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Gold Stocks, the Yield-spread, and the 'Hedge Fund Economy'

Below are extracts from a commentaries posted at www.speculative-investor.com on13th June 2004 and 17th June 2004.

Gold stocks and the yield-spread

Gold and gold stocks are positively correlated with the yield-spread, although the correlation appears to be stronger with the stocks than with the bullion. We say this because during 1985-1986 and 1999-2000 gold stocks continued to trend lower with the yield-spread for about 16 months AFTER the gold price had bottomed. In fact, during both 1986 and 2000 a large advance in gold stocks began on almost the same day that the trend in the yield-spread (the yield on the 30-year T-Bond divided by the yield on the 13-week T-Bill) reversed from down to up.

Relative to its 20-year average the yield-spread is currently very high, but the absolute level of the yield-spread appears to be far less important, as far as the currency and gold markets are concerned, than the direction in which it is moving. This can be seen on the below chart. Notice that when the yield-spread turned higher in November of 2000 its level was very low, but as soon as the yield-spread reversed course a major bull market in gold stocks got underway. Similarly, the trend reversal in the yield-spread in January of this year led to a trend reversal in the gold sector.

By the way, trend-lines drawn on charts are always somewhat arbitrary. For example, trend-lines will usually be in different places depending on the type of chart (candlestick, line, P&F, etc.) and on whether the chart's vertical scale is linear or logarithmic. Also, experienced chartists will regularly draw trend-lines in different places even when using the same scale and the same type of chart. This is why, when identifying support/resistance levels on charts, we usually place a lot more importance on former peaks and troughs than on trend-lines. It is also why the yield-spread's trend-line break in January could have been meaningless until it was confirmed by the April-May breakdown in gold stocks (the yield-spread broke below similar trend-lines in August of 2002 and April of 2003, but in both cases subsequent market action proved that it was still in an upward trend).

The above chart doesn't tell us that a major top is in place for either the gold stocks or the yield-spread because an upward trend-line formed by connecting the lows during the first few years of a long-term bull market is never likely to remain intact throughout the entire bull market. Instead, what tends to happen is that some larger-degree corrections along the way will establish a trend-line that is less steep. In other words, the bottom of the current correction (which might, by the way, already be in place) will probably determine the slope of the long-term upward trend.

What the chart does tell us is that as long as the yield-spread is moving lower, that is, as long as short-term interest rates are rising RELATIVE TO long-term interest rates, the gold stocks will be facing a substantial headwind. The Fed could therefore bring about much greater weakness in the gold sector than has already occurred by getting genuinely aggressive on the rate-hiking front. The thing is, if the Fed did do that it wouldn't just take down the gold stocks; it would take down the entire stock market. And that's why it almost certainly won't happen, at least over the next several months.

The Hedge Fund Economy

Some of the strange linkages we've seen in the markets over the past 15 months and the absurd extremes recently hit by some popular technical indicators can, we think, be at least partially attributed to the proliferation of hedge funds. In theory the thousands of hedge funds that now exist should be a balancing force in the markets -- they should act to make the markets more efficient -- because in many cases they are looking to exploit situations where the markets have temporarily moved 'out of whack'. In reality, though, there appears to be an enormous amount of trend-following going on, with the hedge-fund community piling into, and then out of, trades in the same way that a herd of wildebeest might stampede in one direction and then suddenly change course upon the sighting of a lion.

One of the biggest influences on the markets over the past year was the putting-on and subsequent unwinding of carry trades (borrowing at a low rate and then 'investing' the proceeds in something that is expected to earn a higher rate). Specifically, speculators borrowed large sums of US dollars with interest rates at generational lows and exchanged the dollars for higher-yielding currencies. They also used the borrowed dollars to purchase investments that would likely benefit from the inflation that was clearly raging behind the scenes. And as long as the Fed was talking-up the prospect of DEFLATION, or, at least, refusing to acknowledge any INFLATION, this seemed to be a riskless trade. However, as soon as it became clear that the days of a 1% Fed Funds Rate were numbered there was a rush for the exits that caused sharp reversals of the preceding trends.

The carry trades probably haven't been fully unwound, which is why we get US$ strength combined with weakness in everything that benefits from rising inflation (gold, for example) every time something happens to CONFIRM the inflation. The reason is that the more visible the inflation becomes the more likely it is that the Fed will be forced to hike short-term rates aggressively and the less attractive the US$ carry trades will appear to be. It might not make sense, but this is the thinking that seems to be permeating the markets right now.

The popularity of the carry trade with hedge funds has caused a counter-intuitive response to inflation news over the past two years (talk of a DEflation threat has caused gold to rally and the US$ to fall whereas talk of an INflation threat has caused the US$ to rally and gold to fall), but this is not the only area in which we are seeing the footprints of the hedge fund community. The extremely high put/call ratios discussed in last week's Interim Update are also, we think, the result of hedge fund activity.

Very high values for the CBOE equity put/call ratio have historically been associated with important market bottoms because when the volume of put options is relatively high it is often a sign that the public is very fearful; and when the public becomes convinced that the markets are going to move in one direction the markets usually end up moving in the opposite direction. The recent surge in the put/call ratio has, however, occurred in the ABSENCE of fear. We know this because the volatility indices have remained low, the bearish percentage reported each week by Investors' Intelligence has remained low, and the NDX/Dow ratio has not broken down. Therefore, what we are most likely seeing in the equity-options market is hedge funds simultaneously buying and selling large amounts of put options in order to pocket a 'spread'.

Statistics on equity-options trading are now dominated by trading in QQQ (NASDAQ100 Trust) options, so the sort of trade that MIGHT be boosting the put/call ratio would, for example, be the sale of tens of thousands of QQQ September $40 put options and the concurrent purchase of the same number of QQQ September $37 puts. Such a trade would have the effect of pumping-up the put/call ratio, but it is not a fear-based trade. It is, in fact, a bet that the market will move sideways or higher over the coming few months. And it renders the put/call ratio meaningless because we don't know whether the hedge funds that are doing these trades should appropriately be classified as 'smart money' or 'dumb money'.

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