Gold's Moving Parts: Bull Market Since New Year

The gold market has probably never had as many moving parts as it does today. There are many factors arguing for a much higher gold price in the current year and we believe that gold has commenced a new bull market since the New Year. We will note some of these bullish factors below. But the over-riding issue remains one of investor confidence in financial markets and the financial system. For this reason, gold and financial markets generally move in opposite directions over the long term, with one turning bearish as the other turns bullish.  

As we have consistently stated, if western investors think that risks to equities and bonds are low, if they think that central bank policies successfully back stop the upward trajectory of financial markets, they will have very little interest in buying or holding gold, and if that is so, the much celebrated migration of physical gold to patient hands in Asia, while important in the long term, is not likely to drive the near term gold price. In the short term, the hot money flows managed by the leveraged speculating community are large enough to set the terms for any market including gold. To understand the gold market in the short term, we believe we must understand the mindset of American and European money managers who have sold gold hard in the past two years.

The Risks Are Rising

In our view, the risks in financial markets are high and rising. Yes, the most important equity indices remain very close to all-time highs and the pricing of debt is certainly extraordinarily elevated by historic standards. But the hedge fund community is coming off a poor first quarter in performance terms, reflecting their extreme over-commitment to an equity juggernaut that appears, in our opinion, to be topping out. Is there much more room to run in financial assets? We think that financial markets are very close to a change in sentiment which, at current valuations, could well be catastrophic in its consequences and a powerful driver of gold.

Consider the evidence of risk. Junk debt is trading at the tightest spreads ever to top-rated sovereigns. Junk bond yields have fallen below 5.5% as both institutional and individual investors try to offset the effects of central bank zero interest rate policies. Reaching for yield has generated a huge increase in leverage.  So-called "covenant-lite" financing is back; these are leveraged loans to already highly indebted borrowers which lack the normal protections that mitigate losses in the event of default.

The deleveraging that was widely predicted after the 2008 meltdown was all too brief. Now, the $70 trillion global economy has debt of more than $100 trillion, up $30 trillion (more than 40%) from the mid-2007 peak. The rate of increase in debt is running at multiples of the GDP growth rate in every major economy including China. Corporate borrowings have soared but capital spending has been stagnant; the new money is largely dedicated to financial engineering--stock buy-backs (often at new highs), acquisitions and other devices that boost earnings per share rather than build new productive assets generating cash flows.

Meanwhile, the equity markets have begun to struggle. In a process reminiscent of previous market tops, the weakness has started among the high flyers on NASDAQ and the small caps, sectors where the valuations have moved the most and become the most over-extended. Market capitalization as a percentage of GDP has more than doubled to 145% since 2008, the highest reading since the all-time peak in 2000. As in the debt markets, leverage is the order of the day. Margin debt now stands at $466 billion according to the New York Stock Exchange, setting new records every month. But margin debt is only part of the story. The available cash in brokerage accounts is probably a more important figure. According to Jason Goepfert of SentimenTrader.com, investors' brokerage accounts currently have a ratio of margin debt to cash exceeding 100% for only the third time in history; margin debt now exceeds cash by $177 billion, more than the previous high of $129 billion in February 2000. At the same time, insider sales of stock are at record levels (except for gold stocks where insiders are net buyers).  Are these facts not evidence of a bubble, the third asset bubble created by monetary policy in the past 15 years?

Perhaps the most alarming development in the equity markets is the recent resurgence of IPOs. In the April edition of The High Tech Strategist, Fred Hickey reports that the number of new filings for IPOs in Q1 was only exceeded during the internet bubble of 2000 (source: Renaissance Capital), that 74% of the companies going public have no earnings, the highest level since March, 2000 (source: Jason Goepfert) and that IPO investors are paying a median average 14.5 times annual sales this year for new offerings compared to a multiple of six times sales at the 2007 peak (source: University of Florida professor Jay Ritter). This feels eerily like 2000 all over again, when gold bottomed and equities peaked.

Our point is that markets are risky and increasingly fragile. Central banks have generated excess liquidity and low interest rates that have fuelled speculation rather than investment while at the same time using forward guidance to continually reassure investors that there is no risk of tightening any time soon. These policies have created an immense moral hazard.

It's the QE, Really

Why is the equity market up so much? In our view, there is a consensus fairy tale that says that stocks are signaling an accelerated economic recovery in our immediate future. The fact that the Federal Reserve is now tapering their program of Quantitative Easing (buying assets with newly created cash) is seen as proof because they surely would not be removing stimulus if the economy were not in a strong and sustainable uptrend. In essence, this tale requires you to believe that (1) stocks deserve to be up on the merits of earnings and dividends alone and that (2) QE has strengthened the economy to the point where it is no longer needed.

David Rosenberg of Gluskin, Sheff has calculated that the correlation between the growth in Fed assets from QE and the surge in the S&P 500 since early 2009 is 90%. Is this coincidence? To illustrate this correlation, Ed Yardeni of Yardeni Research, Inc. has constructed the following chart which tells us what happens when the QE drug is injected and when it is removed.

Note that the S&P 500 rose 36.4% during QE1 which spanned from November 25, 2008 through the end of March 2010. The S&P 500 rose 10.2% during QE2 from November 3, 2010 through the end of June 2011. It rose much more, by 24.1%, if we start the clock on August 27, 2010 when Fed Chairman Ben Bernanke first hinted that a second round of quantitative easing was on the way. Operation Twist was announced on September 21, 2011 and the S&P 500 went up 15.9%.

But look at the the QE gaps. Between the end of QE1 and Bernanke's speech on August 27, 2010, the S&P 500 fell 9.0%. Between the end of QE2 and the beginning of Operation Twist, it fell 11.7%. This explains why the Fed has now adopted a policy of gradually tapering QE while at the same time making much happy talk about keeping short term rates low long after a return to stronger economic performance; the cold turkey approach taken at the end of QE1 and QE2 was too much of a shock.

The next chart from SentimenTrader demonstrates the immediate positive reaction to Fed announcements of policy initiatives; the effects clearly establish the market's addiction to QE. It is amazing to us that investors have been able to convince themselves that QE is something they no longer need.

Our sense is that: QE has fomented equity and debt bubbles; the Fed increasingly fears this (which it naturally denies); and that is why the Fed is moving to curtail QE. We believe: there is no accelerated economic recovery in the offing; the financial markets are up largely because of QE; investors are going to discover these facts this year; and the gradual reduction in QE (the so-called tapering) which is now in process is depriving financial markets of the very drug they require to continue to defy the gravity pull of a weak economy overburdened by unproductive debt. What makes this situation so dangerous is the combination of extreme valuations and immense leverage, all premised on the continuation of ultra-loose monetary conditions.

Prepare for a Taper of the Taper

The main proposition of the bear case for gold is that QE tapering will bring down the price. Our view is that tapering is increasing systemic risk and the proof is in the gold price, which is now rising as the taper proceeds. Tapering increases systemic risk because QE is now the primary source of money supply growth. Normally, bank lending creates the new money needed for system liquidity but bank lending has been moribund since the 2008 credit crisis. For highly leveraged markets to remain intact, the money supply must continue to grow at a rapid pace but, in fact, the rate of increase is slowing down to levels that have signaled past market dislocations including 2008. By tapering at this time, the Fed is playing with fire.

The bear case is that gold is an inflation hedge and there is no inflation (by which they mean price inflation). Our view is that where there is price inflation, such as China and India, there is a strong demand for gold, so, yes, gold is an inflation hedge in this sense and there is mounting evidence of price inflation in western countries as well. More importantly, the western central banks have made it very clear that higher inflation is needed to deal with debt burdens and they are determined to create it, under the guise of defeating the forces of deflation. The excessive liquidity central banks have created has gone into financial assets, not goods and services, but in falling markets it will seek other homes, including gold and other tangibles. In any case, gold is much more than an inflation hedge; it is also the ultimate protection against default and a loss of confidence.

The bear case says that rising real interest rates will drive gold lower (real interest rates being the rates after deducting estimated price inflation). Our view is that gold is money and the interest rates that matter for gold are therefore the short term rates that govern the flows of funds between currencies. These are the rates that central banks are vowing to keep at zero far into the future. Short term rates are very negative in real terms and therefore intensely positive for gold.

The markets currently expect the Fed to continue tapering QE at the current rate which would bring QE to an end by November of this year. We think otherwise. We expect that increased volatility in equity and debt markets over the next several months will lead to a correction of sufficient magnitude as to force a pause in the Fed's QE taper program. This pause could generate a short term rally in asset prices but we think real damage will have been done to the Fed's credibility. Markets will understand that although QE does not produce economic recoveries, it is nonetheless needed to keep all the balls in the air. We think investors will see that the Fed is trapped, the consensus fairy tale that has dominated financial markets will come to an end and gold will exceed its old highs, perhaps this year, driven by a change of speculative sentiment in the west.

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