Gold and Silver Bugs, Meet Your Enemy: The Robot

It is more powerful than JP Morgan. More influential than Goldman Sachs. It can override any action taken by Ben Bernanke in less than one millisecond. It does not care how much metal is in Comex warehouses and it knows nothing about quantitative easing. If it goes up, it buys. If it goes down, it sells. Gold and silver bugs: meet your true enemy, the robot:
While many if not most gold and silver bugs believe every move in gold and silver is manipulated by JP Morgan, the Fed, the bullion banks, etc (the “Cartel”), the reality is that most markets, commodities in particular, are driven by systematic hedge funds. These funds use computer algorithms to decide when to buy and sell. Several of the largest include John W. Henry & Company and FX Concepts, which have had great success over the years both in performance and asset growth. As shown below, systematic funds dominate the CTA space. According to Barclay Hedge, systematic funds control $250 billion of assets at 2Q11, whereas discretionary traders (i.e. humans) have only $30 billion under management.
While each systematic fund has its own unique characteristics, the strategies are all generally the same: trend following/momentum. That is, they buy whatever is going up and sell whatever is going down. They don’t care about fundamentals, or news flow. All they care about is price, and which way it is moving. Given that these systematic funds comprise the vast majority of capital trading commodities, moves in commodities, particularly gold and silver will thus likely not be explained by fundamentals. Furthermore, given that many of these systematic funds operate similar strategies, they are prone to buying and selling all at the same time, leading to dramatic moves like the sharp rises and declines exhibited by gold and silver in recent months.
Thus, when you see dramatic moves in gold and silver on little or no newsflow or if it moves contrary to fundamental conditions, do not blame manipulation or The Cartel. Blame the robot.

18 comments:

Warren James said...

Brain, your thesis is sound. Does this not generally mean that price discovery (of any real good, not just metals) is screwed?

Worldwide demand for silver in industry did not plummet 25% in two days (unless it was on the news of that sunken treasure ship discovery). That much is obvious, but how bad do you think the picture is overall (price distortion I mean)?

To me, the robots are just another part of the great wealth pump (which I wrote about in Hard Assets).

Bosco said...

Educate me please if I am wrong.
Aren't robots trading in everything besides metals? If so, why are we seeing 25% downdraft in silver and not in other market (at one point it's actually 35%+)? And why are we seeing price movement of gold and silver most of the time sync in direction (though not necessarily in amplitude) and not with other asset classes? If robots are really that dominating, each asset class should behave pretty much independently over the long term, no?

I think robots do play a major role in price movement but I think they don't set the trend but just exaggerate it. It just makes the market manipulator's job easier.

It still baffles me that there are people naive enough, to believe when huge money interest is at stake, that market will be trading without manipulation. Come on, even small businessmen will try to manipulate the market they are in if they have the chance. Maybe western people are in general too accustomed to a law-abiding environment.

Brian O'Flanagan said...

@ Bosco, I'll take your last point regarding manipulation first. There is no question that manipulation goes on in every market. HFT algo's are particularly skilled at shaking people out of their positions through stop hunting and painting false breakouts. But that manipulation goes both ways, sometimes they manipulate it up, sometimes down, all depending on which way would benefit their positions in the short-term. But there is no evidence of an ongoing price suppression scheme trying to keep prices down and such a scheme would defy logic. Bankers like to make money - suppressing the price of anything would cause them to lose money.

The algo traders are most definitely involved in metals. I'd agree that they generally don't set the trend but serve to exaggerate it and add volatility to it. We are also seeing crosscurrents from different algo strategies - you got the longer-term momentum systematic traders doing one thing and the HFT correlation and mean-reversion traders doing another. So sometimes the metals move with other assets, sometimes they don't, depending on which strategy is dominant.

What we most likely experienced in recent days was rational fundamental selling driven by deflation fears and hawkish policy actions cause prices to correct a little, which then led to a breakdown in correlations (positive with bonds and negative with equities) which drove out the correlation mean-reversion algos and then led to the trend-following algos to start selling. Once the price falls below key technical points and moving averages, the systematic traders all dumped en masse and probably started going short.

Brian O'Flanagan said...

@ Warren, does this mean price discovery is screwed? YES, at least in the short to intermediate term. Algorithmic trading dominates the landscape and there is nothing we can do about it. Take a look at the jobs board on Bloomberg. For every one job listed for a fundamental trader or portfolio manager, there are probably 50 jobs listed for traders with PhD's, math degrees and programming skills. These traders couldn't read a balance sheet or understand even basic economic concepts, yet they are moving trillions of dollars of capital around the market.

As a fundamental trader with a long track record of success managing money for hedge funds, I am now a dinosaur. Maybe someday all these robot traders will collapse and the humans will return, but until then, they rule the world.

GM Jenkins said...

It's been remarked that the gold and silver bug community has a very "religious" feel, what with their believing that a gold standard is the solution to all earthly corruption, that there are clearly demarcated sides of good and evil, and that good will eventually prevail, their enemies sent to suffer in hell.

There have of course been millions of religions throughout world history, and while they all can't be right, it's certainly possible that they all have been wrong. Clearly, when it comes to religion, something other than truth is what's sought, and something other than truth is what's found.

In other words, religion exists only insofar as it is adaptive, whereas truth is truth whether adaptive or not. Assuming in this case that the fundamentals of gold and silver are strong (and as a fundamentals trader, Brian presumably wouldn't have been drawn to the metals otherwise), I think the case must be made that the PM "cult" is an adaptive mechanism that allows its adherents to weather the volatility of the market.

From a strictly adaptive, utilitarian standpoint, as long as the central (and very strong) premise that all fiat currency eventually loses all its value is true-- everything else can be myths and misunderstandings. If it's psychologically more adaptive to view setbacks to your main premise (i.e. fiat currency will go to 0) as caused by an enemy with a face and malicious motives (e.g. Blythe vs. an emergent phenomenon like a robot made up of thousands of independent networks of algorithms), then the religion will appropriate the myth over the reality, all in the service of a greater imperative: sit tight and be right!

Religion has its tradeoffs. Pro: you don't have to think, which can get you into big trouble (in this case, panicking and selling your gold, only to see markets shoot back up; or going through your days as a psychological wreck wondering if China will collapse, Asian buying will disappear, bringing gold back under $1000, etc.) Con: You can get led astray by hoaxes like WB (I pity those who might have piled into options before the latest FOMC waiting for the derivatives bomb etc), and you can really end up in a bad way if your religion's adaptiveness ever ceases.

GM Jenkins said...

I think I've made it clear though that I not only agree with the main premise of the PM bug "religion" -- that all fiat eventually will go to zero (though anyone who pretends to know when is a fraud) -- but I also will not discount offhand even the most far-fetched sounding accusations against cartels and collusion and criminality. Anyone who thinks there's a limit to the lengths that those atop a rotting superpower will go to should read Gibbon's Fall of Rome.

Bosco said...

@Brain:

1) What you said about how robots work is all well and true. But it serves no answer to the point that I said, why silver, being just a not-so-important commodity as it's advertised, is sold off 35%+ at a point in a 2 day downdraft that is not seen in any other market while we all know the speculative money have pretty much been flushed out in May with OI at yearly low. It also doesn't explain why over a multiple year timeframe, that if without the US trading time, silver (and gold) would have been much higher in price whereas the opposite is true for equity (I bet you can find those "evidences" if you want). Maybe Asians are just dumb.

2)
"But there is no evidence of an ongoing price suppression scheme trying to keep prices down and such a scheme would defy logic. Bankers like to make money - suppressing the price of anything would cause them to lose money."

I don't have any "evidence" that I think would convince you and I don't intend to find any of them. Because it's not necessary. Simple logic determines such a scheme has to exist. Why?
Because there's an item that is being constant suppressed in price, right in front of both you and me. That item is called the DOLLAR (which is just a commodity like gold and silver regardless you like it or not) and it is through a process called inflation. What bankers seemingly lost in value, they make up (and huge) in volume (I think this line is from FOFOA). With that, how can there's not a suppression scheme on PM?

Or otherwise Alan must be talking trash here:
"Central banks stand ready to lease gold in increasing quantities should the price rise. - Alan Greenspan, U.S. Federal Reserve Bank, 24 July 1998"
Or you can go read R. Mundell's stuff, maybe he's insane as a silverbug as well.

3) I think guys like Harvey Organ are crazy. He might be a good guy but he's definitely stupid and misrepresenting stuff at will. However, to go from one extreme (everything's manipulated and conspired) to another extreme (nothing's manipulated and conspired) is equally stupid. Simple life experiences tell us free market doesn't exist in anything.

Brian O'Flanagan said...

On the contrary, Bosco, simple logic implies that banks have absolutely nothing to gain from any attempt at price suppression, in fact, they have more to gain by manipulating metals higher. Central banks want inflation and a weaker currency. A suppressed metals price would imply low inflation or disinflation and a stronger currency. Rising metals prices mean rising inflation and a weaker currency. You can't inflate your way out of a deflationary scenario and have metals prices fall.

Gold and silver are not anathema to banking. Banking existed and thrived under the global gold standard. Sure, banks hate to see deposits withdrawn, but it make no difference whether the cash is taken out to buy gold, stocks, bonds, real estate, foreign currencies, copper or whatever. Are all these assets all suppressed too?

By the way, there is a big distinction from manipulation to suppression. Manipulation is easy and happens all the time, suppression would require an exponentially increasing amount of capital to undergo and thus such scheme would manifest itself in exponentially increasing short positions that would quickly become evident for all to see. Yet we are actually seeing evidence of falling short positions. You cannot suppress something and be short covering at the same time.

Finally, silver is highly illiquid and volatile. A decline of 35% is no big deal when the asset more than doubled in the past year. The fast money rushes in and then rushes out. If a big decline is evidence of manipulation in your view, then would it not follow that manipulation is what caused it to get to $50 in the first place.

Brian O'Flanagan said...

One final comment on the Greenspan quote that has been completely taken out of context by the gold bug community. Greenspan was talking about attempts at manipulation and corners in commodity markets and to what extent regulation of OTC derivatives would address those issues. He was simply saying that central banks could deal with an attempt at cornering the gold market by leasing increasing quantities of gold. He used unfortunate words by saying they would lease "if prices rise", but the context clearly shows he meant it would apply in a case of manipulation or corner, not to suppress the price on an ongoing basis.

Read the complete testimony:

http://www.federalreserve.gov/boarddocs/testimony/1998/19980724.htm

Brian O'Flanagan said...

In other words, Greenspan is saying central banks would lease gold to STOP manipulation, not to manipulate it themselves.

Again, read the complete testimony.

Bosco said...

@Brian:

"You can't inflate your way out of a deflationary scenario and have metals prices fall"

So are you suggesting, in short, central banks want a higher metal price? So to kick-start the economy, are you saying central banks should go in and bid up the metal prices so as to re-flate it? Why aren't we seeing this? OR might be after all, WB is a central banker?

I think you have ignored the point of confidence. Central banks want weaker currency compared to another (fiat) currency but want strong confidence compared to the de facto money by human history.

And btw, I have nothing against banking at all. I got my MBA from US and worked in a IB for a while before moving to PE. So I am in the field as well. I am just baffled, now as well as my time in the US, that certain MBA types are so naive when it comes to real world under-table dealings.

"A decline of 35% is no big deal when the asset more than doubled in the past year. The fast money rushes in and then rushes out. If a big decline is evidence of manipulation in your view, then would it not follow that manipulation is what caused it to get to $50 in the first place."

That would be true IF those fast monies not have been flushed in May already. Where were the OI to be flushed in that 35% downdraft? from 120K to 115K? That?
YES. Didn't I maintain the position that it's not a free market at all? That's what I've been saying, blame the robots? My ass. It's human play after all, both up and down.

Brian O'Flanagan said...

The price of metals has nothing to do with confidence in the currency any more than the price of corn, copper, oil and other stuff that the world actually needs. Yet somehow in the silver and gold bug mind, there is some underworld that just has so much hatred of gold and bug that they take time out of their moneymaking activities to deliberately lose billions of dollars just to stick it to the stackers.

The naivete is squarely on those who need to believe such fantasies to justify their positions.

Bosco said...

@Brian:

"The price of metals has nothing to do with confidence in the currency any more than the price of corn, copper, oil and other stuff that the world actually needs."

Yah, maybe you should email Marty and tell him he's plain wrong as well.

And I guess Vietnam gov't should start regulating corn, copper, oil, rubber and so on like they did with gold in the face of their currency crisis.

And btw, these are your own words telling potential investors in one of your presentation:
- Gold is uncorrelated with most other assets and thus adds positive returns and reduced volatility to a diversified investment portfolio
- Fiat money systems have come and gone throughout history, yet gold always survives

I guess what you should do is, after presenting that to your clients, you should tell them, "oh by the way, oil, rubber, corn and other commodities can do the same thing as gold for your portfolio as well, and I am starting to trade pork belly next month, you are welcome to invest as well"

Brian O'Flanagan said...

who is Marty?

Indeed, while gold is unique in many respects, other commodities and assets can serve much the same purpose, which was discussed in my most recent presentation. In that I highlighted housing as particularly cheap relative to gold. Like I said, it's all relative.

So Vietnam regulates the price of gold. Isn't that what communists do?

Hong Kong regulates and suppresses its own currency. Does that mean you should buy it? Such scheme will surely collapse some day. Are you going to start the Hong Kong Dollar Anti-Trust Committee? Is Ted Butler going to start writing about this travesty? Maybe Sprott should start a HKD closed-end fund and sell it to retail dopes at a 20% premium. Let's crush those evil currency boards, man!

Brian O'Flanagan said...

actually, regarding Vietnam, one of the most sought after assets in the black market is good old U.S. Dollar Fiatsos, is it not?

Bosco said...

@Brian:

Martin armstrong.

"So Vietnam regulates the price of gold. Isn't that what communists do?"
What the heck does this have to do with Communism? Vietnam is more capitalistic than most European countries now.

"actually, regarding Vietnam, one of the most sought after assets in the black market is good old U.S. Dollar Fiatsos, is it not?"
Yes. And didn't that also refute what you just said? In a currency crisis, people float to another currency they perceieve as safe FIRST, and then to real goods (not saying they wont). SO you blanket statement is so wrong.

"Hong Kong regulates and suppresses its own currency"
Haven't you answered your own question? Didn't you say you see no point for bankers to gain from suppressing the price of anything? Did Hong Kong gain anything from this? As I said, currency is just another commodity and they have their value from network effect like facebook.

Brian O'Flanagan said...

Hong Kong gains in exports by suppressing its currency whereas the cost is immediate inflation and eventually realizing substantial losses on its reserves.

What would anybody gain by suppressing gold and silver? Nothing.

Kid Dynamite said...

"He (Greenspan) was simply saying that central banks could deal with an attempt at cornering the gold market by leasing increasing quantities of gold."

tremendous point, Brian.