Is everyone a gold prospector?

December 08, 2009  

Without the helping hand of the Fed, we fear that an exodus from risk assets could result in a highly correlated market shock that could take the GLD down with it.

Dean Curnutt
Many investors are asking if this distressed cycle is over. The simple answer is absolutely not. We are, in fact, still in the first inning of a cycle that will not peak until 2014.

It is difficult to turn on a television or pick up a newspaper without seeing a story about gold. Retail investors are being bombarded by commercials luring them to sell old jewelry and buy gold coins. Hedge funds are carrying massive positions in the gold ETF, GLD, according to the most recent 13-F filings. Wall Street sell side research firms continue to recommend the yellow metal and recent increased price targets suggest further appreciation is expected. Central banks around the globe are hinting that they will buy the rest of the IMF's gold reserves. In the past month India and Sri Lanka have depleted about half of the IMF stash. China's surprisingly low reserve holdings has led investors to believe it too is looking for the right opportunity to buy more of the commodity.

Aside from the demand characteristics created by central banks that feel the need to own gold, there are a number of other fundamental reasons gold's ascent may continue. The "biggest carry trade of all-time' is being fueled by the US dollar and may not stop anytime soon. It is becoming consensus that the Fed will keep rates low for most of 2010 giving the world carte blanche to borrow dollars and buy risk assets. During a midterm-election year the Fed will be pushed to keep its policy on the accommodative side. In addition to this being a dovish Fed in general, Bernanke's mission of keeping inflation contained has not been challenged. Most economists are calling for short-term deflation, if anything. Some suggest that the Fed would be ok to permit moderate inflation as a "tax" to the consumer. This would be the path of least resistance rather than for the Obama administration to pass new legislation to raise taxes.

In our opinion, the bottom line is that if rates remain exceptionally low, then the carry trade that is creating the risk asset bubble is apt to continue and the dollar will grind lower. The Fed may decide to extend quantitative easing beyond its current deadline of March 2010, which could effectively grow the Fed's balance sheet and keep the printing press running. Many investors are asking, "Given the circumstances, how does one NOT own gold?'

With expectations of higher gold prices, however, comes higher risk of disappointment. We use the GVZ Index (CBOE Gold Volatility Index) as a measure of expected near-term volatility in gold. Similar to the VIX Index (CBOE SPX Volatility Index), which is frequently referred to as the "fear index," we see the GVZ rise during periods of gold price uncertainty. The main difference is that the GVZ usually rallies on concerns of upward price spikes as opposed to the VIX which typically reacts to sharp downward moves in equity prices. The price of the GVZ is derived from the prices of a strip of near-dated gold options. Therefore, as investors demand more from the options market, either by purchasing hedges through puts or making levered bets through calls, the GVZ moves higher. The chart below shows the GVZ index compared to actual realized volatility in the GLD over a 30 day period. The high risk premium embedded in GLD options is evidenced by this chart and will likely remain until the fixation on gold dissipates.

Another measure of sentiment that we find useful to observe is the "skew" in GLD options. Skew is the spread of implied volatility between downside puts and upside calls. Amidst the highly bullish price action in gold the volatility surface is evolving in an interesting way. The shift in the shape of skew tells us that downside puts in GLD are starting to pique the interest of weary investors. In the chart below we see this change from May to November which tells a different story from what one might expect to learn by looking at the underlying price appreciation. The GLD skew now bears greater resemblance to that of a typical risk asset.

This suggests that the price action in the GLD may largely be a function of the Fed engineered carry trade. Gold, like other risk assets such as equities, may be rising because the dollar is falling. This ties back to the Fed and its policy accommodation. Without the helping hand of the Fed, we fear that an exodus from risk assets could result in a highly correlated market shock that could take the GLD down with it. Given this, we believe the insurance provided by the options market is an important consideration for those investing in gold and the GLD.

Dean Curnutt is president of Macro Risk Advisors LLC, an equity derivatives strategy and execution firm which specializes in translating proprietary market intelligence into actionable trade ideas for institutional clients. The New York-based firm is a registered broker/dealer with the FINRA.

Justin Golden is a strategist at Macro Risk Advisors.


Dumping dollars for gold
Some marquee funds have piled into gold as a hedge against a devalued dollar, though skeptics say the trade is overhyped. "They are all late to the game relative to Eric Sprott of Sprott Asset Management, who put on his long gold position in 1999, perfectly timing the beginning of its current run. Sprott's web site includes a cornucopia of gold-related articles, many of which include predictions about the stock and housing markets that are eerily prescient.


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