3 Windows on Risk Appetite: Stocks, Gold, the Dollar

The surprising jobs data last Friday gave us a not-so-shocking reaction in all risk trades, as expectations about the first interest rate hike were moved in investors’ minds from “not for a long while” to “sooner than I thought.”

I thought I would look at three areas of investment and risk-taking to give us an idea of what we might expect for the next few weeks as the implications of this much greater than “jobless” recovery are reevaluated.

1) Stocks Stalling

I said four weeks ago that I thought the S&P 500 would remain “sticky” around 1,100. But that was based on a trading range between 1,060 and 1,160 as I thought we’d see a nice rally and then pull back. Since then, the market has gone absolutely nowhere, making my prediction look like a severe understatement.

And market leadership is faltering. We saw Goldman Sachs (GS) give up the charge and not make new highs with the broad market in the second week of November. Now Apple (AAPL) has tired and resigned its leadership role, closing below its 50-day moving average last week.

The Wall Street Journal this morning showed some great snapshots of this “tortoise and hare” market since the March lows that highlight another change in returns. Small and medium-size stocks outperformed large caps by 30 percentage points up to October, but since then, the S&P 400 and Russell 2000 indexes have lagged the Dow Jones Industrial Average. Their research suggests that this is a sign of a maturing bull market.

2) Gold Falling

The correction in gold was not surprising and all we needed was a catalyst like a bullish jobs number to get the take-profits train rolling. As I wrote here on Friday, I expect the gold bull to continue after some decent back-and-fill trade between $1,100 and $1,150. The extent of excessive speculation in this market will determine how close we come to strong support at $1,050.

What is worrisome is how professional investors are reacting to the mining stocks as investments here. Many of the big-name gold equities were down 7-9% and two downgrades of Barrick Gold (ABX) in as many days make me wonder if there is going to be a disconnect between the miners’ earnings and the price of gold in 2010. Thomas Weisel cut ABX from “Overweight” to “Market Weight” on Friday and Credit Suisse reduced their rating from “Outperform” to “Neutral” today.

Both firms noted uncertainty for the company’s shares based on a U.S. Appeals Court ruling in San Francisco concerning environmental issues at Barrick’s Cortez Hills project in Nevada. So, this raises another issue for mining stocks that may add weakness to the picture of an industry group so dependent on the price of a single commodity. In fact, gold producers’ fates may be more tied their natural resource than oil producers’ are to theirs.

3) Dollar Carry Trade Reversing?

The dollar is the current “funding currency of choice” for all types of carry trades—stocks, commodities, other currencies. As I described here in September in articles such as The FX Carry Trade and Currency Carry = Interest Arbitrage, a stable or widening interest rate gap fuels carry trades. In other words, if you know you can borrow cheaply for an extended period and invest in things with rising yields and bull trends, you have a significant edge in the trade.

When Friday’s job report woke up anyone who was planning on near-zero rates for dollars well into next year, the scramble was on to take profits. For others who just got in to these trades a little too late, they were running scared to get out, even if they didn’t understand what was going on, i.e., that the market was reacting to the new possibility of interest rates moving higher much sooner than expected.

Does this mean the U.S. dollar carry trade is over and we’ve seen the dollar bottom? Not exactly. The “big and smart” money moves the carry trade. Large institutions with big war chests take big stabs at all kinds of carry trades, in all geographies, currencies, and time frames. So, the big guys were certainly taking profits on Friday in gold (and gold stocks) and in euros and Aussie, maybe even piling in for a short-term short trade. But in the big picture, they are not done with this carry trade because they likely still think the Fed is going to remain on hold with interest rates in the first half of 2010.

Bloomberg even carried a short note this morning confirming this from the likes of JP Morgan, where they say that Friday’s jobs report actually “justifies buying risk” in other currencies versus the dollar. Here is the full quote from Bloomberg reporter Anna Rascouet:

“Payrolls validates dollar shorts versus all currencies but the Japanese yen,” a team of analysts led by John Normand, head of global currency strategy in London, wrote in a research note dated Dec. 4. “Even before payrolls, the speed with which Dubai faded from headlines suggested a certain global resilience.”

The big and smart money is playing the dollar carry trade from all angles and time frames. There is too much left in it to let it go this soon, especially since the Fed won’t even be near still “accommodative” levels of interest rates—such as 2%—for at least another year. After the weak hands are flushed out of this temporary reversal in the dollar, the big players will be positioned for the next leg up in stocks, gold, and currencies.

“Mind the Risk, Bank the Profits!”