Market Deleveraging Smacks Gold

By: Michael Swanson | Thu, Mar 20, 2008
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I'm sure you know that gold and oil stocks took huge hits yesterday. I discussed a likely commodity correction over the weekend and in a WSW Power Investor update yesterday gave some initial targets and explained what I'm looking for as a buy signal. We aren't there yet. I just watched CNBC for a few minutes this morning, because I wanted to get their feel for the market action. The anchors and three of the analysts they paraded are calling this the top in gold and commodities and are taking it as a vindication of the Fed. One of the reporters said that the financial crisis is over and any more bad news that comes out will be "meaningless." Two of the analysts said the market is in the process of bottoming off of the 1270 support level on the S&P 500 - which it has hit three times now this year.

I found the discussion amazing. Already they are calling this the bottom and saying that gold is over. Yesterday was NOT a vindication of the Federal Reserve. There was more totally wild action in the financial markets. People were not selling gold, because they thought the Fed had fixed things. Those selling gold were doing so to book gains on the best performing sector of the year and to deleverage themselves. They also were fleeing into the safety of the bond market as the yield on the 3-month Treasury bill fell 27.78% to close at 0.65%. The yield has fallen from 2.2% to 0.65% in just the past three weeks. This is a shocking gyration in the bond market. It is a result of institutional investors fleeing for total safety.

Last week the Fed announced a $200 billion treasury bond swap on Tuesday. The DOW rallied 350 points on that day. The reasons for the Fed's action was not public, but there were rumors at the time that Bear Stearns was near bankruptcy. On Tuesday people were celebrating the market rally. The next day the DOW fell down a bit. It wasn't much only 30 points or so, which is normal after such a big day. However, the action in the bond and currency markets was alarming. The bond yields dropped sharply and so did the dollar. There was real fear in those markets. Less than 48 hours later Bear collapsed.

This past Tuesday the DOW rallied over 400 points as the Fed cut rates and people made the bet that Bear would be the only big bank to collapse thanks to Fed action. But the very next day panic once again returned to the bond market as 3-month Treasury bill rates dropped sharply. This is not a sign of a Fed that has all of a sudden fixed everything, but a sign of a market still very concerned about the credit markets and worried that the Fed bailouts are going to fail. The move in T-bills began right as the market opened in the green and continued all day long. Now we have to wonder what they were so fearful yesterday.

Much of the selling in gold was due to a giant macro hedge fund that had to sell positions in order to meet investor redemptions. John Meriwether, who if you remember was the guy who set up the Long-Term Capital hedge fund that blew up in 1998, apparently faced huge redemptions yesterday in a group of billion dollar hedge funds. His Relative Value Opportunity fund suffered a 24% loss in its fixed income fund. He also has a billion dollar macro hedge fund down around 9% this year. It is likely that he had to sell gold and commodity positions in this fund to meet redemptions or get off margin.

I believe this contributed to the sharp drop in gold and gold stocks yesterday. However, remember that I was talking about a likely correction over the weekend, so a drop was likely anyway due to the charts. Oil stocks in particular were very vulnerable going into this week.

That wasn't the only news that swamped the market yesterday. Thornburg Mortgage revealed that it has to raise at least $948 million in the next week in order to stay in business.

This remains a very dangerous and volatile market. Although the market is oversold and could hold the 1270 support level on the S&P 500 for a few weeks I believe that this level is eventually going to be breached and I expect that event to lead to a panic waterfall decline in the market. The longer the S&P 500 stays above the 1270 support level the worse the drop will be once it eventually closes below it. The selling in gold and commodities is not a sign that all is well, but is simply the start of the deleveraging of hedge funds that will climax in a sharp market drop that will mark the end of this bear leg that began back in October. Once it ends I expect gold stocks to resume their leadership of the market for the rest of the year.

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Michael Swanson

Author: Michael Swanson

Michael Swanson,
WallStreetWindow.com

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