Reading the gold tea leaves

Gold traders have witnessed the kind of whipsaw action that generally points to a riff in sentiment. One could make a case, as some analysts have, that gold is rebounding from an oversold condition. And while that is partially true, you cannot escape the fact that gold’s rally was magnified in that it occurred in tandem with a rise in the U.S. dollar. Such a twin occurrence suggests that one would be wise to dig a little deeper.

When you think about it, gold is a discounting mechanism that mirrors the risks in the current environment. When gold prices are magnified as they have been recently, it tends to precede a change in market direction.

When trying to read the gold tea leaves you want to avoid the noise which I define as chart watchers emphasizing short term swings such as the rally from an oversold condition, and look to the longer term fundamentals that drive values.

There is little doubt that the recent rally in gold was supported by a flurry of bad news -- is there any other kind? -- from Europe. In the “what-else-is-new” department we have seen a marked shift among hedge funds to a “risk off” trade. Despite what you saw in the U.S. market last week!

The immediate “risk off” shift occurred, as it often does, in the currency markets where concern over stability in the euro zone led traders to sell Euros and buy U.S. dollars. Gold’s rally in tandem with the greenback may be the early signs of a second wave in the “risk off” model and if so, the implication is that something has drastically changed in the euro zone.

Given that we have been looking for light at the end of the Euro tunnel for more than two years it is highly unlikely that we will get a definitive signal that a quick fix is possible. Most likely we will witness a series of nuances shaded by political overtures and backroom negotiations.

The latest nuance is a willingness among major euro zone partners to let Greece exit. Which tells us that euro zone politicians are coming to a conclusion that the financial markets have been advancing for some time. The problem when dealing with sovereign States is that the end game will play out over several months… if not years!

Unfortunately, the financial markets will experience the fallout in the form of whipsaws driven by investor sentiment (note trading activity in the U.S. market over the past two weeks). While we work through this maze investors would be well served to read between the lines of political rhetoric .

To that point you should recognize that any Greek end game will begin with a series of negotiations between euro leaders and the Greek parliament, assuming one can be pieced together through another round of elections. We will witness a series of new debt re-structuring programs aimed at delaying the inevitable until the banking system can be stabilized to the point that it can absorb Greek aftershocks. If we are not already at that point we will be soon.

The Mexican standoff will come full circle when we have clarity -- if ever -- which of the two potential scenarios seems most likely. Either 1) Greece will again fail to meet promised austerity programs that would have been tied -- for political appearance -- to additional capital infusions at which point the exit will begin or 2) Greece will, after a series of severe austerity measures and civil unrest, come to a conclusion that staying in the euro zone is the lesser of two evils.

I am leaning to the first outcome which suggests the following stabilization models. Most likely Greece would begin printing Drachmas -- or some other legal tender -- with the objective of returning the country to a domestic currency.

In terms of finding ways to stabilize an exit I would expect the Greek government to fix an exchange rate between Drachmas and Euros and over time begin splitting their obligations with partial payment in Drachmas and partial payment in Euros. For example, A Greek pensioner earning say 1,000 euros per month might see their payments come in the form of 500 euros and an amount of Drachmas to make up the difference. In time the country would shift entirely out of Euros and into Drachmas.

Of course this strategy is only one possibility as the entire euro zone is working from a playbook that has not been written. But make no mistake, no mater what process is ultimately employed it will only impart temporary stability and will be seen for what it is by the financial markets. The financial markets have a way of abruptly pricing nuances without regard to political appeasement.

The political role is to set the timing of an exit. At some point Greece will have to leave the euro zone and ultimately allow its currency to find a nominal level against world currencies. The will take place when euro zone leaders believe they have fortified the financial system to withstand the tsunami that will follow.

The bigger issue is not Greece but rather how their departure will influence other member States with similar problems and much larger economies. One could make a case that an undisciplined exit accompanied by the inevitable pain that will be thrust upon the Greek electorate will be enough to scare the other members straight. But don’t hold your breath!

The best case scenario, which is not necessarily the setting that will unfold, would see the banking system survive and other member states engage in unpleasant, but necessary, austerity programs.

I suspect the remaining euro zone members and, if necessary the U.S., will throw enough money at the system to ensure the survival of the banks. Some will be nationalized as we have already seen in Spain, and others will simply limp along until a recovery takes hold.

You can observe how traders perceive the euro zone metrics by carefully reading the well written financial market’s playbook. If gold continues to rally it will signal the continuation of the “risk off” trade which, as sure as night follows day, will ultimately work its way into the equity markets.

While I don’t think it likely, should gold stumble it could be a signal of a shift away from “risk off.” But at this stage, rather than trying to fine tune market gradations we have chosen to exercise some cash management skills. Which is to say, keep cash on the sidelines, maintain positions in high dividend paying stocks, engage in covered call writing programs for enhanced cash flow and watch carefully for opportunities.

Speculating on Shifting Sentiment

For those among you who prefer to trade through sentiment shifts you could look at an option strategy that takes advantage of market volatility rather than direction. The strategy is referred to as a straddle and involves the simultaneous purchase of a call and a put on the same underlying security.

The underlying security in this case would be the S&P 500 Depositary Receipts (SPY-N), recent price U.S. SPY is an exchange traded fund that tracks the performance of the S&P 500 composite Index and generally trades at 1/10^th the value of the S&P 500. In this case, I would recommend the purchase of the SPY Dec 132 call at $8.20 US and simultaneous purchase of the SPY Dec 132 put at $10.00.

With a straddle it does not matter the strike price as long as it is the same for both the call and the put (note: the strike price in this example is $132). You should also not get worked up at the cost of each option as we are really interested in the total cost for both options. For this trade, you want to make sure that you do not pay more than $18.20 for both options.

A straddle is a “risk on” trade as you are betting that 1) volatility (i.e. risk) will expand causing both options to increase in value or 2) that the market (i.e. SPY) will rise or fall by more than $18.20 before the December expiration or 3) that both scenarios will unfold.

In fact, if the market drops sharply, both volatility and the value of the put will rise which will make the trade profitable. As always, I will follow up on this trade in future issues.