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.
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
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.
MORE ON GOLD:
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.