ZSL teaching some investors harsh lessons

While cruising around the Yahoo Finance message boards, I read many posts similar to this one:

I learned a painful lesson with this POS. After making a small gain in SLV calls a few weeks ago, lost it all in 2 days. Turned to this and managed to turn $4k into $0 within 3 days with useless calls. I have to agree this is totally rigged, down big when silver is down, but not last week....up big when silver was down....WTF?!!!! I'll be interested if a class action lawsuit is forthcoming.

ZSL is a double inverse ETF based on the silver price. In other words, it is a way to short silver with leverage. From the ProShares web site:

This ETF invests substantially in financial instruments linked to the performance of commodities and currencies, such as swap agreements, forward contracts, and futures and options contracts, which may be subject to greater volatility than investments in traditional securities.

A derivative monster on steroids. If you hold it for more than one day, the transaction and roll costs will eat you alive. ZSL has usually tracked the double inverse of the silver price pretty well for one day periods. But what really changed this past week is that the short silver trade got very crowded. Everyone wanted to short silver on the way down and bid up the price of ZSL far beyond it's net asset value. That premium gets wrung out through resets in derivative prices and from arbs coming in to take the eager short sellers' money.

Even after the horrendous performance last week, the NAV of ZSL is $18.76 while the closing price was $19.70, a 5% premium. I made a little on ZSL early in the week but got out when the premium started getting too high. You can see an outrageous premium in the Sprott Physical Silver Fund (PSLV) as well, something close to 15%. That is not likely to end well. These premiums can build up for a number of reasons, but Reflexivity is probably the best explanation.

This poor investor thinks the ZSL tracking error is due to fraud.

I called proshares about this fraud, they soooo fawked up, gave some bull@#$% explanation, what ever. But people lost lot of money. When silver 5% down ZSL also down too doesn't make any sence at all. This morning SLV up 2% but this turd is down 10%. Play this POS if you just want to loose money. Total fraud, people have to file class actions about proshares doing too much looting with these 2x and 3x scams. SEC should get rid of all these fancy etfs and toss em into toilet.

While there is plenty of fraud in the operation of stock markets, investment companies, and the SEC, this case is not one of them. This investor is probably making investment decisions with the same expertise shown in his grammar and spelling.

Possible end game gold price targets

Note: This post inspired by Eric Janszen articles at iTulip.com.

There are a number of possible resolutions to the world debt crisis and to the titanic debt of the USA. Going through the political calculations and game theory of the timing and final resolution is frankly beyond my ability. However, with the dollar index and trade weighted dollar near all time lows, one possible resolution to prevent the dollar from an eventual collapse would be for the US to reopen the gold window for foreign creditors to allow them to exchange dollars for gold.

This would simultaneously impose (again) some kind of limit on the trade deficits that can be run by the US. The simplest way to accomplish this is to revalue the gold on the Fed balance sheet. The Federal Reserve Act of 1913 put a limit on the total amount of credit and currency that could be issued by the Federal Reserve. Here is the pertinent part of section 16 of the Federal Reserve Act:

Every Federal reserve bank shall maintain reserves in gold or lawful money of not less than thirty-five per centum against its deposits and reserves in gold of not less than forty per centum against its Federal reserve notes in actual circulation, and not offset by gold or lawful money deposited with the Federal reserve agent.

There may be some argument over the best measure of notes in circulation. The most conservative measure might be M1 which includes currency and checking accounts. But since the FDIC insures savings accounts and CDs, M2 might be a better measure. Wikipedia has common definitions of money supply. I've read arguments that the Fed balance sheet, the total liabilities of the Fed, could be used but that doesn't seem to come close to the definition in the Act.

If the US wanted to stick with the letter of the original act and limit redemption to M1 money stock, which was $1,908,900,000,000 as of May 5, 2011. Restrictions on redemption to M1 would force creditors to wait for their treasury bonds to mature before making claims on US gold. Here is where gold would need to be priced to restore the dollar link to gold based on M1:

$1,908,900,000,000 / 261,499,000 oz (US gold reserves) = $7,299.84 / oz
Apply the 40% reserve to get a current target of $2,919.94 / oz.

However, the thesis is that the purpose of reopening the gold window would be to keep foreign creditors from dumping the dollar. Most foreign reserves are stored in treasury bonds. Treasury bonds are simply frozen dollars that pay interest -- dollars that thaw on a specific date in the future. Total US debt is over $14 trillion, but not all of that debt needs to be redeemable in gold.

I think it is safe to exclude Intragovernmental Debt, primarily the Social Security Trust fund, because those bonds are not marketable and will be paid out as dollar benefits (or legislated away). That leaves the debt held by the public, made up of both foreign and domestic creditors. The number we are looking for is the number for foreign creditors.

For that, we need to look into the Treasury International Capital System (TIC). The total debt held by foreigners as of February, 2011 was $4,474,300,000,000.

$4,474,300,000,000 / 261,499,000 oz (US gold reserves) = $17,110.20 / oz
Apply the 40% reserve to get a current target of $6,844.08 / oz.

But does the US really need to give gold to foreign private citizens that hold treasury bonds? Maybe not. The point is to keep international commerce flowing smoothly. To that end, we can look at only the debt held by foreign sovereigns. The total official foreign holdings as of February, 2011 was $3,186,300,000,000.

$3,186,300,000,000 / 261,499,000 oz (US gold reserves) = $12,184.75 / oz
Apply the 40% reserve to get a current target of $4,873.90 / oz.

The Fog of Currency War

If all of the above conjecture is correct, it will still be a murky and twisty path to arrive at the destination. I don't believe the US will reopen the gold window until and unless it is forced to do so. It would be an admission of the failure of the US and Federal Reserve to manage the dollar. It would discredit the theory of a workable pure fiat currency. It would discredit a couple of generations of academic economists, including Nobel Laureates, and the economics profession. Not that being consistently wrong hurts the career of economists in general, but they might have o amend a few textbooks. It would also come as a shock to the general population who for the most part has little or no understanding of monetary history or the current money system.

If gold was remonetized preemptively at a price higher than the market price, the transition might be made without any major disruption. If it happens in a disorderly way, the market price may overshoot the remonetized price and come back down to a permanently higher and managed level. In that scenario, the US may not have as much control of the final price.

Dual mandate: Inflation expectations, Unemployment, Fed Funds Rate

Sources:
Fed H15 http://www.federalreserve.gov/releases/h15/data.htm
NY Fed http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html
BLS

The Fed's dual mandate is theoretically stable prices and low unemployment. There are many different measures of inflation, but one that can be reasonably argued as market based is the difference between the 10 year treasury yield and the 10 year TIPS yield. In the above chart, the difference in yields is labelled inflation expectations. That data is only available back to 2003.

Inflation expectations appear to have completely recovered from the 2008 crash after plunging to depression levels. What has not recovered is the unemployment rate. Based on the recent comments by Bernanke, the Fed is not worried about inflation.

The employment numbers look even more terrible if you look at the raw job numbers that don't ignore people whose benefits have expired. Based on the dual mandate, it is unlikely the Fed will raise rates any time soon. However, if inflation expectations continue to rise, say into the 3-4 percent range, the Fed will have a tough choice to make regarding interest rates.

At the beginning of the graph, you can see the end of the 1% reflation rate set to recover from the 2001 recession. The low rate, held for about 2 years, helped fuel the housing bubble. The even lower rate set by Bernanke has now been in place for over 3 years and I wonder how and where that latent inflation will pop up. We have partial answers right now: stocks, commodities, and metals. Whether those assets will continue to benefit over the next 3 years is an open question.