Volatility and Sector Reallocation

It was another turbulent week on Wall Street with mounting worries about the credit markets. A rebound in the US stock markets was short lived but allowed for conditions to become less oversold before the heavy sell-off continued.

For the week, both the S&P 500 and the Dow Industrials are down 1%, the Nasdaq is down 2%, Financials Select Sector SPDR (XLF) is down 4%, while gold is up almost 2%. Gold and gold stocks are showing their countercyclical character and appear to be stabilizing. However, it is too early to draw any major conclusions.

Volatility remains high and there is a lot of selling driven by fear. The Volatility Index (VIX) closed at a 4-year high on Friday. While the index will fall when the market rebounds, we do not believe that it will come back to the lower teens where it has been over the last few years. The fragile nature of the "Credit Bubble Economy" is now becoming evident to many investors and complacency levels should be decreasing as we enter more worrisome times.

A high volatility level is also a sign that many indices, including the S&P 500, are experiencing sector reshuffling. After the collapse of the Nasdaq, the financial stocks have become the largest component in the US equity markets. It appears the time has come for a change of guard once again. With an ongoing credit squeeze hurting the sector, Financials Select Sector SPDR (XLF) dropped over 13% in less than three weeks on huge volume.

As of June 30, 2007, financials weighed more than one fifth in the S&P 500 Index (based on market capitalization). This is quickly changing. Energy, Materials and Health Care are bound to take a bigger share in the index.

We shall see what happens to the financial stocks and whether confidence will be restored to the credit markets. It will be interesting to refer to the above chart six months from now.

US Dollar or US Consumer

For now, the most noteworthy event the market observers are looking forward to is the FOMC meeting on August 7 and the market's reaction to the meeting's outcome. Our best guess is that the committee will support the markets and give hope of a rate cut despite the weak dollar. In fact, the dollar itself has already priced in a loosening monetary policy and such a move by the Fed may not cause the dollar to break down below its multi-year support level in the following weeks or even months. The leading indicator to watch is gold, not the dollar, and from a technical perspective (gold is still far from making new highs) it is not signaling any major changes at this time.

A sudden rate cut will send the wrong signal to the markets indicating that the Fed is panicking. Likewise, language short of being dovish could be another excuse to produce a selloff in the markets. What will probably happen is that the Fed will set the stage for a rate cut later this year. But for now it can use other means at its disposal to boost money supply. It may work this time. As long as the confidence level in the world financial system remains relatively high, the central bankers will be able to continue building a house of cards. Yet the free market forces are immeasurably more powerful than the bankers. With irreversible deterioration of confidence in the modern financial system, the end of this game is in sight. All it would take is for foreigners to stop purchasing US debt.

Will the current decline in the stock market remain a correction or turn into the first leg of the coming bear market? That will depend on whether the problems in the leveraged credit markets spread to consumers already drowning in a sea of mortgage debt. In October, the amount of mortgage debt that is scheduled for its first interest rate adjustment is expected to top $50 billion, the highest number ever. It will remain above $30 billion per month until the middle of 2008. And since the credit problems are no longer a subprime issue alone, banks may be reluctant to lend at low rates without further encouragement from the Fed.

The Fed is faced with a dilemma: salvage the US dollar or the US consumer. The consumer will almost certainly prevail.

Is Smart Money Going Into Gold?

The real test for gold investors will come when the stock market resumes its decline this fall. Will gold separate from the markets and start competing with US Treasury bonds as a safe haven for risk averse investors? So far the signs are encouraging.

Sentiment in gold and gold stocks is once again negative. We are hearing some calls for gold to slide down to $500. From a contrarian perspective, this is encouraging especially since the smart money is starting to see a safe haven in gold. StreetTracks Gold Shares (GLD) metal holdings are at an all time high of 506.52 tonnes as of August 3 compared to just 464.22 tonnes one month ago. This is a 9% increase compared to only a 3% increase in the gold price.

A flight to gold is happening at a time of serious credit crunch symptoms. If the 500 tonne level is held in the next couple of weeks, it will be a very bullish sign.

Even though the stock market remains depressed and sentiment is negative, there is a lot of physical demand for gold which is a bullish precursor. While gold may not start its bull run just yet, the downside appears to be limited. In this difficult market, a lot of value can be found in precious metal stocks. We hold a core position in best performing groups of gold stocks, but do not neglect shorter term signals to adjust cash positions.

Despite fundamentals turning more bullish for gold with every passing week, we try not to get overly excited about breakouts in gold stock indices, which are still in a trading range as is evident in the chart above. The Bollinger Bands provide nice support and resistance levels for HUI and the chart looks moderately bullish. We continue to believe that an upside breakout in gold and gold indices will occur before the year end.

This is an excerpt from an RSG Newsletter published on August 4, 2007.