April 16, 2013 1 Comment
The decline in gold over the last two trading days has been stunning. But what is perhaps more significant about this recent move is its potential implications for broader investment markets including stocks and high yield bonds.
So what is the reason that has gold been declining so sharply since Friday morning? Let’s first explain what are not the reasons, as the financial media has the tendency to want to assign fundamental reasons to why things are happening in financial markets that are often unfounded if not completely untrue. It had nothing to do with China, the decline in gold was already well underway at that point and signs of economic slowing in China would actually be bullish for gold. It also had nothing to do with reports that Cyprus may be forced to sell their gold to help fund their bailout, as China and India combined could easily buy up all of Cyprus’s gold and more in a single trading day. And if global central banks were to force other countries to sell their gold to support bailouts, we would almost certainly be seeing gold prices soar higher not move lower to serve their own best interests, as central banks have the firepower to do it. It also had nothing to do with money flowing out of gold and into stocks, as stocks have actually experienced a net outflow of -$700 million since the beginning of February including -$1.9 billion in net outflows in the first week of April alone (which, of course, begs the question as to why the stock market has been going higher if money on net has been flowing out of stocks over the last two months, but this is a topic for another article). The fact that stocks have also been down over the last two trading days further refutes this notion. And it also had nothing to do with the supply of gold outweighing demand, as a wealth of data continued to demonstrate sovereign, institutional and retail accumulation of gold over the past year and in particular since the middle of February despite the decline in price along the way. Lastly, this is not just a story limited to gold, as the entire commodities complex including silver, platinum, palladium, copper and oil have also been in sharp decline since early Friday.
So exactly why is gold in such sharp decline over the last two trading days? In a word – liquidation. In order to highlight this point, it is worthwhile to review how the decline has unfolded over the last two trading days.
During the early morning on Friday, gold was behaving as it would on any normal day. But the clock struck 10:28AM EDT and gold suddenly plunged into a cascading decline, shedding $40 in just over a half hour before steadying for the remainder of the trading day. Following the weekend, after continuing lower during the overnight hours on Monday, the clock struck 10:25AM EDT that morning and gold once again cascaded lower by another $40 over the next 36 minutes before actually bouncing higher and moving sideways for the remainder of the day. In short, nearly half of the entire decline in gold occurred over the course of one total hour in the last two trading days, with most of the remaining drop occurring from 4:30 to 6:00AM EDT on early Monday morning. These details are informative in helping to pinpoint the exact cause of the gold sell off.
Did an extraordinary fundamental event take place at 10:28AM EDT on Friday morning that sparked the massive sell-off over the course of just 30 minutes? Absolutely not. And what is so special about half past ten in the morning on the east coast that another massive sell-off occurred at almost the same exact same time the next trading day on Monday? The timing here is not a coincidence. And the same can be said about the drop during the overnight hours on Monday.
All indications suggest that the massive decline in gold over the last two trading days has been the result of massive liquidations by major global financial institutions that have been forced to raise cash quickly. What is the likely cause for this liquidation activity? The increasing radioactive interest rate volatility associated with Japanese government bonds is the most likely culprit, as institutions have been forced to come up with sizable capital contributions to protect their massive positions against the recent wild swings in the second largest bond market in the world. This situation in Japan is becoming increasingly worrisome that continues to require close monitoring for additional spillover effects. More on this point in a moment.
When these types of situations suddenly arise, gold and other commodities are often sold first since they are among the most liquid investable assets in financial markets. And the impact of these mass liquidations have spillover effects, as any investors that have purchased gold on margin are eventually forced to sell and cover their positions, which only exacerbates the downside move. This helps explain why the entire commodities complex has also sold off sharply over the last two trading days.
Eventually the decline in gold and other commodities will cease. While it is likely that much of the major institutional forced selling of gold has now played out, we may see further downside in gold over the next few days as more investors are forced to sell to cover their margin debts. And once this selling is completed, it is just as likely that we will see an equally stunning bounce, as the precious metals complex already had short interest that was already multiples above the previous historical highs. For once these massive shorts move to cover by buying back gold, the rush to the upside could be just as extreme. But once this process is completed, an extended period of choppiness including aftershock declines should be expected, as the gold market still contains a huge number of weak cash longs that will be desperate to exit their positions at higher prices given the opportunity. For this reason, I will be looking to use any such rallies to strategically reallocate precious metals allocations.
While the liquidation in gold has been notable, perhaps the far more significant issue looking ahead is what it may be indicating for broader investment markets including stocks. Major global financial institutions do not simply enter into forced liquidations in a cascading market like gold over the last two trading days without good reason. Such liquidations occur because something is becoming disconnected within the financial system. And once these disconnects start to occur, they have the potential to spread like wildfire and unravel very quickly. While commodities like gold are often sold first during these episodes, stocks and high yield bonds are almost always the next in line. This is what happened in 2008 – commodities including gold began selling off sharply in August 2008 with stocks and high yield bonds following soon after in September 2008. And this is the first time we have seen such rapid and massive liquidation activity since that time.
The fact that stocks and high yield bonds deteriorated lower throughout the trading day on Monday suggests that the liquidation problems plaguing gold and commodities may already be spreading into these markets. This is a major risk that will take several days at least to see how it plays out, but the potential downside for both stocks and high yield bonds is considerable. Not only can these declines become extremely swift once they take hold as demonstrated by gold over the last two trading days, but both stocks and high yield bonds are also in a far more precarious place on a much higher perch than from where the precious metals began their descent. Unlike the precious metals that have been trading lower since mid January, stocks and high yield bonds are trading at fresh new highs. In the case of stocks, this rise has occurred despite weakening fundamentals and valuations that remain well above the historical average. Moreover, unlike gold that had relatively lower margin debt and massive short positions already in place, stocks are currently operating with their highest level of margin debt since July 2008 with relatively little short interest to spark any meaningful covering bounce. As for high yield bonds, they are currently trading a premium that essentially represents one year’s worth of coupon payments, which is an unprecedentedly rich valuation for the asset class in an environment where economic data is showing increasing signs of weakness. Thus, the potential downside in either of these categories is considerably more than the commodities complex in a liquidation event. The fact that stocks dropped by -28% over the course of just eight trading days in early October 2008 highlights how swift and painful these downside events in stocks can be.
Given these risks, the opportunity was used today to lock in gains and close out a number of stock positions, particularly those that have enjoyed a recently strong run and are currently overbought. This way, if the recent move in gold turns out to be an isolated event, the opportunity will exist to buy back into stocks particularly as first quarter earnings season progresses. But if the recent liquidation in commodities spills over into stocks, instead of trying to get out of a sharply declining stock market, the powder will already be dry to seek high quality names at discounted prices on pullbacks. As for high yield, this is a market that was exited early last month on extreme valuation but would warrant renewed interest on any solid correction.
I will be continuing to monitor these events across all markets as they unfold in the coming days and will follow up with updates.
The contents of this post are provided for information purposes only. There are risks involved with investing including loss of principal. GWM makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies implemented will be met.