They say a picture is worth 1,000 words. This picture happens to be worth a 50-something-page essay, but for your sake, and mine, we will keep this to couple prevalent issues.

Note that this chart, courtesy of Kitco, is of Friday A.M. trading; the end of another amazingly volatile week for global equities.

The Carry Trade

The first item of importance is the column labeled Chg% x = 1$USD, or the percent change in each particular currency compared to the USD. Besides the loony, which is trading up because it got whacked on Thursday, the only two currencies showing strength are the Japanese Yen and Swiss Franc.

These are the carry trade currencies. Essentially investors borrow the Yen and Franc at ultra-low interest rates and invest them abroad in higher yielding assets. To make these trades profitable, the Yen and Franc have to trade even or lower against the currency that denominates their higher yielding interests.

A common denominator, first brought to my attention during the February sell off, is the out performance of the Franc and the Yen against other major currencies of the world during major equities sell offs. This signifies, that the carry trader are forced to sell his/her assets, buy Yen or Franc, and repay the initial loan, hence causing strength in the Yen and Franc.

Also, if a carry trader’s profits turn negative due to market volatility, they will be forced to liquidate their position and pay back their loan at a loss…sometimes a hefty loss. This also causes strength in the carry trade currencies.

It’s hard to say if a strong Yen/Franc causes carry traders to liquidate their equities, bringing about market woes and a stronger Yen/Franc… Or if market volatility forces these same traders to sell, cut their losses and buy back the Yen and Franc to pay back their loans.

It’s similar to the question of what came first, the chicken or the egg? In the case of the carry trade, I believe it’s actually both, and it’s easy to see the snowball effect created. Look for these currencies to strengthen further. This will be both a result and a cause of future market volatility.

The eventual unwinding of the carry trade, among other factors such as subprime concerns and credit woes, will rip liquidity from the markets, pushing along the bear market in equities.

So where do investors turn?

Got Gold?

The second item of importance to note is that gold is trading up in EVERY major currency in the world. This comes as a flight to quality during market volatility, and if you ask us gold bugs, it is long overdue.

Around the gold watering hole, investors believe a true bull market in the yellow metal must be a GLOBAL bull market. As you can see from the chart at the beginning of this piece, this definitely holds true.

One thing that immediately drew me to the gold market is that it’s not a basic commodity, and it’s not a currency either. It’s a hybrid between the two.

Now I read several gold articles and newsletters every day. I hear opinions from way opposite spectrums.

On one side, you have a gold bug that feels the yellow metal has completely decupled from its inverse relationship with the dollar. This type of gold bull believes that the only thing pushing the gold bull market forward is supply and demand fundamentals.

On the other side, you have an individual that believes gold to be the ultimate inflation hedge, and that the only thing that matters is the value of the currency going forward.

It’s a simple notion. If you lived in Zimbabwe, where inflation is running at several thousand percent, you would definitely feel like gold is in a bull market. What if, at the same time, the Yen is going through a period of deflation and the price of gold is declining?

This is why to accurately judge a TRUE local bull market, you have to look at the supply and demand fundamentals.

What the supply and demand fundamentals do is give us a judge of mine production and the supply of gold from central banks. This will affect the price of gold in every currency of the world.

According to GFMS, global mine production in 2006 was 2,471 tonnes. A decade earlier, mine production was 4,127 tonnes. During both these periods, even with the change in tonnage, mine supply made up roughly 60% of total supply. A country like South Africa, which has historically produced a very extensive amount of gold, has a mine production level at a 22-year low.

And for demand, look at the ETFs from 2004. These have greatly increased the demand for gold and in 2006 ETF gold holdings have more than doubled their holdings since 2004.

That’s it for how the global bull market is shaping up. But, what does that mean to you?

Well there are small-cap plays in all of this. In fact, these are the best ways to profit from a bull market like this. More on that tomorrow…

Until then,
Nick Jones
August 13, 2007

P.S.: The best way to exploit an opportunity like this is to find a “special situation” stock that allows you to leverage a bull market for even higher gains. My fellow editor, Chris Mayer, does exactly this.

Penny Sleuth Contributor

The Penny Sleuth also features commentary by other financial analysts, small-cap experts, investment gurus and an array of contributors from various fields and occupations. Their diverse insights and contrarian investing ideas are hand selected by the Penny Sleuth editors.

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