The Return of Ugly Goldilocks

So in the past few weeks, we’ve been beating the drum as to why gold is in the danger zone.
In today’s carnage we added to our precious metals-related shorts — FCX, silver, and a few other selected plays — as the bearish metals thesis plays out.
While we are not long-term bearish gold (in the long term we are neutral for now), the near term price action has been fairly compelling.
Regarding our “Gold looks terrible: clarifying thoughts” piece, Mercenary community member Luke writes in:
I am an “open minded” gold investor, so I loved the article; however, my concern is that the US Government cannot AFFORD to let interest rates rise at all or the government debt servicing will eat up all of their revenue. I agree with most of your points, and it would make sense that interest rates SHOULD rise shortly – but if that means unsustainable debt servicing, then don’t you think the Fed will do everything to fight an interest rate rise?
First off, good on you for being open-minded Luke. As we like to say, “Love your family — not your positions. Be loyal to your friends — not your trades.”

Your concerns about debt service issues are valid. The problem has to do with timeframes!
I believe it was Brian Gelber in Market Wizards who first pointed out the timeframe problem.
There are significant issues when it comes to pairing long-term fundamental factors with short to intermediate term moves. Simply put, you can’t trade weekly or monthly time frames off what could amount to a multi-year view!
Take the mother of all cases-in-point: Japan.
The land of the rising sun has a deadly serious “interest rate affordability” problem too. At some point, in relation to retirement demographics and spender-vs-saver calculus, Japan will experience “exploding debt dynamics” and the fiscal situation will collapse.
But here’s the rub: While that statement is true, it has been true for years!
Roughly speaking, the Japanese Goverment Bond (JGB) market is 95% supported by domestic savers. At some point the JGB market will hit “the end of the line” as Mrs. Watanabe crosses from saver to spender in her advancing age. When this happens, falling JGBs coupled with rising service costs will result in epic disaster… and the vaporization of the yen, as the BOJ is forced to “destroy the currency for the sake of the economy” (to paraphrase Von Mises’ biggest prophecy).
But WHEN will this happen? Heck, it could be happening right now (which is why we’re short yen). But it might not happen until 2013… or 2017… who really knows?
Getting back to U.S. fiscal issues: You may be correct that government debt service issues will eventually force the Fed to go “nuclear,” essentially vaporizing the dollar (by way of printing press) in an effort to monetize (stabilize) the bond market.
But again, when will this happen? There are duration risk and “can kicking” factors to consider. And what might gold do in the meantime?
Our central argument is not that the long-term gold bulls / dollar bears are necessarily wrong… but rather that gold could fall precipitously between here and there (even if they are right).
For trading and even investing — though far moreso the former — timing is critical, and must be factored into your convictions.
There is nothing wrong with making a conviction-based investment and holding through short-term adversity, if such is your style and temperament… as long as you can quantify the worst case adversity scenarios (in terms of unfavorable price action) and anticipate your reaction to them.
If you are truly committed to the long gold case, for example, you must quantify what that means in regard to near term “uncle points:”

• Will I still like my gold position if we go back to $1500 per ounce?

• Will I still like it if we go back to triple digits ($999 per ounce)?

Both outcomes are entirely theoretically possible, even if your long term forecast for U.S. government debt service issues turns out 100% correct.
(And the question of whether the debt service issue really is a bull factor for gold is a whole ‘nother can of worms, by the way — having to do with monetary theory — that we have discussed in past but will not get into here for the sake of time.)
Being traders and Soros-style fallibilists — always aware of our potential to be wrong — we embrace the virtues of flexibility, sticking to the mantra that “the small loss is the best loss” and taking a short bias to gold in the near term (always having the option to flip long later).
Ugly Goldilocks
The real problem with gold right now is a scenario in which the U.S. economy “recovers” at just enough pace for inflation to remain low and stimulus to be withdrawn.
This is the “ugly goldilocks” scenario — one in which things are muddling along, but the poor position of middle class consumers, stubbornly high unemployment and stagnant wages keep inflation concerns in check.
Consider the following headlines, which together paint a very ominous picture:

• U.S. Economy Enters Sweet Spot as China Slows (Bloomberg)
• Car sales surge as recovery gains steam (Reuters)
• Fed turns down volume on stimulus talk (YF/Reuters)
  

You see the picture that paints?
The average situation for Joe Sixpack sucks and Wall Street knows it. But middle class pain is also reining in “core” inflation — not including food and gas prices, of course, but the Fed doesn’t care about those.
This results in a positive equity, “abandon gold” scenario where, once again, the imminent inflation and fiscal destruction is put on Japan-style hold. (Did I mention that bets against the Japanese government bond market have been going sour for so long, they call it “the widowmaker” trade?)
Goldilocks could whack equities too
As this note is being written, live trades executing in the background, the S&P is seeing its most meaningful correction in a while (down a little over 1% as I type).
This speaks to another irony — the same hole that gold has fallen into could suck in equities too. It works more or less like this:

• Ongoing Federal Reserve stimulus has led investors to believe Ben Bernanke is their savior and friend.

• But the Federal Reserve’s main goals are to 1) protect and enrich the banks and 2) stabilize the economy.

• The banks are doing ok now (seen the share prices for WFC, BAC and C?) and the economy appears to be stabilizing.

• These conditions naturally lead to potential “stimulus withdrawal” of the sort that could lead to a Wall Street temper tantrum.

The above, in fact, is what Tuesday’s action was all about.
Now, it may be that Bernanke reverses position and starts talking “QE3″ again — sooth saying the market — IF general economic conditions deteriorate.
But if general U.S. economic conditions do NOT deteriorate — if “ugly goldilocks” continues apace — then we could actually see the stock market correct meaningfully! In this scenario, good news (for the economy) is bad news (for the stock market) due to stimulus withdrawal.
And also bad news for bonds…
“Trade of the Year” Candidates
If you’ll forgive an uncharacteristic bit of horn tooting, on February 14th we wrote “Long bonds and Yen: Big Shorts for 2012?” We put our money (trading capital) where our mouth is on both of those positions, to good result.
Then, on March 30th, yours truly tweeted the following:
http://stks.co/39XI If you want to hop on the bearish long bond train, this may be your chance…
We took that opportunity to agressively pyramid our existing TBT position. You see what happened next…

CLICK TO ENLARGE
Furthermore, on March 20th we tweeted the following:
http://stks.co/2xcJ Short Aussie could be one of the biggest trades of the year on global growth fade
And you can see how that one is going:

CLICK TO ENLARGE
What’s the moral here? Follow our tweet streams?
Better yet, follow the Mercenary Live Feed. That’s where we tell you what we’re thinking and why, every day, and share our real-capital trade executions, along with position size metrics and portfolio composition, in real time.
Look, there is no crystal ball at Mercenary headquarters. We get our share of stuff wrong. But that’s the whole idea behind the trading game… when you are wrong keep it small… “the small loss is the best loss.”
Then keep your eyes open.. look for opportunities to ramp up exposure in premium situations as they unfold… and know how to dial it up when Mr. Market tips his hand.
By the way, we love questions and comments in respect to market action, themes and trends, economic theory etc… in addition to discussion points, some of you have even forwarded your own trading theories and high quality research pieces, which we love.
This kind of interaction is what the Mercenary community is all about. Write to us! You can ping us directly via jack@, mike@ or nathan@, or general purpose via feedback@mercenarytrader.com.
funny old world innit,
JS