Newsletter - 79th edition

The BIG Gold Picture

By Christopher Laird

• Gold this week - general market drops


• A list of reasons for a possible market collapse
• Gold is still sound
• The Yen Carry Feedback loop - stocks and gold
• Yen strengthening is a serious problem
• Gold in this market situation
• US and Japanese economy right now
• Conclusion

• Gold this week - general market drops

First of all, I want to address some concerns that people would naturally have with the 40$ gold drop this week. Then we will get into some specifics regarding gold this week and say the Yen carry trade - then on to on the Yen carry later in this issue.

What has happened to gold is a flight to 'cash' - flight to liquidity in the markets world wide. Gold paper has been sold for liquidity partly because it had a great run recently. But more importantly, funds had profits in gold, so when the sell offs started in China, the US, Japan, Russia, and so on, margin calls were hit, stops were hit - in stocks and then subsequently in gold.

Initially, on Tuesday morning, gold was down, the USD was down, oil was down, and we knew that the Chinese market had sold off about 10%. I wrote that first PS alert about a general market sell off coming, based on those observations, when gold was recovering back to its original range, see chart, and, seeing gold recovering, hoping to give you a heads up on what seemed to be coming- a scenario for general stock and then gold liquidations due to liquidity problems.



The YEN, one of the worst of fiat representatives of the major currencies strengthened. Previously, the BOJ raised interest rates .25% , before the China crash. That undoubtedly had a role in the China crash. But one main reason for that crash was because China was attempting to stop their stock bubble by perhaps taxing gains, and other measures. That market was up over 150% in the last year, so, it was ripe for a crash anyway.

As the Yen strengthened, there was also preexisting bubble pressure on all the major stock markets. Then add the first drop in China, and the strengthening Yen, and you got a feedback loop set up for market liquidations. First, China drops, then there is Yen carry trade unwinding and further selling. Then the Yen strengthens more. Then further Yen carry unwinds. This is a fatal combination - a feedback loop of cycles of market drops-Yen strengthening-market drops.

This appeared to be happening all this week, as the Yen strengthened about 3%. That is Huge- Unfortunately, that feedback mechanism now still exists. It might cause further selling next week on its own now. All that had to happen was a change in market sentiment - and then the Yen Carry feedback loop was all set up to eat up the stock markets. It does not matter now that the BOJ is still way behind the interest rate situation, causing the Yen carry trade in the first place. What has happened is that the Yen carry trade merely built up to whatever level, then, when markets started to drop - selling and unwinding of Yen carry occurred, then buying of Yen to pay off Yen carry loans, then the Yen strengthens, then more pressure to unwind Yen carry again - then more market selling….and so on.

Now I don't want to sound too alarmist but I do have to say this:

The markets right now are at a risk of a serious continued crash. I'll denote some of the reasons. But, that is why I said in the later PS alerts last week (Thur) that you have several days to move to cash and or gold bullion (not etfs or stocks) if that is your inclination. I am not telling anyone to sell anything. I am merely pointing out that if you want to get liquid, you have/had several days, based on the possibility of a continuation of stock drops. Monday, we may have a real mess on our hands. However, I am not certain that we will, and the US and Japanese plunge protection teams have a great deal of power to at least stabilize their markets. But, the Yen carry is so huge, and the already preexisting market speculation and leverage is so huge, they may not be able to stem a real market crash this time. This risk will be high for weeks coming.

• A list of reasons for a possible market collapse
  
  
  • Major electronic market problems- Last week, there were 3 billion stock transactions Tuesday, and Dow fell behind in the Dow quotes. That led to a 200 point instant drop in the Dow on that day, when they switched over to a back up system. Talk about scaring the hell out of the markets! I have said before that these markets are not electronically strong enough to handle a coming great stock crash - just due to computer limitations. Traders had to resort to trading on napkins and such Tuesday (not kidding here). Basically, there was a widespread condition of market confusion when they realized the Dow was behind. Dow notified many traders that they were behind, but what good would that do? This is further amplified by computer program trading getting bad data - bad Dow quotes - I have to say that the markets are not electronically robust enough or ready at ALL for a possible major world market crash - and all this will do is make a possible crash far worse. I said before the Nikkei froze for about a day last year when their computer trading systems exceeded their limits…this is not a side story, it is a huge issue - computer limitations. Remember, I was an Oracle systems engineer, so I am not just talking BS here. I have personally dealt with real time commercial sized systems that were internet accessible that froze seemingly out of no where - and when I researched the problem in one case, found that a previously never exceeded sessions limit was reached in Oracle - It was not Oracle's fault - it was a parameter that was set too low when the database was created. When that was exceeded - further new internet sessions were locked out until the sessions dropped below the limit they had set. That was a user error. They didn't know of this problem until their internet sessions exceeded this limit. You might want to read my Gold-Eagle editorial several years back about some of these stories called
  Technical Financial Meltdowns
  
  
  • There is a preexisting Yen carry feedback loop constantly waiting to unwind. It is gigantic and has a lot of unwinding to work out. Whenever market sentiment gets bearish, that loop will kick in, and who knows how far down the thing (yen carry feedback loop) can take markets, and over weeks and months? You could consider this huge Yen carry waiting to unwind like gravity on the markets.
  
  
  
  • Market sentiment alone can take markets down, it doesn't need the Yen carry situation. But these both do the same thing, and viciously, and they feed on each other.
  
  
  
  • Ridiculously low risk premia in all markets - eventually this has to return, and that will cause further market liquidations.
  
  
  
  • Lots of profits and a long stock bull market so far - people will be inclined to go to cash at any signs of stock weakness.
  
  
  
  • Dow and other markets have dropped decidedly below their recent long up trends - take a look at this chart:

Fiat currencies have strength in immediate flight to safety - but - underlying these, is a rot. In a market liquidity crisis, they strengthen. But that is a temporary thing.

Gold, on the other hand is also cash, but was sold off to get back into fiat - to cover margins, or losses… But once those losses stop - and the governments have to resort to continued deficits to cover everything under the sun - gold will become very valuable - way beyond what it is today.

What we are seeing now is the often discussed issue of gold and gold stocks and commodities dropping in stock crashes.

I have to point out that, in the Great Depression in the 1930's, gold and gold stocks did very well after the initial crashes.

• Gold is still sound

So, since this gold drop was due to liquidity issues, Gold is not selling off for its own reasons. In fact, I consider all the fundamentals that drove gold up to the 680's to be the same. There is one difference in that, now, there are stock sell offs, and probably more next week.

Consider gold to be a savings account. Once you buy those ounces, they stay exactly the same. The price fluctuates in fiat, but the ounces never change . If you have x ounces and the price drops, you still have x ounces - gold coins do not evaporate.

SO, even thought the price 'today' of gold has dropped 40$, do not be deterred from recognizing what gold is, that is a store of value long term.

The only reason gold weakened this week is because markets are liquidating, and, gold, as a cash asset, is sold to cover margins/or losses by funds. We have already talked in the past several newsletters that there is a lot of paper speculation by funds and even ETFs in commodities and gold. That causes gold to be hit two ways in this present market liquidity situation and unwinding of the Yen carry trade. We will discuss that later in the NL.

Relax, your gold is still real wealth. But, you must understand that it must be regarded in terms of ounces -not fiat prices. Also, when I reference gold, I mean precious metals in general.

The fact that markets are fleeing to liquidity - and temporarily - currencies are strengthening vs vs gold - is more of a temporal issue with gold. I do not consider the present price activity of gold to be a fundamental problem with the gold market intrinsically at this time.

We have stated many times, that in a market crash - gold, and gold stocks would suffer. Longer term, there will be severe pressure on the Yen and the USD. Gold will rise way above where it is now.

SO, don't worry too much about this particular $40 gold drop. And also, next week could be very hairy too. Don't be too worried about that either - if you have actual bullion in your possession.

Now if you have stocks and ETFs, these are more fiat related entities - you redeem these in Fiat. So you will have to suffer the fluctuations of the Fiat gold price. If you have ounces, they just sit there, never changing.

• The Yen Carry Feedback loop - stocks and gold

Lots of people have written about the Yen carry trade, how huge it is, and how detrimental it can be in market declines. Here are some reasons why the Yen carry is so potentially bad:

First, the Yen carry has built into over a trillion dollars in my opinion. It has built since Japan has had ridiculously low interest rates - for 5 to 10 years. People borrow Yen very cheap, and then speculate in all these markets with it. Then, markets are further leveraged by hedge funds and derivatives. So, you have lots of borrowed capital that is then taken and leveraged further by funds and such. I have stated previously that you should consider these financial markets leveraged at 50 to one or more, not the usual stock margin levels of 2 to 1….because of this successive leveraging of capital.

This means that at the 'margins', where prices are determined in financial markets, there is this high leverage. At any sign of a market drop, this stuff is just waiting to pile on (unwind) in the feed back loop I discussed above.

Gold is also at risk from two sides from the Yen carry unwinding. First, there is Yen carry that is invested in gold (Precious metals like futures) and such directly. That is unwound along with other general Yen carry. Then, gold, being a liquid investment, can be sold off to cover other stock margins, or to cover losses. This is what happened last week, in the general stock market sell off. People sold gold during that process to get cash - ie in a flight to liquidity, so they could use that for fund redemptions or whatever.

Here is a good news post on this:

1500 GMT [Dow Jones] - Gold remains on the defensive, with investors "retreating into cash" amid concerns about markets generally, says Neal Ryan, director of economic research at Blanchard and Company. "Hedge funds and others likely got slammed with margin calls on investments, and that meant having to clear up capital from all investments to meet those margins," he says. "Gold and silver being up 12% already this year made those investments and easy target to get capital from investments." He cites an unwinding of "yen carry trades," with short selling taking a toll on short-term speculative longs, triggering stops. Comex April is down $11.60 to $653.50. As for the longer term, Ryan said, "we need some more time to shake all of this uncertainty out of the market, especially amongst metals investors, and recognize that nothing from a fundamental standpoint has changed. Supply is still significantly lower and demand is trending higher. Oil prices are creeping back up towards $70 per barrel and the U.S. dollar is heading back to the low end of the trading channel it has been in for six months." (ALS)

http://www.futuresource.com/news/

• Yen strengthening is a serious problem

The Yen may strengthen on its own from now on, causing similar pressure to what happened in the 1997 Asian stock crash. Then, the Yen had strengthened something like ten percent rapidly, and this caused a huge Yen carry liquidation. It took concerted efforts by the Fed and other world central banks to stem that crisis.

Last week, the Yen strengthened 3%, a huge move for its potential effect on the Yen carry trade.

The ECB has stated that they are very concerned that the Yen carry can cause market collapses. They and other central bankers have also said that the recent period of Yen weakness could be setting the stage for a rapid rise in the Yen - a change in direction, and one of the last times that happened there was the 1997 Asian Crisis - directly attributed in part by: first a fall in the yen for a period of years, then a rapid rise in the Yen. We have these same conditions now.

A surprise rise in the Yen is a prime condition for a spark of Yen carry unwinding. We may have only seen the beginning of this.

It is not clear whether the small increase in the BOJ interest rate from .25% to .5% was the cause of the China market crash. It could have caused that, because of some unwinding of Yen carry due to that interest rate hike, who can tell? We do know that interest rate hikes put upward pressure on a currency. In any case, this week, the Yen rose 3% amidst financial market liquidations, and right after the Chinese stock crash Tuesday.

We can definitely say unwinding of Yen carry had a big role in last week market crashes everywhere. This will continue to be a serious problem for a good while.

Both the US and Japanese stock markets have not shown any recovery last week after Tuesday, but have weakened further. Friday the Dow was down 110 and the Nikkei down 235. This does not look good for next week.

• Gold in this market situation

I have stated that gold is getting hit two ways by this market sell off liquidity situation. First, gold is bought directly by speculators recently - they want to take profits before they lose them. Second, gold /gold paper is getting sold due to liquidity problems, margin calls and such in funds.

Now, next week, since gold has already dropped a great deal, it could recover. However, if there are continued serious stock crashes like last week, then gold will likely suffer again.

This situation is also amplified by all time high volatility - in sheer stock and commodity and general financial market transactions. See the VIX chart below later in the NL. ETFs definitely are figuring here because, as I had stated several news letters ago, the ETF phenomenon is a blessing and a curse for gold and commodities. A blessing as money flies into ETFs because these are such easy analogs for gold and such. A curse, because money can flow out of ETFs much faster than it came in, and this is what we saw Tuesday with gold in the NY access market.

• US and Japanese economy right now

Aside from ETF activity, the Yen carry overhang on markets and so on, there is a general problem developing with sentiment on the US and Japanese economy. Last week US durable goods orders plunged 7.8% for January. Japan likewise is having new flirtations with deflation worries, their inflation rate is just out recently at 0%.

There is also a lot of other very bearish economic news, not to mention the US housing market has horrible stats recently. Also, the VIX (volatility index) has risen an amazing 60% in a down market! So, all this overoptimistic market sentiment that has been talked about for years is just now switching to a new direction - down. Take a look at the VIX chart.

• Conclusion

So, concluding, the markets are very scared. There are serious issues with huge Yen carry trade overhang and a strengthening Yen. There is the Yen carry feedback loop that is set up similarly to the types of conditions the Yen saw in the 1997 Asian panic. However, you can be sure the FED and the Japanese plunge protection teams are at maximum alert. It is feasible that they will try to engineer a market turnaround the beginning of next week.

I would not try and speculate on further market drops for that reason. Those entities have a virtually unlimited war chest. I have to say, though, that these central banks are likely not quick enough to turn a decided world financial collapse around, given the speed of electronic markets today, and the leverage out everywhere at historic levels. If things really get out of hand, the central banks will likely fall behind dealing with it.

Alternatively, it is possible that the Fed and the BOJ will only do damage control and try to allow a somewhat orderly market decline. The trouble is they may not succeed - not the way things are looking. Add to this the already existent computer market problems with the Dow last week, and signs of market illiquidity, not only due to a lack of buyers, but by computer overloading….

We have just recently added email alerts to the Prudent Squirrel newsletter. I was originally going to charge extra for this, but so far this is being included to PS.

We cannot guarantee delivery of email alerts because the emails systems everywhere are spotty at times. And, on occasion some people might not get them from our end too.

So please understand that this email alert system is not guranteed. If you have any problems getting them, then let us know and we will attempt to find the problem. By far most people are getting them.
I do not do email alerts on a regular basis. They are only sent when things are happening that I foresee.

Copyright 2007
Christopher Laird
Editor
www.PrudentSquirrel.com

I grant subscribers the right to post up to 10% of any newsletter to their friends, as long as a link to www.PrudentSquirrel.com is included and credit is given to me.

Disclaimer Chris Laird is not an investment advisor and the newsletter is not investment advice, but commentary only.