Moment of Truth for Gold
Boris Sobolev
Jul 30, 2007
Equities fell off a cliff last week and gold along with gold
stocks followed. We think parachutes will open to ensure a safe
landing as the financial authorities will yet again come to the
rescue.
Over the last year, fuel for the equity markets has largely been
coming from cheap debt available to private equity firms mostly
due to the yen carry trade. The Dow Jones "Private Equity
Analyst" reports that the US private equity firms raised
$137 billion during the first half of 2007, a 42% increase over
the first half of 2006. The cash from Leveraged Buyouts (LBOs)
flooded the markets and was reinvested pushing stocks to their
all-time highs. The key point here is - the stock market is
being pushed up by borrowed funds. Since a lot of the debt
will have to be repaid in yen, the sharp rise in the Japanese
currency last week spooked all markets.
Careful market observers will note that European markets took
a bigger hit than US markets last week:
- Europe 350 iShares down 7.2%
- Emerging Markets iShares down
6.4%
- S&P 500 down 5.4%
As an example, the above chart
shows that the German Dax Composite underperformed the S&P
500 Index primarily due to the strength of the Japanese yen.
This is the third time since last December. To us, this signifies
that the yen carry trade global unwinding has now become the
most serious issue among some others, such as the US subprime
problems we discuss below.
Subprime Worries and Rising Credit
Spreads
Additional warning
signs recently emerged in the US markets that the subprime worries
are starting to spill over into the private equity fundraising
efforts. The latest bombshell fell when Bill Gross of Pimco commented
that "enough is enough" referring to the liquidity
glut that has caused artificially low interest rates for high
risk debt. He warned that this debt is going to be re-priced
as investors begin to realize that the subprime problem may not
be an isolated event.
A crowd of highly leveraged sellers rushed for the doors causing
panic selling last week. Credit spreads rose all across the board,
from high quality corporate debt to junk bonds.
In fact, anyone looking to sell corporate paper with less than
AAA rating would have had a very difficult time. The chart below
shows a ratio between the US treasury bonds and investment grade
corporate bonds indicating the biggest credit spread jump in
years.
Of course, Mr. Paulson, Mr.
Bernanke and crew realize the risks involved. The Treasury Secretary
made a few speeches last week to reassure the markets that the
government remains vigilant and will prevent the problem from
developing into a crisis or a panic. While many skeptics are
smirking at the government's response, we think the message Mr.
Paulson is sending to Mr. Gross is that "it's not yet enough"
- the liquidity bubble will continue.
The government and the Fed are concerned that a further decline
in the stock market could be a catalyst for an economic slowdown
or even a recession. Corporate profits will dry up causing LBO
related loans to turn not only to junk but to trash. As a result
liquidity will plunge and yields spreads will rise further. A
dry out of liquidity will in turn increase defaults among the
speculative grade issuers and cause the stock market to plunge
even further. A credit crunch is a nightmare scenario for any
banker.
To show that it is serious about avoiding such a scenario, the
Fed pumped more than $8 billion into a non-government and agency
debt paper last week. Given the strength of the emerging economies
and the Bank of Japan's reluctance to change its long term inflationary
policy, the Fed should not have a problem this time in restoring
liquidity to the market to avoid a crash scenario.
While cracks in the worldwide financial system are starting to
appear, its collapse is very hard, if not impossible to time.
The waiting game continues.
Implications for Precious Metals
Stocks
The US stock market
is extremely oversold based on a number of indicators. A rebound
in the markets should happen this week, but such a recovery,
we expect, will be relatively short-lived. August and September
are seasonably bad months and a retest of lows set by stocks
last week is highly likely.
As far as the precious metals stocks are concerned, while the
correction last week may seem sharp and brutal, the technical
picture remains positive. A rebound along with the rest of the
market should happen shortly.
The moment of truth for the precious metals sector will occur
when the next stock market decline commences. This decline will
happen during a steepening yield curve environment, which is
very bullish for gold. At that time, the smart money should start
reallocating into the real safe haven - gold, not the US treasuries.
As a result, gold and gold stocks will not follow the general
market to the downside. This will mean that the new leg of the
gold bull has begun.
At this critical situation we remain bullish and see this decline
as another buying opportunity.
Boris Sobolev
Denver, Colorado
email: Contact@ResourceStockGuide.com
website: www.ResourceStockGuide.com
Disclaimer: The above information
in this article pertaining to investing, stocks, securities must
be understood as information provided and not investment advice.
The information provided by Resource Stock Guide is obtained
from sources believed to be reliable but is not guaranteed as
to accuracy or completeness. Resource Stock Guide advises all
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Copyright © 2006-2007 Resource Stock Guide, All rights reserved.
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Ltd
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