Stock Market Investors Fooled by Talk of Economic Recovery

By: Miles_Banner

What a week we’ve just witnessed. In 3 days the entire gains in equities in 2010 have been wiped out. The Dow, Nasdaq and S&P 500 all fell into the red for the year to date. The gold price dropped to its’ lowest in a month. And this all happened at a time when investor confidence had started the week at a 27 month high according to the VIX index…

The CBOE Volatility Index (VIX), also known as Wall Street’s fear gauge, is widely regarded as the best measure of investor confidence in equities. If you look at the chart below you can see that at the start of last week the VIX was at a 27 month low. This means that investors were less fearful of big falls in share prices… They were optimistic. The Investors Chronicle ran an article titled ‘Low volatility signals end to credit crunch’. People were beginning to believe in the recovery. A survey carried out by the Bank of America Merrill Lynch measured fund managers attitudes, it reported –

‘Fewer investors are protecting themselves against a fall in equities.’ And the head of European Equities strategy at BofA Merrill Lynch Global Research, Gary Baker was quoted as saying "This survey is one of the more bullish we have seen and suggests that investors buy into the idea that this recovery has legs,"

VIX index chart

But, as the chart points out, those legs are still standing on shaky foundations. In three days the VIX index shot up 55 percent, constituting its biggest three day jump in almost three years.

The FTSE 100 lost 32.11 points. The S&P 500 dropped 3.9 per cent. The markets experienced a huge volume of panic selling.

What happened?

Following an embarrassing defeat for the Democrats in Massachusetts, a state that has long been a liberal stronghold [click here to read the Less Obvious Consequences of the Massachusetts Election] Barak Obama attacked the US banks, promising reforms to curb the risk taking of bankers at Wall Street. Soon after, Ben Bernanke’s support for another term as the chairman of the Federal Reserve was under doubt which only added fuel to the spiralling sell off and the uncertainty in the markets.

Wall street and traders around the world reacted by pulling the rug from under the so-called recovery.

As we noted last week, the giant carry trade in the US dollar [see The Three Major Questions That Will Determine the Gold Price in 2010 ] has widely been used to fund the growth of higher yielding, riskier assets. This recent, sharp sell off and flight from risk has resulted in these assets being liquidated and a minor unwinding of this colossal carry trade. The dollar rebounded as a result of this and it’s identity as a risk averse holding. And, as we’ve noted before, a dollar rally isn’t good news for the gold price.

Last week’s gold price in US dollars

It, seems as a result of the carry trade, assets across the board suffered. But whilst gold was hit by a wave of short term selling it still managed to put the brakes on just under $1100. Monday’s trading will give us an indication of where we’re heading but signs were that bargain hunters were buying positions when the price dropped to anywhere near the $1080 mark.

Twice in the second half of December the gold price experienced similar falls to near $1080, but were quickly retraced higher.

The price would have to drop below $1000 and stay there for the long term picture to turn bearish. In this case we’d look to see if India, China and other central banks would look to add to their reserves [click here to see what events were happening when India bought 200 tonnes of gold in November 09 ].

This recent turn of events has woken people up to the real possibility that this credit crisis isn’t over. Now investors and market watchers the world over are asking is this a definitive market top that will lead to a resumption of the bearish trend? Has this been one giant bear market rally fuelled by an excess of liquidity in the system?

The evolution of this economic crisis has taken another twist. We’ll keep you up to date with what’s happening every week, continue reading us next week as we unravel the next moves in the markets and assess the impact for gold.

Digger
Gold Price Today

P.S Digger writes a weekly email analysing the gold price and the gold industry. Visit Digger at Gold Price Today (http://goldpricetoday.co.uk).

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