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The Herd of Lemmings, Part II

by: Graham Summers August 12, 2008 | about stocks: DIA / ERO / GLD / QQQQ / SPY / UDN / UUP    

Graham Summers

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On Monday we discussed the trading patterns and investment relationships followed by hedge funds and other quick moving investment groups. Today we’re delving into how these relationships and herd mentality impacted the financial markets last Friday.

The first indication that Friday was an unusual trading day occurred when oil plunged after the eruption of the Georgia/ Russia conflict. Historically, oil has shot up during war or announcements of war—WW II, War in Iraq, etc.

However, this recent conflict created a situation that superseded the historic relationship between oil and war ...

It slammed the euro.

The euro has had an incredible run over the last five years, rising nearly 50% relative to the dollar. The situation had become overextended and needed to correct. It started to earlier in the month, when the Federal Reserve indicated it is not likely to cut interest rates again—thereby making the dollar more attractive—and the European Central Bank [ECB] indicated that it might have to cut interest rates—making the euro less attractive.

However, it was the announcement of the Russia/ Georgia conflict that really pushed the euro off the ledge. When it did, traders—and I’m talking about billions and billions in capital—went wild plowing into the dollar.

As I mentioned in Monday’s essay, traders and trading models all follow certain basic relationships between investment classes. For a quick review, these relationships are:

  • The euro and the dollar are inversely correlated
  • The dollar and commodities are inversely correlated.
  • Commodities and equities are inversely correlated.

So, when the euro plunged on Friday, traders went wild piling into the dollar. The buying frenzy pushed the dollar to a six month high. This in turn triggered a “sell commodities” signal, resulting in a massive sell off in the commodities markets—gold fell to test its May 2008 lows, oil broke down to $115, and agricultural commodities across the board got slammed.

Finally, seeing commodities plunge triggered the “buy stocks” signal and traders jumped into the equities markets with both feet, pushing the S&P 500 up 2.39%. The talking heads saw this and the plunge in oil and proclaimed, “the bull market is back in stocks and the commodity bubble has burst!”

They’re wrong. The whole debacle on Friday was the result of trading models being triggered worldwide due to the plunge in the euro. It was nothing more. The fundamental argument for owning the dollar has not improved, nor has the reason for owning US equities—when you remove big oil’s massive profits from the mix, corporate earnings, which drive bull markets, have plunged more than 26% in the last two quarters.

However, this whole situation has given us one blessing: the ability to buy gold at a low. Gold is now almost at its 2008 low. As the primary inflation hedge and catastrophe insurance, gold will be THE investment of choice for the remainder of 2008. We’re not anywhere near the end of the turmoil in financial markets—just look at AIG (AIG) and Freddie Mac’s (FRE) 2Q08 results for proof.


I’m buying gold now. And I’m not the only one.

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This article has 8 comments:

  •  
    Aug 12 04:50 PM
    My "gut" had been telling me the same thing. Nothing had changed fundamentally. Inflation still massive with more bailouts coming weekly. Unless you're in the market for a German car, I suppose.
    Reply
  •  
    Aug 12 05:59 PM
    Ditto. The fits going to hit the shan real quick. Ruskies are feeling their oats. The FEDs printing press is overheating. Waiting for $750 gold is like waiting for Condi and the Neocons to admit they don't know a damn thing about Russian geopolitics.
    Reply
  •  
    Aug 12 06:24 PM
    I'm staying long gold and energy.
    Reply
  •  
    Aug 12 08:04 PM
    Yes but... Crammer said the market has bottomed, Kudlow says we have a "Goldilocks" economy and Maria Bartiromo always manages to interview bullish portfolio managers who's livelihoods depend on a healthy market. What more do need to convince you that all is well? CNBC is a piece of immoral garbage and a big part of the cancer of greed and consumption that corrupts the US to it's core. I love how they are trying to fuel the greed needed to pump the market by airing half a dozen programs glorifying excess and conspicuous consumption. What a pathetic society!
    Reply
  •  
    Aug 12 08:23 PM
    The dollar's movement Friday does not explain gold's 15% decline from it's July's highs. Gold like other commodities is supply/demand driven. Investors are bailing out of all asset classes including gold. Many don't trust anything at the moment. Reduced demand will yield reduced prices on gold as well. Gold has no particular value of it's own, it is only worth what someone else is willing to pay for it at a particular time.
    Reply
  •  
    Aug 12 08:43 PM
    The trading model relationships did not hold up in 2005:

    "The euro and the dollar are inversely correlated" - YES
    "The dollar and commodities are inversely correlated" - NO
    "Commodities and equities are inversely correlated" - NO
    Reply
  •  
    Aug 13 02:22 PM
    The dollar is up because of central bank intervention purchases. Both gold and silver prices are being massively manipulated by the bullion banks shorting of COMEX futures contracts. Silver shorts by eight or fewer traders at the recent peak before silver "corrected" was 350 million ounces or about 7 month of mine output. But 14.00 on silver and 800 on gold are higher lows on the chart. When the need for financial calm caused by the Olympics is over I predict all Hell is going to break loose and both gold and silver will really shine.
    Reply
  •  
    Aug 13 02:24 PM
    Come on guys, we gotta have a bubble in something.
    Reply
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