that liquidity premium any day instead of being kept on hold while our broker, banker, AND counterparty susses out our position before making a market in a back month future. Even if you execute the Dec contract for yourself on a screen, who do you think is bidding up the December contract with no fear of anyone selling it to them? They borrow at 0.00% interest. Their staying power is bigger than you and your 18% visa card. And they know you are coming to buy. Its Bayesian probability and asymmetric risk for them. You are toast. Their whole commodity model has de-evolved into a Martingale trade, And Double Zero is the Fed going under.
c. If it were more efficient to buy December futures than to buy April and roll them over, there would be no back month independent marketmakers or arbitrageurs, because there wouldn’t be sufficient edge to support their trading. But yet there are plenty of back month futures marketmakers willing to make a market in something you know infinitely less about than they do. Back month marketmaking is not a public service. Meanwhile, there are hardly any spot month independent marketmakers anymore, because the market is just too tight to make a living unless you are arbing another venue. Natural flow as a result of transparency and technology makes the market now. December, not so much.
Why they may be recommending this tactic with less than your best interests at heart:
1. They could already be long December contracts given to them from producers who hedged production last year. The Bank’s own hedges could be in April and they seek exit liquidity on their December long leg while they unwind their shorter dated leg, which is infinitely more liquid for them.
2. They are long April and are perfectly happy putting on the April/ Dec spread at higher than interest rate differentials. Specifically, 8 month rates will be less than what you pay buying December at a price while April is trading at a lower price. Example: they sell Dec, buy April and collect a cost of carry spread of say, .25% and then trade a bond spread that charges them .15%. Tadaaa, inefficient markets make them money.
3. Because their market share in commodities has shrunk since ETF’s have trumped their own GSCI for retail flow, and they have to make up some “special” reason to buy a December contract in Gold.
4. Maybe they are helping to create exit liquidity for a client they give a shit about, someone like Paulson? Free Abacus with every Dec future?
5. Some other reason our paranoid minds haven’t thought of.
In the one size fits all category, they should be telling you to buy an ETF. No rollover risk, less entry and exit vig and no cost of carry. But they can’t control that transaction can they? Unless of course they expect a paper versus physical delivery issue. In which case you should be long April, not December.
Even if their idea is legitimate and we’re wrong. They should at least describe the risks of buying a deferred expiration contract and not in some fluff piece by shill Jim Cramer’s site.
The irony of a good marketmaker is that his success attracts competitors and his service is then no longer needed. As these banks make less money on tighter bid/ask spreads they seek legislative protection of their franchises, less transparency, restrictions on competition and such. Call it white-collar welfare. Failing that, they seek more and more arcane ways of convincing you to put on a position which could be executed much less expensively. They seek to migrate your positions into the desert of liquidity. Where transparent light rarely shines. This way the bodies are harder to find if it blows up. They are in a war with exchanges as well. Exchange products are trumping bank intellectual capital and salesmanship. And so the banks are trying and succeeding in buying pieces of them now. There is a new wall going up, and it is being constructed by the government around the Exchanges. The banks want to be on the right side of that wall. Even while they rail against the exchange clearing monopolies, they want in. But we digress.
We are Bullish on Gold
Here is what we are telling you at the most basic level: if you are bullish, and haven’t fallen asleep yet reading this; buy the front month contract and use some reliable methodology to generate a stop loss. Be it technical analysis, bank roll management, voodoo, interest rates or whatever. Just have a level to get out if you are wrong.
If you insist on buying a December futures contract, the screen market will be 2 to 3x as wide as the April, and we’re sure higher than the cost of carry. Whatever gets you through the night we guess. Vaya con dios.
If you wish to express your position in options, consider a tight December call spread or a ratio if you are not afraid of margin calls. But learn what we are saying here first. Google it or email us. We’ll respond.
If you want to get fancy, do what the pros do, a covered write. Buy April Gold. Then ask yourself at what price do you want to get out? Goldman says $1480.00. If you agree, sell a December 2011 $1500 call and create a dividend for yourself if the market doesn’t get there. If it does, laugh to the bank. Just make sure you have the capital to handle a margin call, even as you are making profits. Keep your powder dry and don’t put too much in any one idea.