Death Of The Gold Bull Market?
Is it time to start dumping your holdings in gold? Has the turning point finally arrived? According to the Financial Times this past week that answer is a “yes”.
"Investors are losing their enthusiasm for gold as signs of improvement in the US economy tempt them away from the traditional haven.
Interest in gold has surged in the past ten years, as prices have risen more than sevenfold from just $253 in 2001 to a peak of nearly $2,000 last year. But investors have become more wary about putting fresh money into the metal ... according to some bankers. Gold prices have already dropped 9 per cent since late February, on Thursday hitting a 10-week low of $1,627.68.”
Here is the key sentence:
“With the US economy showing signs of recovering and fears about the eurozone sovereign debt crisis easing, investors are putting their money into equities and other assets geared towards economic growth rather than havens such as gold. The US Mint's sales of American Eagle gold coins, seen as a good indicator ... fell in February and March to their lowest level since mid-2008, down about 70 per cent from last year. Open interest in gold futures on Comex in New York is close to a 2½-year low."
This is an important point because IF the economy has turned the corner, and the fears do ease, then gold, which has always been a “fear” based trade, will lose its appeal as an investment alternative. This is something that I have discussed many times in the past.
Gold has been chased over the last decade out of fear, greed and speculation. Gold, as a metal, has some commercial uses but no real underlying value as a currency. You can’t go to the store and buy things with it, it provides no income stream, and is solely a bet on someone willing to pay you more for it in the future.
There was a time when gold was a currency, or, it backed a currency. Gold has been used to bribe border guards to escape oppression and war. Gold is still coveted highly in some countries, like India and China, as a show of wealth and status. I am not discounting any of those current and historical issues.
However, when it comes to the United States, gold is a commodity and, as such, it is a speculative investment at best. As investors, therefore, the only VALUE it has is that we can buy it at one price and then sell it, hopefully, at a higher price. Therefore, we have to understand the principles, both fundamentally and technically, that drive the price.
Everything in the universe has an ebb and flow to it. Whether it is the seasons, life, economies, investments or the ocean – they all contain cycles both short and long. Gold, like the stock and bond markets, has short term (cyclical) cycles and long term (secular) cycles. What is important for investors, and where the Financial Times misses the mark, is understanding the difference between the two. The chart shows these cycles more clearly on an inflation adjusted basis.
The first note is the S&P 500. When you look at the index on an inflation adjusted basis you can see how dismal returns have been over the last 12 years. No wonder that individuals are giving up on the stock market.
During periods of geopolitical stress, rising inflation and weak stock markets - investors have turned to gold as a “safe haven”. During the secular bear market of the 60’s and 70’s as we battled with Vietnam, Iran, spiking inflation and oil prices and a weak market – gold was the investment of choice.
The chart shows the Dow versus interest rates, Fed funds, inflation, P/E’s and dividend yield. As you will see the period began with low interest rates, inflation and dividend yields and high valuations. By the end of the 70’s, after three nasty bear markets and a negative rate of return over an 18 year period, the inverse of each had been reached. As a consequence - gold had risen sharply during this period as an offset for all of those inherent risks.
Note: Pay attention to these points as there is a test in a moment.
As the 1980 Presidential election came into view - the world, as far as the average American was concerned, was a disaster. As Reagan entered office he embarked upon his plan to break the back of inflation, increase employment and improve the economy. Through massive deficit spending programs, tax reform, deregulation and policies – the economic underpinnings began to improve.
As shown in the chart – the economic revival period began with stocks traded at a trailing P/E near 9, dividend yields were approaching 6% and inflation and interest rates were beginning to fall reducing input costs and increasing profit margins. Those fundamentals, combined with the greatest increase in debt in history, set the stage for what was to come.
Over the next 18 years the world would experience the greatest financial market boom in history. The fundamental backdrop, combined with what appeared to be a booming economy, gave investors every incentive to move assets into the financial markets and out of the safety of gold. As a consequence gold prices plunged.
Unfortunately, all good things must come to an end. While the media and investors believed the good times would last forever - in 2000 we began talking and writing about the coming secular bear market.
At the end of 1999 stocks were trading at a whopping 42x earnings, dividend yields had plunged to under 2% and interest rates had fallen to levels not seen since the mid-60’s. The stage was once again set for the return of the next gold bull market.
From 2000 to present, gold has once again become an asset class of choice as the world has been engulfed in the secular bear market. The buildup of debt, destruction of savings, and lax credit and monetary policies has now met their inevitable conclusions. The problem is that today exponential credit creation can no longer be sustained. The process of a “credit contraction” which will continue to occur in fits and starts over a long period of time as consumers, and the government, are ultimately forced to deal with the leverage and deficits.
The good news is that process of "clearing" the market will eventually allow resources to be reallocated back towards more efficient uses and the economy will begin to grow again at more sustainable and organic rates.
Of course, after 12 years of the secular bear market and counting, all of this brings to mind the most important question. It is the same question that I get whenever I travel with my lovely wife and four wonderful kids. We generally have not gotten much further than the end of our block before a tiny voice from the back asks: “Are we there yet?”.
“Are we there yet?” How you answer the following questions should very much determine how you are invested with your hard earned savings today.
As the FT correctly stated, if the economy is indeed turning for the better then gold will have likely seen its peak. However, is that the case?
Let’s review where we are today.
- Are the ingredients necessary to launch the next great secular bull market in place today?
- Are interest rates and inflation in a position to boost the profitability of corporations in the future?
- Are valuations truly at a level - based on real trailing GAAP reported earnings - that would promote long term rises in stock prices?
- Based on the data points above does the current environment look more like 1962 or 1982?
- If dividends rise back to more normalized levels will increasing dividends, which reduces profits, help or hinder market returns in the future?
As we discussed this past week in our post “The Fly In Ryan’s Budget Ointment” the current economy requires $4 of debt for every $1 of GDP.
“The time to implement austerity measures is when you are running a budget surplus and are close to full employment. That time was two Administrations ago when the economy would have slowed but could have absorbed and adjusted to the measures. However, when things are good, no one wants to ‘fix what isn't broken’.
The problem today is that with a high dependency on government support, high unemployment and near record budget deficits implementing austerity measures will only deter future economic growth, which is dependent on the very things that are in need of being ‘fixed’".
- Therefore, since increasing debt levels have financed economic growth, including the real estate market, over the past 30 years what is the future going to look like?
My views on the economic future are not bight and happy ones. For myself I cannot reconcile how we can honestly expect to return to 4% growth in the economy, and consequently a booming stock market, when the ingredients required to acheive that growth are simply not available. This point doesn’t even include the impact of the 70+ million baby boomers moving into retirement over the next 10 years.
As you know I am not a “Gold Bug”. I don’t have a stash of gold bullion sitting in a vault, a bunker full of guns, ammo and c-rations awaiting the end of civilization as we know it. I am not bashing those that do – it is just the simple reality that if the world collapses overnight, which it won’t, I have the personal skills, knowledge and physical ability to obtain what I need. Unless, of course, zombies are involved – then you just need to surround your house with treadmills.
In the real world, where we must actually live and function, it is much more important to allocate capital to those areas where money can be made. Our job, yours and mine, is to allocate capital in a manner to ensure that the money we have SAVED grows at a rate to sufficient to keep the future purchasing power parity of those dollars the same in the future. Period.
The problem with the FT article is that it extrapolates a short term correction into a change of economic and fundamental trends. Nothing could be further from the truth. However, this is the continued problem with the myopic analysis by the media that is looking for the next headline.
“Should I Buy Gold Now? In a one word answer…Are you kidding me – Gold has never been this overbought before and if you ever want to be the poster child of buying at the top – this is it.
Okay, not really a one word answer but here is my point. Gold is currently in what is known as a ‘Parabolic Spike’. These do not end well typically as it represents a ‘panic’ buying spree.
Therefore, if you currently OWN gold I would recommend beginning to take some profits in it.”
While the swings have been a bit broader than I originally expected the pattern has played out extremely closely.
Today, gold has worked off the extreme overbought condition from last summer. With gold currently very oversold on many metrics, and sitting on the long term trend line support, the risk/reward of owning gold here is favorable.
More importantly, the catalysts necessary to push buyers into gold are still very prevalent. The crisis in the Eurozone, while temporarily suppressed by a couple of trillion Euros of injections, has not been solved – merely postponed.
Domestically, the economy here has been supported by the warmest winter in 65 years which as skewed the underlying economic reports that adjust for seasonal conditions. We pointed this out in our post last week on “LEI – Slower Growth Of Growth”
“We can find further confirmation of weakness in the overall economy if we look at the ratio between the Conference Board's coincident and lagging indicators. This acts like a book-to-bill ratio for GDP. Currently, it is off of its peak by about 2% and at levels that have normally coincided with recessions in the economy.
While the current month to month data points are still indicative of growth - the concern is strength of that growth. With the underlying economy fragile and very susceptible to external shocks it will not take much to create a retrenchment. If this was truly not the case the Fed would not be holding the line at zero interest rates and floating hopes of continued asset purchases (QE) in the future.
Now with China slowing more rapidly than expected, and Europe continuing to slide, the ability for the U.S. to withstand that drag indefinitely is negligible. As the seasonal weather patterns return to normal ranges, along with the data skews, we will get a much better picture about where the economy currently stands. My bet is that the mainstream media is going to ‘unexpectedly’ disappointed”
Time To Buy Gold?
I have done my best today to lay out the case that gold, both technically and fundamentally, are in the right place for continued ownership, as well as, adding to existing or implementing new positions.
I am not recommending that you buy gold – that is a matter of personal choice and how you answered the personal self-test above. However, my personal belief is that gold has not lost its appeal just yet. With plenty of risks still prevalent, both globally and domestically, the “fear” trade is far from over. The psychological factors combined with the technical underpinnings are supportive of the fundamental overlay.
At some point in the future the economy WILL begin a strong and lasting recovery. Things will get better and gold will plunge in price. This is why I recommend owning investments in gold that can be liquidated at market price with a click of a button. Physical gold will be nearly impossible to liquidate when the panic sets in.
Of course, if zombies do show up, none of this really matters.