Trader’s Narrative

What better way to reliquify the world financial markets than sacrificing a currency?

If you’ll recall this is a well worn script. The last time we had a financial crisis, it was the Yen that was used as the vehicle of choice. Massive amounts of capital were borrowed in Yen and invested in other risky assets with the nudge-wink agreement of central banks that it was a one way trade.

Today it is the US dollar that is being sacrificed at the altar of the new bull market… in everything. Roubini has been among the most vocal to raise the alarm. But almost everyone else has decided to enjoy the trade while it lasts.

Of course, the sensible thing is to realize that you can’t drink yourself sober, just as you can’t dig yourself out of a hole. But since when have monetary policy wonks been fans of reality?

While it is difficult to prove definitively that the US dollar carry trade is the reason almost every single asset class has appreciated, its footprints are hard to miss. Here are David Rosenberg’s recent observations on the correlations across asset classes:

Historically, there is no correlation at all between the DXY index (the U.S. dollar index) and the S&P 500. In the past eight months, that correlation is 90%. Ditto for credit spreads — zero correlation from 1995 to 2008, but now it has surged to 90% since April.

There was historically a 70% inverse correlation between the U.S. dollar and emerging markets, such as the Brazilian Bovespa, and that correlation has also increased to 90% since the spring.

Even the VIX index, which historically has had no better than a 20% correlation with the U.S. dollar, has now sent that correlation surge to 90%. Amazing. The inverse correlations between the U.S. dollar and gold and the U.S. dollar and commodities were always strong, but these too have strengthened and now stand at over 90%.

The scary consequence of the US dollar carry trade is that it has pushed almost all risky assets to be correlated. And when the music stops and someone starts to unwind the trade, it will get ugly. When everything you hold is correlated to each other and everything else in the market, even a small tremor of selling will lead to an avalanche as the value of your portfolio starts to decline all at once.

If you expect gold to be a safe haven, you’ll be sorely disappointed. Historically, gold and gold stocks have never been a stronghold in a severe sell off. So maybe that’s why short term T-Bill rates have been pushed so low.

With today’s close the S&P 500 index arrived at a new high for the year. So far, it has risen 22.8% - not bad at all compared to the average historical return. And the year isn’t even over yet. If we look at the performance from the very bottom of the lows in March, it is even more remarkable at 63%.

But even as the stock market continues to power ahead, and longevity of this rally continues to strain all credulity, we can’t ignore that the market breadth is down right horrible. Usually, the measure of advancing vs. declining stocks rises and falls like a tide, keeping a rhythm with the indexes.

Right now however, the 20 day average of Nasdaq’s daily advancing and declining issues is acting the way it would at intermediate lows - even though we’ve well into an uptrend:

This means that fewer and fewer stocks are pushing the averages higher. When we start to see less participation from the wider spectrum of stocks trading on the exchange, we don’t have a healthy rally. My hunch is that most of gains can be laid at the feet of the large caps either because of their international sales exposure or because of the dollar carry trade (sell the dollar and buy anything risky). Check out the Russell 2000 - it has yet to confirm a new year to date high as the S&P 500 index. The same can be said for the equal weight S&P 500 index.

Another cause for concern is just how quickly the index has been able to rise on the back of fewer and fewer rallying stocks. For a bull market to be considered healthy, it has to have staying power. This is an endurance run after all, not a sprint. I measure the speed of a rally by comparing the closing daily price to the long term trend as measured by the 200 day moving average.

While the 200 day moving average has been rising, it hasn’t been able to climb as fast or faster than the price it tracks. So the distance between them as a ratio has increased. With today’s strong close, the S&p 500 index is now 19.3% higher than its long term trend line. That’s slightly more than the last time this same metric made me raise the caution flag: Stocks Have Little Room to the Upside.

That was 11 points lower than we are now. Running the numbers with a 20% and 21% ceiling, we get 1117 points and 1127 points respectively. So imagining that we leapfrog 8 to 18 points from here, we will have hit an invisible wall. Check out the previous link above to see a chart.

So odds are that we either correct here (again) to give the long term moving average a bit of time to catch up. Or prices meander to and fro, not really going anywhere and boring both bears and bulls. There is very little probability, from a historical study of the market, that we will see a rush higher.

A little while ago I tried to separate the effect of the weakness in the US dollar on the price of gold to determine whether gold’s bull market could actually stand on its own: US Dollar’s Weakness or Gold’s Strength?

There is a better index out there to determine this very question. The Kitco Gold Index is the price of gold measured not in terms of US dollars, but rather in terms of the same weighted basket of currencies that determine the US dollar index: Euro (57.6%), Japanese Yen (13.6%), UK Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and Swiss Franc (3.6%).

So instead of pricing gold in the unit of a US dollar, the chart below charts it in the the same unit that we use to measure the US dollar index:

Source: Kitco Gold Index

This is the one year comparison but you can also see a 5 and 10 year chart (follow above link). These both tell the same tale. There is definitely a bull market in gold. But, it has been aided and abetted to a large degree by the weakness in the US dollar. Seen through the lense of other currencies, the gold bull is much more tame.

If you look at a very long term chart of the comparison, it becomes obvious that there are periods where the price of gold in US dollars shoots up only to come back in line with the currency basket. Right now is one of those times.

As you can see, the price of gold in the currency basket has yet to breach the high it set earlier this year. This was something I pointed out when others were focusing on the breaking of the nagging $1000 resistance: Major Non-Confirmation in Gold.

Also, the purest equity proxy for gold, the Philadelphia Gold Bugs Index (HUI), has yet to surpass its highs from last spring (March 13th 2008 - 515). According to the k-ratio analysis of the gold sector, this suggests that gold is ‘overvalued’ relative to gold stocks.

Last week we looked at the breadth of the gold stocks which showed about 80% of them closing above their short term moving average. Here’s an updated chart:

While gold stocks managed to eke out another positive day, breadth slipped from almost 90% to below 80%. Usually, in the past, when breadth has been this stretched, and heading down, there is a good chance that a short term top has been already made.

The US dollar index is back down to the lowest levels for the year. But as I mentioned in the Politics of the US Dollar, it has yet to fall below the 2008 lows. Right now it is about 5% above that floor.

A bright side of the weak US dollar is the earnings boost it gives to US corporations with major international sales:

Source: Bloomberg

Today Geithner told Japanese reporters, “I believe deeply that it’s very important for the U.S. and the economic health of the U.S. that we maintain a strong dollar.” This is the same “strong dollar” pablum that all Secretaries of the Treasury have to peddle as part of their job.

But the unvarnished truth is that the US dollar is being sacrificed so that the US economy can continue with the least amount of structural changes. Instead of having to actually face the bloated deficits and debt racked by the US consumer and the US government, it is much easier to simply reflate your way out. The only sticking point is that this trick is an easy one and much too transparent. Almost every single developed country is racing each other to the bottom.

It is entertaining to watch from our perch as traders. But don’t forget that the stock market can defy the dollar and climb, as it has for the majority of this year. In fact, the dollar carry trade is pretty much single-handedly responsible for the rescue of the world economy from total collapse. As long as it is a controlled decline, it is welcomed.

You can either argue whether this is any way to manage an economy or realize what is going on and make decisions to profit from it.

The poor besieged dollar gets a short reprieve as the gold bull market pauses. But the gold bugs suddenly have an unexpected and persuasive ally in their camp. As an interesting addendum to what’s next for gold? in the most recent quarterly client letter, Paul Tudor Jones II builds a fundamental case for a long term bull market.

He compares the relative historical value of the precious metal to the US monetary base, crude oil and the S&P 500 index. Their econometric model declares “gold is 20% undervalued over the next 24 months”. But the rationale is not restricted to the monetary forces which are at play.

Strengthening his case, he delves into the basic demand and supply of the commodity. On the supply side, mining production has been stagnant for the past 10 years. And central bank selling has slowed to a trickle with no new sales planned in the future.

On the demand side, the physical investment allure of gold continues strong. As well, to that we can add the penchant of modern investors for digital investment in gold. Relative to the gargantuan size of the equity market, the bond market and alternative investments (real estate, timber, etc.) gold’s share continues to be lilliputian. This means that even a sliver of asset flows diverted to gold will dramatically alter the equation.

Source: Tudor Investment 3rd Quarter Letter

Gold ETF holdings as a ratio of above ground stocks has increased incrementally 4 years. And the trend, does not look like it is about to reverse.

While Paul T. Jones presents a text book case for the long term bull based on fundamental analysis, I can’t help but think it is all an elaborate window dressing to rationalize a position he has arrived at through other, shall we say, more esoteric means. Clients obviously prefer logical, well thought out reasons for why a professional is allocating their money a certain way.

No one would be comfortable to be told that their trust fund is being gambled on nothing more than squiggles and trend lines or better yet, something called Elliott Wave (which we know, by the way, that Paul T. Jones II used to make a killing on Black Monday while practically everyone else on Wall Street was busy having an aneurysm). Interestingly enough right now Elliott Wave is bearish on gold.

This is just speculation on my part, of course. I have no way of knowing exactly why Tudor Investments is bullish on gold. Maybe I’m too cynical and we can take them at face value. In any case, even if the long term gold case is solid, you might want to fine tune the entry by looking at the gold sector sentiment.

Here is a chart comparing the price of gold and the Hulbert Gold Sentiment Index, which measures a subset of newsletters which time the gold stock sector:

Source: Risk Management and Convex Return Profiles

While the Hulbert gold sentiment metric isn’t as high as we’ve seen it historically, at these levels it does not bode well for another leg up. At least not without a pause first. As I mentioned before, to me it isn’t just the altitude of the bullish sentiment, it is also the attitude: as gold has corrected recently sentiment continues to reflect the same amount of optimism.