Opinion on the Gold Market

In our opinion, the gold price is a measure of the level of perceived risk in the financial system. We think that risks to the financial system and financial asset valuations have probably never been higher but the market continues to disagree. We are therefore faced with a widening gap between our expectations for the gold price and where it actually trades. This past quarter was an especially brutal one for gold and gold stocks, which was not what we had anticipated. The market is always right in the short term, but we do not believe it is properly discounting systemic risks, just as it failed to do in early 2000 and early 2008.  

None of the fundamental reasons for our expectation of a higher gold price has changed. Our analysis of COMEX data strongly suggests that the short-term pricing of gold and gold stocks has been primarily driven by a for-profit cadre of traders who went aggressively short on the CME exchanges during a period of low volume, aiming for a break below the double bottom of June and December, 2013 in order to force liquidation of the metal and the shares. They were successful at engineering the break but it remains to be seen if they will be able to cover their shorts for a profit. GOFO rates have gone extremely negative in recent days, evidence of significant tightness in the physical gold market which could generate a rally.

Dollar strength

It is always useful to examine the bear case to see what has supported this move lower in gold. The prime argument has been that a stronger US dollar means a lower gold price. The trade-weighted US dollar index has gone up nearly 9% since the end of June, 2014, meaning it has risen against other major currencies. Or, you could say that those currencies have weakened against the dollar. This is a dubious distinction given the terrible performance of the Eurozone and Japan, the two most important other currencies in the index. More persuasive is that the dollar is up in real terms-about 30% higher against a basket of commodities since the end of April, 2014. The financial media and the markets have simplistically interpreted this performance as benign and certain to continue. After all, the oil price is down and that's good for US consumers!

The latest US trade data already shows that the dollar is depressing US exports and America's largest corporations are beginning to revise down their foreign earnings estimates (nearly half of the sales of S&P 500 companies are non-US). But that is only the beginning of the negative consequences from a rise in the value of the world's reserve currency.

In our view, a rising dollar adds substantial short-term risk to the financial system. For example, emerging markets have borrowed an estimated $3 trillion in dollar-denominated debt, not including China. In recent years, the Federal Reserve's QE (Quantitative Easing) and ZIRP (Zero Interest Rate Policy) unleashed an international torrent of dollars in search of yield, much of it ultimately going into shallow, illiquid markets dependent on higher commodity prices. Now, emerging market economies are slowing along with the rest of the world and some major countries like Brazil appear to be entering recession. Meanwhile, the Fed has ended QE and is threatening to end ZIRP. Emerging market equity, debt and currency markets are under pressure as international investors try to liquidate and repatriate their dollars. The risks of default are rising, which supports the outlook for gold just as the Euro debt crisis did in 2011.

Pick your poison

Analyzing the gold price does not tell you much about the future of the gold price, in our opinion. You have to look at other markets. Gold moves inversely to financial assets, making it the best available hedge against the risks in financial markets. In our view, there are many risks to choose from, the most important being equity valuations.

The chart below, produced by John Hussman of Hussman Funds, shows measures that have a strong historical relationship (correlation near 90%) with subsequent 10-year S&P 500 total returns. The data is from the Federal Reserve, Standard & Poor's and Robert Shiller. As Hussman notes, it's easy to lose sight of the extreme nature of the present situation, but these measures are well over 100% above their historic norms. On the most reliable measures, S&P 500 valuations are now within about 15-20% of the 2000 extremes, and are clearly above every other extreme in history including 1901, 1929, 1937, 1972, 1987, and 2007. This is what risk looks like.

Earnings are being driven by debt-financed share buybacks and take-overs, not organic growth. Leverage continues to grow. Share buybacks in the past 12 months for the S&P 500 have totaled 95% of earnings.

Gold bears declare that gold is down in part because of the end of QE. But QE did not go into the gold market the last few years, it went into the stock market and now this market has lost its most important source of new fuel. In our view, that's why volatility has increased and equities have begun to struggle. The major indices still look strong in the US, but underneath, the average stock is down sharply. A real bull market is characterized by a synchronous rise in all major indices and broad participation by a majority of stocks. In our view, what we have now is a speculative bubble, not a bull market, driven by monetary policy-cheap, plentiful credit-not earnings growth based on savings and investment. We believe that there is a significant risk of another stock market crash similar to 2000 and 2008, with the same result for gold...a substantial
move higher.

Still waiting for the US recovery

The dominant narrative among investors remains that the US economy leads the world and that it is just about to enter a period of accelerated growth. The Fed and Wall Street have started every year for the past five with confident predictions of "escape velocity" and every year the projections have been marked down. Every year, we have said in these pages that the recovery is an illusion. There are basic contradictions in the data that are being ignored. The most important economic indicators of economic progress remain increases in employment and wage income and the data is far from indicating recovery, much less acceleration. We offer the following evidence from Jeffrey P. Snider (Alhambra, Nov 7, 2014):

If we have robust job growth resulting in less slack in labor markets, as the Fed says, how is it that labor incomes are so unresponsive? And how is it possible that over the past 25 months, only 771,000 have joined the labor force out of 4.7 million who qualify as new members? This is not a reflection of changing demographics as baby boomers retire. These are adult civilians under the age of 55 who are choosing not to look for work. Worse, the labor force is essentially unchanged since the snow stopped this year, which is decidedly not what should have taken place if the economy had been depressed by the weather and had finally shifted toward that elusive recovery which the Fed continues to claim.

We remain unrepentantly bullish

In our view, QE has not ushered in an economic recovery but rather a stock market bubble that has pushed valuations well past the danger point. As QE has come to an end, foolishly high asset valuations are coming under threat because they depend on cheap plentiful liquidity from the Fed, not economic growth and real corporate performance. We expect 'discontinuous market pricing events' to bring down valuations and increase the perception of risk. And we anticipate that the Fed will be back with more QE to ease the pain, but this time it will be seen not as an effective economic elixir but as a desperate measure to keep the system together. That is our scenario for a higher gold price and we do not think it will be long in the making.

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