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'Go long on precious metals'

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May 20, 2006 14:28 IST

American traders refer to the Chicago Board of Options Exchange Volatility Index (the Cboe's VIX) as the fear gauge of the US markets. The CBOE looks at the premiums of outstanding puts and calls on the S&P 500 index to derive a weighted average of implied volatility.

Stripped of mathematical jugglery, the concept is simple. Premiums are influenced by expectations of volatility (the IV) during the life of the option.

If IV is high with respect to actual historic volatility, the market is jittery and vice-versa.

In practice, the VIX has been negatively correlated to actual index movements since 1986 through dozens of key market reversals (VIX was introduced in 1993 and recalculated in 2002 and back-calculated till 1986). When prices are near the bottom, VIX tends to be high due to panic. It is usually low due to complacency when prices are topping out.

What's scary is that the VIX is close to historic lows now. If history is repeated, a big crash is due in the US stock market. US bond market behaviour (yields are rising after a recent Fed hike and expected to rise further) and forex behaviour (the dollar has weakened despite the aforementioned hike) reinforces this expectation. It may be only a matter of time before US stock markets follow the plunging dollar.

This was a partial explanation for the crash across emerging markets. Another reason was hedge fund selloffs in the metals markets and in metal stocks.

This may have been caused by a mixture of profit-taking and nervousness. A third reason was margin calls once prices dipped below key levels. A fourth in India was the announcement of new norms that could affect FII tax incidence.

As in most places, the selloff in India hit metals especially hard. Speculators drove up metal prices in February on higher projections of Chinese consumption. They've sold off now that it appears those estimates were over-optimistic. Most metal stocks are down by near 20 per cent in the last week.

Has the reaction been exaggerated enough to make base metals (and metal-producing stocks) worth buying on the rebound? Opinions are sharply divided. Some highly respected fund houses expect further deflation of the base metal bubble. Other, equally-respected houses opine that demand driven by India and China will ultimately pull prices up from current levels.

You could toss a coin. Further short-term volatility is guaranteed and metal prices could move in either direction given the lack of consensus. You may find another way to resolve this argument though and one that attempts to exploit base metal volatility with less risk.

Ignore base metals and go long on precious metals. There is fear apparent across global currency markets and an expectation that crude prices will stay high driving up global inflation.

That fear is the perfect recipe for gold bugs to prosper. It has already pushed precious metals to 25-year tops. Dips on Monday and Tuesday were followed by renewed buying on Wednesday.

If base metals recover and the asset bubble continues, gold and silver will continue to gain ground. If base metals collapse again and inflation fears get stronger, precious metals will again gain ground.

If the US stock market collapses, or the dollar drops, precious metals will once more gain ground. This bull run would halt only if inflation somehow cooled off and traders regained their equilibrium. That's unlikely at the moment.
Devangshu Datta