Why Gold Markets Went One Way and US Stocks the Other

Congratulations to the S&P500…another record closing high on Friday! The financial media loves round numbers, and the big US stock market index obliged by closing at 1,900.53. It didn’t quite take out the intra-day high reached earlier this month, but a few words from Janet Yellen should do the trick.

Closer to home, the going isn’t as easy. Japan’s Nikkei is down 12% this year and Hong Kong’s Hang Seng index is down 1.5%. According to the Wall Street Journal, investor interest in these markets is tepid:

In Tokyo, stock-trading volume has fallen each month this year, while in Sydney turnover remains more than 30% short of its monthly average with a week to go in May. In Hong Kong, turnover is also running below average 2013 levels and set for a monthly drop. The three markets are Asia’s biggest excluding mainland China, which is largely closed to foreign investors.’

Perhaps it’s the lure of the ‘resilient’ US market that is seeing investors turn away from the Asian region? We think it has more to do with the Fed’s ‘taper’, which began in December last year. As the US Federal Reserve winds down its quantitative easing (QE) program, global liquidity slowly dries up.

While it’s true the Fed is still injecting US$45 billion per month in additional liquidity, it’s down from the US$85 billion monthly rate of late 2013. They are slowly turning the tap off.  As we wrote to our subscribers last week, if the Fed keeps reducing QE at its next few meetings, by July there will likely be a liquidity deficit in the US market too.

Why? We won’t go into the detail, but it has to do with the funding of the US current account deficit and the drop off of net foreign capital flowing into the US over the past six months. The US Federal Reserve is funding US deficits! QE withdrawal is impacting markets peripheral to the US now, but within a few months the impact will flow through to the big US markets.

In fact, the impact has already started. You’re just not seeing it in the big indices. But there is weakness elsewhere. The Russell 2000 (small cap index) and the Nasdaq (tech index) are both well off their highs, which suggests to us the nascent effect of tighter liquidity at work.

What about the gold market… it’s been pretty quiet there lately. Well, we think you’re about to see some fireworks in the sector. We sent the following chart around the office on Friday and asked whether the next move in gold was likely to be up or down.

Gold — ready for a big move…

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click to enlarge

As you can see in the chart, over the past month or so gold has traded in an ever narrowing range. These trading patterns do not persist for long, and very soon you’re going to see gold move violently out of that range. It’s either going to surge higher or plunger lower.

So we asked some of the people in the office for their thoughts. The votes came back. Eight people said gold would head lower and four thought the next move would be higher. Hmmm…

In recent weeks, we’ve read commentary from a number of investment banks predicting the next move in gold would be down. There are not (m)any predicting a move higher. The majority of people at Markets and Money HQ reckon the price is going lower…and these folks are generally bullish!

Nearly three years of a relentless bear market has completely demoralised sentiment. Very few can see light at the end of the tunnel. Most just see another train coming. For many, the path of least resistance is down.

Here’s another chart we sent to our colleagues last week. It shows the S&P500 (blue line) versus the gold miners index. For most of the time (the chart starts in 2005) gold equities pretty much tracked the S&P500 — there was a high level of correlation.

Massive divergence between gold and stocks

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click to enlarge

But the correlation ended violently around September 2012. Gold tanked and equities soared.

What happened?

Our guess is this was when the market latched on to the narrative of the central banker as monetary hero and chief risk underwriter. In other words, investors (read hedge funds) realised that the world’s central bankers were basically telling them to take on risk…to buy, buy, buy and don’t worry about the repercussions, because they would be there to sort it out if anything went wrong.

Why at that time?

Well, in July 2012 ECB Chief Mario Draghi told the world he would do whatever it takes to save the Euro. This was code to stop shorting Italian/Spanish/Greek/Portuguese bonds and start buying them. Then Japan’s Abe came out and launched ‘Abenomics’, an economic plan to fast track Japan’s demise, which in the meantime gifted torrents of liquidity to global speculators.

And in September 2012, Ben Bernanke (now scoring around US$400,000 a pop on the talking circuit…getting back a small fraction of what he gave to the investment banks during his tenure) launched another round of QE.

Taken together, this was a powerful signal from the world’s largest monetary authorities. Global speculators responded by selling insurance (gold) and buying risk (the S&P500). That trade produced the wild divergence you see in the chart above.

So the question is, does the divergence continue or began to narrow? We guess narrow. Gold is so beaten down and out of favour, and the S&P500 is so proud and popular, that the balance is completely out of whack.

We’re not sure what the catalyst will be to end the divergence, but the way the world is looking today, there is no shortage of candidates.

Regards,

Greg Canavan+
for The Markets and Money Australia

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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