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I hate to say it but I presently find myself buying into the whole doomsday scenario that seems to dominate the headlines these days. If indeed we have nothing to fear but fear itself, then consider me to be sufficientely frightened of fear. Forgive me. Several weeks back we moved to a new house in which I now have a nice first floor office. One night I went into the basement to setup my wireless connection. Long story short, Murphy (still) hates me and while I could get my computer to recognize the network I could not get the network (“hey knucklehead, here we are, go ahead, click the icon again, har, har”) to hook up to the Internet. Then I got too busy to mess with it anymore and couldn’t be without an Internet connection.

So during the entire week of the infamous October 2008 market meltdown instead of sitting in my nice new first floor office I was hunkered down in my basement with boxes stacked around me, my modem hardwired into my laptop. As I sat there alone in “the dungeon” and watched the red numbers cascade down my quote screen, it become something of a surreal scene. Every once in awhile my faithful golden retreiver Candy would come down and attempt to arouse me from my stupor by imbedding one of her toys into the side of my thigh. Also, one time the guy working on the chimney turned on the outside hose. The noise in the basement was so loud and so unexpected that for just a moment the only explanation my poor brain could muster was that the aliens actually were coming in for a landing in my back yard. And at the moment I was about ready to board the craft.

Eventually I staggered up the stairs to the first floor only to reach the top basement step and then recoil in horror at the bright sunlight shooting through the first floor. “Agh, the light” I intoned, hands outstreched, my head turned to the side. Then I turned and quickly scampered Quasimodo-like back down the stairs and into the abyss. So forgive me. I am definitely prone to seeing the “darker side” of things at the moment.

Anyway, the question on everyone’s mind at the present is, “is this Armagedon or is this an opportunity?”  I don’t claim to know the answer; however, I look at it this way. If it is Armagedon, what’s the difference? I’ll just stay down here in the basement. So we might as well look for opportunity. Please note I said “look for opportunity,” not “just assume the bottom is in and get wildy aggressive.”  Yes, Virginia, there is a difference. In any event, let’s take a look at some areas of potential opportunity.

GOLD STOCKS  

Gold stocks have been destroyed in the recent stock market decline. Chart 1 displays the ticker GDX which is an ETF that tracks stock of gold mining companies. Consider this just another blow to the “gold as a store of value in time of panic” theory (Kaeppel’s Corner: All That’s Golden Does Not Always Shine. 9/17/08).

Chart 1 – Gold stocks (GDX) plummet

All told, gold stocks have lost -62% since March. Ouch. And as a result, the vast majority of individuals will avert their eyes and say, “I think I’ll look at something else for awhile.”  However, please note that the Barron’s Gold Mining Index divided by the price of gold bullion (also known as the K-Ratio) has never been lower in the 33 plus years of data. The K-Katio essentially suggests that gold mining stocks are “oversold” or “undervalued” when it falls to 1.20 or below. As of 10/17/08 this ratio stood at a fairly stunning 0.76.

I’ve read in some places that hedge funds have been dumping gold stocks en masse, which may in part explain this massive expulsion of gold stocks. Of course I’ve also read that hedge funds are responsible for crude oil prices – er, wait, maybe it’s the oil companies that “control” that – the credit crisis, all of today’s societal ills plus, well, pretty much all that is wrong with the world today. Also that all hedge fund managers should have their wealth confiscated and be put in jail (Gee, I guess then the government will be running the hedge funds soon too – sounds like a great plan. I digress.).   

Chart 2 displays the Barron’s Gold Mining Index (GMI) and the price of gold bullion. If you look closely, you will notice that whenever the ratio narrows, gold stock invariably advances sharply.

Chart 2 – Gold stocks extremely cheap relative to gold bullion

So does this mean that a bottom in gold stocks is at hand? Is there any guarantee that this low will also be followed by a massive rally in gold and gold stocks? Sadly – and as always – the answers are “no” and “no." Still, there appears to be an opportunity here. All I know for sure is that I will not be too surprised if gold stocks experince a breathtaking advance in the not-too-terribly-distant future.

CLOSED-END FUNDS (CEF)

I can relate. Closed end funds are kind of like the Quasimodos of the stock market. They are out there in fource but tend to lurk in the shadows of most investor''s minds. Unlike an open end mutual fund or an exchange-traded fund – which trades at net asset value - closed end funds trade like shares of stock but do not necessarily trade at (or in this case, anywhere near) their net asset value. So a CEF can trade at a premium to NAV or at a discount. So for example, if a CEF has a net asset value of $10 a share but is presently trading at $9 a share, then it is trading at a discount of 10%. Most CEFs trade at a discount to NAV for the simple reason that there just isn’t much demand or interest for a lot of these things.

The hope of many first-time CEF investors is to buy a fund trading at a discount of say 20% and have it return to NAV. The truth is that this rarely happens. Nevertheless, as they say, “we live in interesting times” and every dog has its day. In the meltdown during the week of 10/10, closed-end funds basically – and I wish there were a more delicate way to say this but – “got puked."

A scan of the closed-end funds section of Barrons Financial Weekly that weekend revealed fund after fund after fund trading at a discount to NAV of 40% or more. To be clear, this meant that you could buy a fund holding assets worth $10 a share for just $6 a share. In addition, many bond related funds not only traded at massive discounts but were sporting current yields well in excess of 10% (please note that CEF yields are not guaranteed coupon payments).

Chart 3 displays a handful of CEFs that have been killed and which sported massive discounts to NAV (for the record, the ticker symbols for the funds displayed in Chart 3 are BQY, EDD, EVV, FF, RMR and WEA).

Chart 3 – Investors “puke” closed-end funds
Click here for larger view

I have no idea what some of these funds actually invest in (some are in stocks, some are in certain segments of the bond market, one is in real estate, etc.), so they are by no means “recommendations." But the point here is simply that when the investment world decides to divest itself so completely of a given asset class, the bell may be ringing.

The bad new is that you need to do a little homework on these funds before you buy them. It’s hard to tell from the name sometimes just exactly what some of these funds are up to. The other bad news is that CEFs rallied sharply last week so the bargain table may be a bit less crowded than before. Lastly don’t make the mistake of thinking that if a CEF is traded at a discount to NAV of 50%, that it will somehow magically “eliminate the discount” and suddenly double in price.

COMMODITIES

Harken back to a bygone time. George W. Bush was president, crude oil was on its way to $200 a barrel, gold was going to burst through the $1000 an ounce level, and the bulk of humanity was going to starve due to “soaring grain prices." Yes, it was, well, June of 2008 to be exact. Hmmmm. Wait a minute. The consensus was wrong. What do you know about that? It’s a funny thing about commodities and financial markets, isn’t it. They go to extremes, then they change course. Who knew?

Still, in the spirit of “wow, look at how badly that got killed, I wonder if there is an opportunity there,” cast your eyes upon the commodity related ETFs displayed in Chart 4.

Chart 4 – Commodity price collapse
Click here for larger view

The tickers in Chart 4 represent Agriculturals (DBA), Silver (SLV), Natural Gas (UNG), Crude Oil (USO), Copper (JJC) and Coal (KOL). Do you notice a particular trend or theme running through these charts?

So are commodity prices now going to turn around and start screaming higher again? Probably not. Typically after commodity markets experience a market decline they tend to consolidate – often within a very wide trading range – for a period of time. But again, the purpose here is not to predict anything. The purpose here is to spot opportunity and start tracking in some areas where a lot of people would normally not tread. The commodity based ETFs displayed in Chart 4 offer investors and traders the opportunity to trade commodities just like they would trade a stock.

SUMMARY

These are scary times, for many reasons. In the short run you have the collapse in stock prices, home prices, commodity prices and most recently bond prices. I have always been fond of saying “there’s always a bull market somewhere.”  Maybe I should modify “always” to read “usually.”  Beyond that, for those of us who are unfortunately not blissfully ignorant, there is great uncertainty, which the markets hate more than anything else. Have we seen the worst of the mortgage crisis? Will the government really be able to bail us out? Is having the government buying bank shares really a good idea? And just exactly how much of our wealth will need to be spread around before everyone is happy? Plenty to fear.

At the same time, the vast majority of indicators that I follow have recently hit their most extremely oversold reading in history. So if by chance we do not in fact swirl into the abyss, there is a better than even chance that we will look back on October 2008 as a buying opportunity.

Nevertheless, I think I’ll linger down here in the basement a bit longer. Hopefully someone will eventually bring me some food…

To search for previous articles written by Jay Kaeppel, please click here.


Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site 

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